Three things every investor needs to know
Reprinted courtesy of MarketWatch.com
Published: Feb. 20, 2013
To read the original article click here
This column could be called Investing For Grownups. You’ve undoubtedly heard many truisms of investment advice: Keep your expenses low; invest early; use dollar-cost-averaging, etc. Those topics are important, but they’re best taught to freshmen and sophomores.
If I could teach an upper-level college course on investing, it would go well beyond what’s obvious. To get a passing grade, a student would need to understand a limited number of extremely important principles.
Today I’ll present three of those points. In future columns, I’ll discuss more of them.
One: The past and the future are very different animals. It’s easy to look back and see which investments have made money. If by some magic I could get my hands on next week’s stock prices, I could tell you the single stock that would make the most money between now and then. Most likely it would be a company you have never heard of.
If you had that information, would you buy the stock today? I doubt it, and here’s why: When you’re putting your money on the line and looking into the future of an unknown entity, what you see is risk.
But there is no risk in the past. The latest price of a stock represents a done deal—you know how it turned out.
And yet Wall Street wants you to think the future will be like the past.
Imagine that you’re starting a job as a securities broker. A good place to start is by finding some investments that have performed well in the past, then recommending them to your clients.
In fact, this happens tens of thousands of times every business day. Naive investors are impressed. But savvy investors know better; they understand the past is not the future.
If you are a savvy investor relying on somebody for advice, you should care about how that person’s past advice turned out in real life, when the future was unknown.
A naive investor may be satisfied with a list of funds that, in hindsight, were successful over the most recent 10 years. A savvy investor wants to know what funds the adviser was recommending 10 years ago, and how THOSE funds turned out.
This is the smart way to differentiate the past from the future.
Two: There’s only one free lunch for investors—diversification. Wall Street spends hundreds of millions of dollars every year trying to convince investors they can have their cake (very low risk) and eat it too (attractive returns). All too often, this pitch works.
But at least half of those enthusiastic buying decisions will produce below-average results. Investors are collectively hoping for a form of magic that any middle-school math student could tell you is statistically impossible.
University professors believe that the expected return on any one stock in the Standard & Poor’s 500 Index is the same as that of the index itself—over the very long term, about 10%.
Own just one large-cap stock, and you can expect 10%. Own all 500, and you can expect 10%. Here’s the free lunch: In one case you take enormous risk; in the other case, you get the same expected return without the risk of disaster.
Three: When you get within range of retirement, you should know yourself well enough to recognize when enough is enough. Sometimes people have enough money to retire but they don’t realize it, so they remain mired in the mental mode of accumulation, exposing their portfolios to unnecessary risks.
About five years ago, I realized this was happening to me. I had saved enough to retire, even though I wasn’t ready to do so, and I was taking more risk than necessary.
I realized what I would recommend if I were advising somebody in my situation, and I followed that advice. I reduced the risk level of my portfolio to something that would be appropriate for an investor who is already retired.
Almost immediately I noticed that I had more peace of mind, especially since I was continuing to add to my savings and keeping enough of a position in equities to benefit from the long-term economic growth that I believe is still ahead.
Obviously this doesn’t happen to everybody. But I’ve seen it more often than you might think.
In next week’s column, I’ll share another five important points that you would have to know in order to achieve a passing grade in my upper-level course.
Richard Buck contributed to this report.
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