Keep it simple, avoid the pitfalls
Washington Post, January 25 2013
“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will be abandoned at the first sign of under-performance.”
That’s from Tadas Viskanta of Abnormal Returns, a “forecast free” investment blog. He was talking about the disadvantages of complexity when creating an investment plan. Even though specific complex strategies can be mathematically shown to outperform the market over time, they often fail to do so.
The primary reason? The people running them never seem to stick with them long enough. Computer help desks have an acronym for this issue — PEBKAC, or “problem exists between keyboard and chair.” Fear, higher volatility and significant drawdowns derail all but the most disciplined investors. As soon as trouble shows up, they are gone.
We must recognize our own behavioral errors. To be blunt, you are not likely to become a cognitive Zen master anytime soon. But a little enlightenment could keep you from making some common investing errors.
Knowing these limitations, we can design an investment plan to circumvent the behavioral pitfalls. And a good step is to simplify. Toward that end, keep these 10 ideas in mind when approaching your portfolio:
1 Go passive. Here is a dirty little secret: Stock-picking is wildly overrated. Sure, it makes for great cocktail party chatter, and what is more fun than delving into a company’s new products? But the truth is that individual stocks are riskier than broad indices. Managing those positions through the ups and downs is complicated and time-consuming, and most investors lack the skills and discipline to do it well.
Consider this: The world’s greatest stock-pickers got creamed in 2008. And the world’s worst stock-pickers made a killing in 2009.
Your solution is index ETFs, vastly preferable to picking individual stocks. Lower cost, reduced turnover, fewer taxes — and much less risk.
2 Diversify across asset classes. Owning a variety of asset classes means that some part of your portfolio will be doing well when the cyclical turmoil arises. A broadly diversified portfolio includes large capitalization stocks, small cap, emerging markets, fixed income, real estate and commodities.
A typical portfolio might look like this: 33 percent big cap, 25 percent small cap, 20 percent emerging markets, 15 percent bonds, 5 percent REITs and 2 percent commodities. Younger investors will want to include technology or biotech as a class as well. Older investors might want more income-producing holdings such as REITS and lower-risk holdings such as bonds.
3 Be mindful of valuation. When making purchases, valuation matters more than anything else. What you pay for an investment is the single biggest determinant for how successful that investment will be. When equity prices are high, your returns will be lower. When they are cheap, your returns will be higher.
The valuation challenge is that stocks become cheap during a panic and expensive during a boom. Your instincts will lead you to do what feels good — buy high, sell low — the exact opposite of what you should do. Our next step solves this.
4 Dollar cost averaging. This means automatically putting the same amount of money each month or quarter into several broad indices. When stocks are high, the fixed dollar amount means you buy fewer shares; when they are less low, you end up buying more. Just about all of the retirement custodians and online brokers can automate this for you.
5 Keep costs and expenses low. Overhead is a big drag on returns. Compounding of the (noninvestment) costs and expenses adds up to be an enormous sum after a few decades.
Let’s assume that 30 years ago, you invested $100,000 and had an average annual return of 8 percent. If you put it into an ETF that had an expense ratio of 0.20 percent, it would now be worth about a million dollars. That same investment into a higher-cost fund with an expense ratio of 1.19 percent would be worth $242,079 less.
Reducing your costs may be the only free lunch in all of investing.
6 Rebalance your portfolio. I mentioned holding various asset classes in a hypothetical model of 33 percent big cap, 25 percent small cap, 20 percent emerging markets, 15 percent bonds, 5 percent REITs and 2 percent commodities. After a good run in any asset class, your model will have drifted from the original allocation. Rebalance at least once a year for smaller holdings and semiannually or quarterly for larger portfolios (in which the frictional costs won’t matter much).
Rebalancing back to the original allocations accomplishes three things: You buy more of what has become cheap, sell a little of what has become dear and keep the diversification of the original design. This should be easy to do, with most online brokers having automated tools for rebalancing.
7 Avoid the noise. Our goal is to block out the things that send you down the path of pointless complexity. A good start includes dramatically paring down your consumption of online, print and TV financial news.
You don’t have to go cold turkey, but ask yourself: Has this outlet helped me make money? If the answer is yes, then keep it. Pare back 90 percent of everything else. You will be much better off spending your time reading classic investing books than consuming ephemeral market gossip.
8 Review your portfolio regularly. At least once a quarter. Check your allocations, see what is working, what is lagging. If you like to look at charts, use weekly, not daily, charts. A lesson we learned over the past century was that when markets are down 30 percent or more, you can raise your allocation to equities some; when markets are down 50 percent, raise it some more.
Throughout the collapse, I heard tales of investors who refused to so much as open their monthly account statements for three years. They missed a lot of opportunities by putting their head in the sand. The ostrich approach to investing hardly ever pays off.
9 Steer clear of venture capital and private equity. With the new rules on marketing private investments, hedge funds and other non-public forms of risk-taking, I expect to hear about a lot of losses over the next few years.
Why? These forms of investing are extremely challenging. The numbers of even the best venture investors are lots of zeros, a handful of break-evens or small winners and very few home runs. It ain’t easy — and odds are you lack the skills, capital and risk tolerance for these sorts of high-risk early-stage investments. What is available to you are the leftovers — typically, what the VCs have already picked over and passed on.
9b Most IPOs are a sucker play.
10 Avoid new financial products at all costs. New financial products are seemingly created all the time. They tend to be complex, expensive and dangerous. For the most part, they are designed primarily to capture a fee for the underwriters.
The major asset classes have hundreds of years of history. When products have proven themselves, like low-cost ETFs, you can freely buy them. Their costs, risks and downsides are known entities.
10b Don’t buy “house product,” either.
Investing has become so complicated because so many entities have a vested stake in keeping you active and paying excessive fees.
By keeping it simple, you avoid that problem. You reduce your costs and stay on target to meet your goals. But most of all, you prevent yourself from doing something rash that you later regret.
Simplicity is a virtue.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz.
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