10 Thing That Most People Should Know About Investing

10 things that most people do not know about investing

1. It has not been a “lost decade.”
Everything you’ve heard about this being a “lost decade” is not entirely true, at least not for everyone.  In fact, investors who bought a low cost stock and bond index fund did quite well.  The trouble occurs when investors use only one asset class to justify timing the market. Unfortunately for those who invested all of their assets in the S&P 500, it was a lost decade. A globally diversified portfolio with 100% stocks had an annualized return over 9%. Do not make the mistake of limiting yourself to a few asset classes.

2. “Good” companies can be a bad investment.
Companies like Chrysler, Lehman Brothers, World Com, General Motors, and Conseco are often thought to be great companies that will never have problems.  However, no one knows who the next Lehman Brothers will be. Resist the temptation of investing in large, popular companies based solely on the fact that they are large and popular. Do not get caught speculating on individual companies and don’t base your investment decisions on public sentiment alone.

3. Mutual fund out performance can be explained by luck, not skill.
The mutual fund industry has told us that it is smart to pay a star fund manager big money to pick stocks for you. This has been contradicted by the performance data showing that the vast majority of funds fall short of low cost index funds. Those mutual funds that did beat the market (about a third in most years) will not likely beat them next year or the year after.  Mutual fund companies have hundreds and sometimes over a thousand funds to guarantee that they will always have good performing funds to offer.  Consequently, investors get caught chasing returns and switching to the funds that have a presently good track record but lack consistency.  If outperformance is based on luck, there is no way to predict the next lucky fund. Investors should avoid actively managed mutual funds and build a globally diversified portfolio that is rebalanced with no stock picking involved and  a much lower cost.

4. Eliminate market timing from your portfolio.
Market timing is essentially an attempt at predicting the future. The future is marked with uncertainty and, for many investors, fear. If someone could tell you what is going to happen with inflation, long-term interest rates, share prices, and overseas markets, then there would be no fear.  So investors are often convinced that someone else has the information, power, and insight to forecast the future. Looking at the time period from January 1, 1990 to December 31, 2009 (5040 trading days), the S&P 500 return was approximately 8.2%. However if we remove the top 30 trading days, the return drops to almost 0.  Investors are more comfortable thinking that they make investment decisions based on logic; however it is typically emotions, such as loyalty, hope, greed, and fear that drive investment decisions. Dalbar, Inc. studies investor behavior and shows that while the S&P 500 had an 8.2% annualized return from 1990-2009, the average equity investor only received 3.17% because of market timing and speculation. Don’t let fear and fortune telling rule your investment strategy.

5. Past performance is no guarantee of future results.
The biggest mistake that I see investors make is looking to the past to see which investments or managers will do well in the future. Study after study has shown that using past data and hoping these investments or managers will continue to outperform the market is overwhelmingly negative. A good example of past performance would be the run on technology and U.S. large stocks in the late 1990s. After several years of impressive returns, investors started to feel “safe” putting large amounts of money into these investments. This false sense of security led investors to make decisions based on their emotions, thereby defying the rules of investing. No one can predict the future. Mutual fund companies understand this and provide hundreds of funds, guaranteeing themselves a “hot” fund to offer for the next year. These are also the funds that get a 5 star rating from Morningstar, adding to the illusion that past performance will repeat.

6. Chasing big returns is gambling, not investing.
Investors often fall prey to advisors and brokers who claim they can “beat the market.” However, performance data has shown that the vast majority of funds lag far behind low cost index funds, and the funds which do beat the market aren’t likely to do so year after year. A Dalbar, Inc. study found that from 1990-2010 the S&P 500 averaged 9.14%. However, average investors made only a 3.83% gain during the same 20 year period. Free markets factor in data that is known or predictable. The only thing that moves markets is new, previously unknowable information. Every year there are individual stocks that do tremendously well, but just like the lottery, no one could know the hot pick beforehand. Wall Street brokers prey on main street investors by selling false hope that they too can strike gold on the next hot stock.

7. Diversification is about more than owning a lot of “stuff.”
Contrary to what we might think, diversification is about buying the right combination of assets, not just a lot of different stocks. Correlation, the relationship between two investments, is the cornerstone of diversification. Utilizing investments with low correlation is one of the best ways to reduce risk in your portfolio and get a higher return with less volatility. We look for assets with dissimilar price movements, so that when one goes down, the other has a good potential of offsetting it with an up period. Most investors migrate towards asset categories like large cap stocks (e.g. S&P 500) and small cap stocks (e.g. Russel 2000) with which they are familiar.  Unfortunately, US large and small cap stocks have a high correlation and achieve little diversification. The other mistake that investors make is not owning enough stocks; never invest in 10, 50, 100, or 200 stocks. To be properly diversified takes a minimum of 11,000 globally diversified holdings. When you own that many holdings, you’re not worried about which one is paying a dividend or having a great year. Most likely, you’ll already own it, and the ones that go bankrupt or stop paying a dividend will have less of an impact on your portfolio.

8. Rebalance….Rebalance….Rebalance…..
Rebalancing puts risk management on autopilot. With any globally diversified portfolio, there will be assets that are up and assets that are down. Rebalancing your portfolio is a way to buy low and sell high while keeping emotion out of investment decisions. This is important because it can seem counterintuitive to sell assets that are doing well to buy assets that are distressed. Rebalancing also maintains a standard deviation, or level of risk, consistent with your investment objective. Market movements provide opportunities to buy asset classes when they are under-weighted and undervalued and sell securities when they are over-weighted and overvalued. Rebalancing is an effective way to control your risk while continuously and systematically maintaining discipline in your investment policy.

9. Commodities do not create wealth – they only appreciate or depreciate.
Commodities are the raw materials (e.g. energy, metals, grains, livestock, food, and fibers) that are used to create consumer products. Commodities historically have long periods of low to negative returns and occasional short periods of spectacular increases. A recent example is the rise in gold prices. Investors see commercials about what a great investment gold has been, so they invest with their emotions chasing short-term profit. Commodities are not productive assets, so how can they create wealth over time? No economic growth is created. Commodities are not investments; they are a speculation based on selling your current position to someone at a higher price. Commodities are a product rooted in speculation and gambling.  They have no place in a portfolio whose foundation is built on academics and efficient markets.

10. This time is not different.
Many investors justify their investment decisions by telling themselves, “This time is different.” They let their emotions override good investment strategy. This is nothing new; it is called market volatility. Market prices are random and unpredictable. No one knows where the next 20% or 30% move will be, but the next 100% is always up. While it is hard to remain disciplined, you would not sell your home just because housing prices are down. So why would you do so with your portfolio? Encouraging you to sell destroys your long term potential for success. Wire houses and broker dealers want you making repeated transactions so they can earn commissions and increase their profits. Those who panic and sell lose out in the long term.

 

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