Completely different theme today: real-world investing. This is actually just a copy-paste (with a few edits) from a document I wrote quite a while back and that I updated recently for a friend. Over the years, several people have asked me for my take on investing. I am not sure why: it's not something I usually discuss with people. Perhaps my overall nerdy aura makes people think I am an expert! I am not, and should never be mistaken for one. I can't emphasize that enough. I hope this 'primer' is a useful *starting* point for those interested in understanding investing, but it should never be an *ending* point in such a search. Talk to a professional! But this primer should give you the knowledge you need to ask the right questions of such a professional.
INVESTING 101: A STARTER’S GUIDE
The first rule of investing is straight from Douglass Adams: DON’T PANIC. (Sadly, the second rule is not ‘42’.) The reason many investors lose money is that right when it becomes the least expensive time to invest, they sell. To understand what I mean, imagine the following scenario. You need to buy a new suit. You go to your local department store and the clerk tells you that a big sale just ended, so it’s the most expensive time to buy. So you think to yourself, huh, most expensive time? Cool. Then suits must be worth a lot! I will take two!! The next week, the store has a huge 50% off sale. So your logic is, well, then suits must not be worth as much as I thought they were, so I’d better unload them before they lose even more value! So you return to the store for a refund. The clerk looks at you like you’re crazy: “Sir, you realize that since the sale is on, I have to refund the SALE price, not the price you paid? You will lose half your money!!” To which you reply, “Yeah, but I am nervous prices will fall even further...please give me money back.”
Now that little scenario may sound silly to the point of inane, but stop and think about the way most people handle their investments. This is exactly how they behave. They get into the stock market because it’s ‘hot’ (meaning prices for stocks are often at their HIGHEST). Then, right when prices get reasonable and smart investors are buying up cheap stocks (i.e. during market corrections), the foolish investors run out of the market in a panic, locking in their losses forever. They do this because they believe they are smarter than the markets, that they can ‘time’ the market. That is a fool's errand. Don't try it.
The key to making money in equities is a very simple strategy using two tools:
1. Dollar-cost averaging. The reason it is called ‘dollar-cost averaging’ is that you are buying steadily through all the market fluctuations, so you average out the cost of ownership of your equities. So it’s just a technical way of saying ‘slow and steady’. Invest a fixed amount every month (or every paycheck or whatever) and do NOT SELL during market corrections. In fact, quite the opposite: if the market is correcting, think of it as that sale at the department store: if you do anything at these times, it should be to buy more when all the panicking masses are 'returning their overpriced suits!'
2. Indexing. The reality is that unless investing actually interests you and you are willing and able to take the time to research stocks thoroughly, your best bet is simply to buy ETFs or mutual funds that are tied to the major indices that reflect your goals and risk-aversion level. DO NOT buy actively-managed funds. These are funds in which the managers actively buy and sell stocks in the belief they can beat the market consistently. But check the facts: the VAST majority of actively-managed mutual funds fail to beat the indices most comparable to their strategies and goals. Many can brag they have done it for, say, a year or two or even five, but in the end, the ‘invisible hand’ will always win. In fact, since they all fall sooner or later in comparison to the indices, any funds that brag they have beaten the market for a few years, are actually the very ones to avoid as it means they will sooner rather than later revert to the mean.
You might say, “Well, that sounds good in theory, Christopher, but look at the reality of the stock market over the past decade. I know a lot of people who lost a fortune in the markets during that time. So how can you defend equities as a sound investment?” The answer is: easily and justifiably. Go back to dollar-cost averaging and apply it to the wild and crazy markets over the past ten years. For example, the NASDAQ is actually lower as of this writing (January 2011) than it was exactly ten years ago today. Scary, huh? So if you were a foolish market-timer who went in when it was hot (right before the bubble burst) and ran out at every scary correction, you would be broke (or close enough anyway). But if you had been a smart investor following this simple strategy, look at what would have happened:
Buy $10,000 last day of every October starting 2000, so ten purchases spread over the decade (2000-2009). (Normally you would buy every month or few weeks, not just once a year, but let’s keep it simple for the sake of example.) Even though the NASDAQ is lower now than ten years ago, you would, as of last trading day in October 2010, have $124,769.24 on that $100,000 investment, thanks to dollar-cost averaging and a disciplined approach to investing, with no panicked withdrawals. That may not look huge – and by historical standards, it isn’t great for equities– but you are still ahead of the game, even after inflation. And compare it to what your ‘safe’ friend did when he ‘wisely’ sold all his stocks after the crash, got out of equities and just put it all in bank certificates of deposit (aka CDs) at, say, 2.5%: even if he escaped with that same starting $100,000, he now has $114,834.66. That barely (if at all) keeps up with inflation, so in real terms, he has lost money on his ‘safe’ approach.
If it’s so easy, why do so many people lose money? See rule number one. People panic. They buy at inflated values (when stocks are ‘hot’) and sell at deflated values (when it’s ‘time to get out’).
So the bottom line is simple: invest steadily, don’t panic, and stick with it!
