The Basic Simple Truths of Investing

For investors, it’s a perfect time to go back to the basics
Barry Ritholtz
Washington Post, December 21, 2014

 

 

Look around you: This is the time of year when the pages of newspapers and magazines are filled with predictions and lists and all manner of money-losing nonsense. I have pushed back against much of this silliness in these pages over the years.

Today, I am going to suggest you take a different route: Focus on 10 basic, simple truths that many investors seemingly ignore. Some of you are unaware of these realities; others understand them intellectually but cannot act on your knowledge. These are the simple things that amateurs and pros alike get wrong.

There are no guarantees on Wall Street. But if you take the following admonitions to heart — and act on them — I will extend you this money-back guarantee: You will become a much better investor.

Enough chatter. On with the list:

1. Stock picking is a sucker’s game. The ability to select stocks, manage them over time and know when to sell them is incredibly difficult, even for professional fund managers. 2014 was an especially challenging year, with 85 percent of mutual fund managers under-performing the benchmark S&P 500.

A lot of what people think of as trading skill is actually just random luck (a lesson that many investors eventually learn, but only after losing a huge amount of capital). Even those who beat the market a few years in a row end up a wash once fees and other costs are considered.

2. Turnover, fees and taxes exert a huge drag on returns. In addition to the challenge of picking winning stocks, you then have to deal with all the expense associated with turnover. Commissions add up, taxes are a big drag, margin ain’t cheap. A good accountant costs money as well. The math on this one is obvious, yet investors often fail to recognize it: Keep your costs low and your turnover lower and you will win in the end.

3. You are an error machine, a mess of biases and emotions. When it comes to investing, you are your own worst enemy. You allow short-term thinking to derail your long-term plan (assuming you have one). Emotions get in your way, as your lizard brain behaves as if you are still on the savannah fighting for your very life. You allow yourself to be unsettled by the day-to-day noise — irrelevant news, temporary setbacks, even company gossip. This is a recipe for failure.

In short, you suck at this. But it’s not your fault, it’s how you were built. A little awareness goes a long way in correcting these wetware errors.

4. Hedge funds are great at making hedge fund managers rich (making you rich, not so much). The hedge fund industry is not having an especially good year in terms of performance. While the S&P 500 gained more than 10 percent in 2014, the industry is barely positive, racking up gains of just 2 percent. But thanks to the industry’s “2&20” model — charging fees of 2 percent of assets under management, plus 20 percent of trading gains — it means big bucks for managers.

Yet despite this underperformance, hedge funds continue to attract massive amounts of money, with total assets at $2.82 trillion. It is perplexing that so many investors keep playing this game. This is why it has been said that “Hedge funds are a wealth transfer system disguised as an asset class.”

5. You are likely less diversified than you think. I’m amazed by what people believe diversification means. We often review other portfolios in our office that are little more than huge collections of overlapping funds — lots of similar big cap companies, lots of tech, very little in the way of small cap value, REITs, TIPs, munis or other asset classes that are less correlated with each other.

Meanwhile, the typical stock portfolio often looks like an expensive concentrated bet. Rather than play this game, a broad asset allocation strategy is vastly superior, holding asset classes that do not move in lock step with each other.

No one knows what the top-performing asset class will be next year. Lacking this prescience, your next-best solution is to own all of the classes and rebalance regularly.

6. You can only succeed if you educate yourself, remain patient and practice discipline. Do you understand what “the long term” actually means? You need to recognize that periods of volatility and drawdowns are not at all uncommon over time. You must grasp that in a diversified portfolio, some asset classes will always be lagging while others will be leading (this is a feature, not a bug). And, you need to really comprehend what your portfolio was designed to do.

Finally, you have to have the discipline to stay the course even when it is uncomfortable. Without these skills, you cannot successfully manage your own investing.

7. You my not need a financial adviser. If your financial circumstances are relatively simple, you probably don’t need to pay for full-service financial planning. If you can control your emotions, you can manage a simple allocation plan on your own.

Unfortunately, a lot of people lack the self-discipline to handle market pressures when the going gets tough. They may need an adviser to talk them off the ledge.

Then there are investors who have complex financial circumstances, with many moving parts. Tax and estate considerations, generational wealth transfers, sale of a business and many other complexities suggest you should seek out good advice. Just understand what you are paying for, and then derive full value for it.

8. Understanding financial truths intellectually and emotionally are two completely different things. Even when you understand what you are supposed to do, it is very, very hard to actually do it. Since we are approaching the time of year when new year’s resolutions get made, think about how many people vow to stop smoking, exercise and lose weight. Then consider how many achieve those goals. The same gulf appears between people’s financial intentions and how they actually behave.

9. It is never too late to start. That said, sooner is much better than later. Patrick O’Shaugnessy is a twentysomething who wrote the book “Millennial Money.” He points out you will never have a longer investing timeline over the course of your entire working career than when you are in your 20s. This can have a potentially enormous impact on your investing returns.

10. The secret to success in investing in one word: compounding. The beauty of investing is that you get to compound gains upon gains. Over time, that adds up to outsized returns — but only if you allow time to work in your favor.

Consider a simple portfolio that yields 8 percent a year. Over 30 years, the money will multiply tenfold. That’s the power of compounding.

William Goldman said “Nobody knows anything.” The screenwriter was referring to the movie business, but he might as well have been talking about finance.

Still, after many years of study, we do know something. It is up to you to learn to separate fact from fiction and invest accordingly.

This list can give you a head start.

~~~

Ritholtz is chairman and chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz.

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