The best investment advice ever
Reprinted courtesy of MarketWatch.com
Published: June 6, 2014
To read the original article click here
Over the years I’ve dished out lots of investment advice, and I believe I’ve gotten it right most of the time. Lately, though, I’ve wondered: What’s the best advice I ever heard?
I’ve been fortunate to hear a lot of excellent advice.
‘Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.’
— Warren Buffett
I’ll share a few of my favorite tips. I’m sure you’re already familiar with some, but a couple are being published here for the first time.
Everyone is aware of Warren Buffett’s most famous piece of investment advice:
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”
Richard Russell, who has been publishing the Dow Theory Letters newsletter since 1958, says much the same thing, but with more teeth: “This may sound naive, but, believe me, it isn’t: If you want to be wealthy, you must not lose BIG money. Absurd? Silly? Maybe, but MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten business deals, greed, poor timing, in the stock market, in options and futures, in real estate, in bad loans, and in their own businesses.”
Here are a few other great gems:
Two are from Ben Franklin:
- “An investment in knowledge pays the most interest.”
- “Beware of expenses. A small leak will sink a great ship.”
Vanguard founder John Bogle is known for dozens of memorable quotes (read Bogle’s recent interview with MarketWatch’s Chuck Jaffe). One I like a lot: “Why look for a needle in the haystack when you can buy the whole haystack?” (In other words, buy index funds instead of individual stocks.)
Pundits who want to persuade people to do the right things (or who at least want to sound wise) commonly rely on other familiar aphorisms.
At the top of this list might be this: “Don’t invest in anything you don’t understand.” This is good, as far as it goes. Way too many people get into complex, expensive, risky investments, only to be stunned when things don’t turn out for the best.
The problem is how to know you fully understand any investment more complex than cash or a guaranteed bank deposit?
OK, a bond is relatively straightforward, and so is a share of common stock. But a mutual fund is governed by a legal document called a prospectus. Almost nobody reads it; unless you do, how can you be sure you understand the fund?
Another common example: “If it sounds too good to be true, it probably is.” In other words, don’t let your hopes trump your common sense. But if you take that literally, you might dismiss two very good deals that are for real: the “miracle” of compound interest and the apparent magic of dollar-cost averaging.
A third: “Cut your losses and let your profits run.” This sounds like unassailable common sense. But when you try to put it into practice, it isn’t much more helpful than Will Rogers’s tongue-in-cheek advice to “buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”
I promised to include two bits of advice you’ve not read before.
I asked my friend and longtime writing partner Richard Buck what his own best-ever investment advice would be. His reply: “Make your investment choices as if they were the most important ones in your life — and never forget for a moment that your investments are only a means to what is really important.”
He went one step further and asked his wife, Susan Pelton, for her best-ever investment advice. This made me quite curious. Susan is very intelligent but has no professional background in finance. As soon as I saw her first three words, I was hooked.
Her advice: “Buy and hold good personal relationships throughout your life, and pay close attention to the choices you make. Diversify your relationship portfolio in terms of age, gender, education and income level. Don’t be afraid to drop your poor performers.”
Those three sentences pack a lot of wisdom.
Never take an investment risk that doesn’t pay a premium for taking that risk over the long term.
Now for my own best-ever advice. It’s based on things I learned over the years from lots of smart people. It’s firmly rooted in the notion that risks are every bit as important as returns.
I first heard it in 1994 at a conference of academics, and I still think it’s the single best piece of investment advice I know: Never take an investment risk that doesn’t pay a premium for taking that risk over the long term.
Let me explain by giving a few examples of investments with a history of paying a premium return to those who took the risks involved. The returns below are for the 30-year period 1984 through 2013.
My first example won’t surprise you: Stocks are riskier than bonds. And they provided a premium return. The Standard & Poor’s 500 Index SPX, +0.74% returned 11.1% annually with a standard deviation of 15.5%. (Standard deviation is a statistical measure of volatility or risk; higher numbers represent higher risk.) The Barclays U.S. Aggregate Bond Index returned 7.7%, with a standard deviation of 2.9%. Conclusion: Investors in the S&P 500 took much more risk — and got much more return.
Small-cap stocks are riskier than the large-cap stocks of the S&P. And they provided a premium return. An index of U.S. small-cap stocks had a standard deviation of 20.9% and returned 12.9%. Again, more risk and more return.
The same is true of value stocks. U.S. large-cap value stocks had a standard deviation of 18.6% and returned 13.4% (versus 15.5% and 11.1%, respectively, for the S&P 500). U.S. small-cap value stocks had a standard deviation of 21.2% and returned 14.8% (versus 20.9% and 12.9%, respectively, for the U.S. small-cap index).
Without burdening you with figures, I can report that the same pattern holds for international value stocks, both large and small.
I can’t prove this next example with reliable statistics, but I am quite sure that investors who use professional investment advice achieve higher long-term returns than those who make their own decisions. Every DALBAR study that’s been released points to that conclusion.
But in one respect hiring an adviser can actually be riskier than doing things yourself. Professional advice costs money, and, as I have said many times, every dollar you pay in expenses is a dollar you no longer own. When you pay that money, you’ve got no guarantee that it will pay off.
You may notice some investments are missing from this list. You won’t find gold, commodity funds, technology funds or penny stocks. Every one has above-average risks — but none of them has paid a long-term premium return. Annualized performance over the same 30-year period:
- Gold: Its standard deviation is 20.1%, but its return is less than 5%. If you’re OK with that much risk, U.S. small-cap stocks returned 12.9%.
- Technology stocks: The Nasdaq Composite Index has a standard deviation of 17.8% and returned 8.5%. For less risk than that, you could have had the 11.1% return of the S&P 500.
- Commodities: The Dow Jones Commodity Index has a standard deviation of 15.3% but a return of only 2.1% — less than one-third the return of bonds!
- Penny stocks: Their risks are sky-high, and their returns are essentially a crapshoot.
My best-ever advice certainly isn’t all you need to be successful. But it’s simple and robust. It applies to anything you can quantify, because it’s based on facts, not hype, hope and vague notions. To put my best advice into practice you have to quantify expected risks as well as expected returns.
I hope you’ll do just that and increase your probability of long-term success.
Richard Buck contributed to this article.
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