The next question is, how aggressively should you invest? After all, there are stocks and then there are stocks...blue chip indices like the Dow tend to be less sexy and maybe not as lucrative, but they are less volatile and offer better dividends (i.e. fixed income regardless of price performance); small cap indices are very aggressive, but tend to fluctuate a lot and there is more downside risk that can offset some of that upside reward. And what about overseas indices? To decide the right blend, you must consider two things:
1) What is your risk tolerance? In simplest terms, people fall on a spectrum from ‘risk-adverse’ to ‘risk-seeking’. You either want steady but lower returns, or you want (potentially) higher returns but with more downside risk. It’s all fine and good to say ‘Don’t panic’, but if you are the type of person who WILL - despite all advice - panic when he sees an index tank, say, 30%, then you are more on the risk-averse side. The most important move you will ever make as an investor is when you truly ask yourself what kind of person you are and then honestly answer that question. If you are risk-adverse, admit that to yourself and proceed accordingly. This isn’t a test of your personal courage or self worth!
2) What is your time horizon? Equities are great investments, as I have shown above, but the shorter the investing time frame, the riskier they can be. Think of it this way: if you need to buy a car next week, you aren’t going to invest the money you need in Apple or Microsoft. Yes, they may go up several percentage points in a week. But they can also tank several points in a week. But if you are buying that car in, say, ten years, then part of your investment to save for it may well be in equities. So you need to blend accordingly and even create different portfolios (one for short term with CDs, bonds, and maybe just a very small amount in equities; another for long term, mostly in equities). For retirement savings, it is all about one portfolio, but one that evolves over time. Personally, I use a very simple approach: every year, roughly one percentage point more of my portfolio goes to safer investments (e.g. high-grade bonds, etc) and one point comes out of stocks. So by the time I retire, only around 30-35% of my money will be in stocks. That might seem high, but remember, retirement isn’t a one-day event: it also has a time horizon of its own, since some of the money will be needed ASAP, but the rest will not be needed til well after the day you retire.
Making mistakes around time horizon is why you hear about people who are shocked to lose their retirements just before they are due to retire. How many stories like that have we heard in recent years? “I was two years from retirement, then I lost 75% of my portfolio...now I have to work til I am 90!” So what two mistakes did this poor fellow make?* First of all, he broke Rule 1: he panicked and sold after the market correction, meaning losses are locked in. But the overarching issue is a mistake related to time horizons. The question you should ask that fellow is, “If you were 63 years old and needed that money at 65, why in the world did you have it all in equities?!?!” At 63, he should have had well over half his money in very safe places like CDs, highly rated bonds, etc. Money exposed to short-term fluctuations should just have been money he needed later in retirement, so there would be time to recoup.
In summary, first decide what kind of investor you are, then look at your time horizon, then make a plan to invest regularly, with a firm commitment to yourself not to panic at market downturns. Do this and you will be fine!
A small post script here: accept the fact that no matter how disciplined you are, you are still human and you will still do stupid and/or highly risky things. Set aside a ‘play portfolio’ with 2%-5% of your investing capital (or a few grand...whatever feels right, but no more than 5% of all capital) and use it to play hunches, buy ‘hot stocks’ your friends tell you about, whatever. Think of it as your investment playground. Silo this from your main portfolio, though: separate account, maybe even separate brokerage. (That’s to avoid the temptation to transfer money from your real portfolio.) This can also be your ‘lab’ where you can learn about investing, feeling safe to make mistakes. But remember not to get cocky: no matter how good you get, you will never beat the markets in the long term, so don’t get any stupid ideas about transferring your major assets here just because you do well for a while.
Some sample portfolios:
Risk-seeking, long-term investor with at least 20 years til retirement:
5% in a safe money market fund or high-grade bond fund
5% in high-yield (lower grade) bond funds
20% in ETFs or index mutual funds tied to major world indices
30% in ETF or index mutual fund tied to Russell 2000 (small caps)
20% in ETF or index mutual fund tied to S&P Mid-Cap 400 (mid-caps)
20% in ETF or index mutual fund tied to S&P500 (large caps)
Mildly risk-adverse, long-term investor with at least 20 years til retirement:
10% distributed among safe money market funds, a high-grade bond fund, and maybe even some precious metal shares (e.g. ETFs tied to price of gold)
15% in ETFs or index mutual funds tied to major world indices (ex-USA)
10% in ETF or index mutual fund tied to Russell 2000 (small caps)
10% in ETF or index mutual fund tied to S&P Mid-Cap 400 (mid-caps)
55% in ETF or index mutual fund tied to S&P500 (large caps)
*Well, the FIRST mistake was probably just plain greed, but that's another blog posting for another day. I truly do feel sorry for all the people who lost so much in such a short period of time, but I can't escape the reality that much of it was due to their own foolishness and greed. Even in cases of fraud. Take the Bernie Madoff debacle. Yes, he defrauded all those poor folks and he is a monster. But why weren't those people following the rule of 'if it seems too good to be true, IT IS'? And why were they sinking ALL of their money into his funds and not hedging against the risk by putting at least some of it elsewhere? Sadly, the answer in all cases is 'greed'. And let's be honest with ourselves: Madoff wasn't the only con artist. The SEC played a witting role in allowing his Ponzi scheme to flourish, despite many warnings from a fraud investigator who had been sounding the alarm about Madoff for YEARS.