How to Avoid Making Dumb Investment Decisions
Smart people sometimes make dumb mistakes when it comes to investing. Part of the reason for this, I guess, is that most people don’t have the time to learn what they need to know to make good decisions. Another reason is that oftentimes when you make a dumb mistake, somebody else—an investment salesperson, for example—makes money. Fortunately, you can save yourself lots of money and a bunch of headaches by not making bad investment decisions.
Don’t Forget to Diversify
The average stock market return is 10 percent or so, but to earn 10 percent you need to own a broad range of stocks. In other words, you need to diversify.
Everybody who thinks about this for more than a few minutes realizes that it is true, but it’s amazing how many people don’t diversify. For example, some people hold huge chunks of their employer’s stock but little else. Or they own a handful of stocks in the same industry.
To make money on the stock market, you need around 15 to 20 stocks in a variety of industries. (I didn’t just make up these figures; the 15 to 20 number comes from a statistical calculation that many upper-division and graduate finance textbooks explain.) With fewer than 10 to 20 stocks, your portfolio’s returns will very likely be something greater or less than the stock market average. Of course, you don’t care if your portfolio’s return is greater than the stock market average, but you do care if your portfolio’s return is less than the stock market average.
By the way, to be fair I should tell you that some very bright people disagree with me on this business of holding 15 to 20 stocks. For example, Peter Lynch, the outrageously successful former manager of the Fidelity Magellan mutual fund, suggests that individual investors hold 4 to 6 stocks that they understand well.
His feeling, which he shares in his books, is that by following this strategy, an individual investor can beat the stock market average. Mr. Lynch knows more about picking stocks than I ever will, but I nonetheless respectfully disagree with him for two reasons. First, I think that Peter Lynch is one of those modest geniuses who underestimate their intellectual prowess. I wonder if he underestimates the powerful analytical skills he brings to his stock picking. Second, I think that most individual investors lack the accounting knowledge to accurately make use of the quarterly and annual financial statements that publicly held companies provide in the ways that Mr. Lynch suggests.
The stock market and other securities markets bounce around on a daily, weekly, and even yearly basis, but the general trend over extended periods of time has always been up. Since World War II, the worst one-year return has been –26.5 percent. The worst ten-year return in recent history was 1.2 percent. Those numbers are pretty scary, but things look much better if you look longer term. The worst 25-year return was 7.9 percent annually.
It’s important for investors to have patience. There will be many bad years. Many times, one bad year is followed by another bad year. But over time, the good years outnumber the bad. They compensate for the bad years too. Patient investors who stay in the market in both the good and bad years almost always do better than people who try to follow every fad or buy last year’s hot stock.
You may already know about dollar-average investing. Instead of purchasing a set number of shares at regular intervals, you purchase a regular dollar amount, such as $100. If the share price is $10, you purchase ten shares. If the share price is $20, you purchase five shares. If the share price is $5, you purchase twenty shares.
Dollar-average investing offers two advantages. The biggest is that you regularly invest—in both good markets and bad markets. If you buy $100 of stock at the beginning of every month, for example, you don’t stop buying stock when the market is way down and every financial journalist in the world is working to fan the fires of fear.
The other advantage of dollar-average investing is that you buy more shares when the price is low and fewer shares when the price is high. As a result, you don’t get carried away on a tide of optimism and end up buying most of the stock when the market or the stock is up. In the same way, you also don’t get scared away and stop buying a stock when the market or the stock is down.
One of the easiest ways to implement a dollar-average investing program is by participating in something like an employer-sponsored 401(k) plan or deferred compensation plan. With these plans, you effectively invest each time money is withheld from your paycheck.
To make dollar-average investing work with individual stocks, you need to dollar-average each stock. In other words, if you’re buying stock in IBM, you need to buy a set dollar amount of IBM stock each month, each quarter, or whatever.
Don’t Ignore Investment Expenses
Investment expenses can add up quickly. Small differences in expense ratios, costly investment newsletter subscriptions, online financial services (including Quicken Quotes!), and income taxes can easily subtract hundreds of thousands of dollars from your net worth over a lifetime of investing.
To show you what I mean, here are a couple of quick examples. Let’s say that you’re saving $7,000 per year of 401(k) money in a couple of mutual funds that track the Standard & Poor’s 500 index. One fund charges a 0.25 percent annual expense ratio, and the other fund charges a 1 percent annual expense ratio. In 35 years, you’ll have about $900,000 in the fund with the 0.25 percent expense ratio and about $750,000 in the fund with the 1 percent ratio.
Here’s another example: Let’s say that you don’t spend $500 a year on a special investment newsletter, but you instead stick the money in a tax-deductible investment such as an IRA. Let’s say you also stick your tax savings in the tax-deductible investment. After 35 years, you’ll accumulate roughly $200,000.
Investment expenses can add up to really big numbers when you realize that you could have invested the money and earned interest and dividends for years.
Don’t Get Greedy
I wish there was some risk-free way to earn 15 or 20 percent annually. I really, really do. But, alas, there isn’t. The stock market’s average return is somewhere between 9 and 10 percent, depending on how many decades you go back. The significantly more risky small company stocks have done slightly better. On average, they return annual profits of 12 to 13 percent. Fortunately, you can get rich earning 9 percent returns. You just need to take your time. But no risk-free investments consistently return annual profits significantly above the stock market’s long-run averages.
I mention this for a simple reason: People make all sorts of foolish investment decisions when they get greedy and pursue returns that are out of line with the average annual returns of the stock market. If someone tells you that he has a sure-thing investment or investment strategy that pays, say, 15 percent, don’t believe it. And, for Pete’s sake, don’t buy investments or investment advice from that person.
If someone really did have a sure-thing method of producing annual returns of, say, 18 percent, that person would soon be the richest person in the world. With solid year-in, year-out returns like that, the person could run a $20 billion investment fund and earn $500 million a year. The moral is: There is no such thing as a sure thing in investing.
Don’t Get Fancy
For years now, I’ve made the better part of my living by analyzing complex investments. Nevertheless, I think that it makes most sense for investors to stick with simple investments: mutual funds, individual stocks, government and corporate bonds, and so on.
As a practical matter, it’s very difficult for people who haven’t been trained in financial analysis to analyze complex investments such as real estate partnership units, derivatives, and cash-value life insurance. You need to understand how to construct accurate cash-flow forecasts. You need to know how to calculate things like internal rates of return and net present values with the data from cash-flow forecasts. Financial analysis is nowhere near as complex as rocket science. Still, it’s not something you can do without a degree in accounting or finance, a computer, and a spreadsheet program (like Microsoft Excel or Lotus 1-2-3).
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