The following guide first explains how the stock market works. Then, we’ll look at stocks vs mutual funds that hold stocks. We’ll finish by looking at the main ways people invest in the market and help you determine which method fits you best.
Stock Market Overview
Many people are intimidated by investing in the stock market because they don’t understand the basics. Well, if that describes you, we’re about to solve that problem once and for all.
To understand the stock market think about any other market and you’ll be a master. In markets, people who have stuff to sell “meet” with people who want to buy and they trade with each other. That’s it. And that’s exactly how the stock market works today. It’s also how it got started several hundred years ago.
In the late 1700’s business owners who wanted to expand their business put up notices in downtown Manhattan – on Wall Street and Broadway. Entrepreneurs who needed money to grow their business back then would pin up advertisements and offers on trees. If someone was interested in investing they would contact the business owners who were looking for investors and negotiate the deal.
Usually, this resulted in those investors owning a piece of the overall business. That was the formula then and it hasn’t changed very much since. When you own stocks you become a part owner of the company. When you buy a mutual fund that buys many stocks, you become a part owner of many companies.
Why do some people say that stocks are good investments for the long run?
This is THE key question when it comes to stocks. And to fully understand the answer, let’s look at the S&P 500 index. Why? Because this index is a compilation of 500 of the largest companies in the United States (and the world) and is considered a proxy for the entire market.
What many people overlook is that the S&P changes. That’s right. Each year the people who own the index add some companies to the pot and take others out. Here’s a quick video I did the last time a big change happened. It explains this process fairly well:
For most people, changes in the index is a non-event. For people who invest in narrowly based sectors, the impact could be huge. But it’s an important wake-up call for everyone. I’ll explain.
Most investors think of the S&P 500 as a static investment. But this move shows it isn’t anything of the kind. Therein lies the big take away from what’s happening.
If you take a step back, you’ll see that this demonstrates the importance of paying attention to the market and change holdings accordingly. That’s what the people at Standard and Poors do every year and that’s why I think it’s important for you to do as well. As the market reality shifts, update your portfolio.
In my experience, it pays to pay attention to the market and shift holdings accordingly. There are a number of ways to do this and none are perfect but in my experience, it’s far better to do this than ignore the market. I explain how to do this in a very detailed way in other guides.
Back To The Index
On any given day, some of these stocks go up and others go down in price. The combined result is the performance of the index and is one of the most widely followed numbers by investors. They use that performance over varied time frames to get a sense of how the market is doing. You’ll see why this is important shortly.
Who decides which companies are included in this index?
S&P stands for Standard and Poors – a private company. This is the firm that created the index and they decide which companies are included in the index and which are not. They select the companies based on a number of factors. These companies are drawn from either the NYSE or NASDAQ market exchanges. Usually changes are made the index each year. Some new companies are added to the index while others are taken out. This is very important because in effect, the S&P is constantly changing. You’ll see why I make this point shortly.
How Have The Stocks That Make Up The Index Performed?
Here’s a graph to give you an idea:
This indicates that over long periods of time, the S&P 500 has done a good job of helping investors accumulate wealth in the past. Of course, it’s no guarantee of future results.
Why has the value of these companies gone up over time? There are many reasons. But mainly, stock prices move over the long-term because of the company’s earnings. Over time, if a business earns greater profits, it is worth more because it has the potential to pay out dividends or invest further to earn still greater profits. If profits rise, the business will be worth more and if the business value grows so will its share price.
Let’s take an example. Let’s say you start a painting company and in year one, your profit was $25,000. If your neighbor offered to buy your company for $50,000 you might sell. But what if you don’t sell. And what if your profit skyrockets to $100,0oo the following year? Would you sell for $50,000 then? Of course not.
You’d want at least $200,000 and maybe quite a bit more. That’s because the future looks bright and you might prefer to hold on to the company and profit $100,000 this year (and hopefully more next year) rather than sell out at $200,000 and be out of the picture. So you see, as earnings rise, so does the value of the company. If that company is traded on the stock exchange, you’ll see the shares go up over time as earnings go up. This doesn’t happen immediately or in lock-step. But over time, stock values rise with company earnings.
Keep in mind that the opposite is also true. If earnings fall, the value of the company and its shares usually fall as well.
There is one very important caveat to emphasize; earnings drive stock prices over the long-run but not necessarily over the short-run as I mentioned before. Over a short period of time, the market is ruled by emotions – mostly fear and greed. Real earnings may have nothing to do with short term prices. Perceptions are everything for the short-run.
If, for various reasons, people are frightened and anxious about the future, share prices could fall. This can and does happen even to companies that are doing well and have strong and growing profits.
If the market (buyers and sellers) think that hard times are ahead and that it will be more difficult for companies to grow the profits, they will rush the exits to get out of their shares and many will be willing to sell at lower and lower prices.
And just to give you a sense of how unimportant short-term stock prices can be, consider extreme changes that happen on a daily basis. Can share prices rise or fall by 10% in one day? Of course. It happens all the time. But do you really think the value of the company changes that much in 24 hours? It can happen of course. But usually it doesn’t. When something really surprises investors such as the Brexit vote outcome in 2016, global markets immediately took a dive because people were caught off guard. That was an emotional reaction. But within a couple of weeks, world-wide markets stabilized because investors realized nothing had really changed at that point.
Over the short-term, what changes is perceptions and that’s what fuels daily price movements – not value. To be fair, perceptions can change in response to real events. That’s true. But it’s usually the emotional reaction to those events which move stocks – not the events themselves. And that’s why investing over the short-run is typically more risky than long-term investing. Over the short-term, it’s all about emotions. Over the long-run, it’s all about earnings.
Should you invest in the stock market?
Assuming you don’t have serious debt, you have an adequate emergency fund, you can save money each month, you can stomach the ups and downs of the market and you have at least a 5 to 10 year investment time horizon, there is probably a case for investing at least a part of your money in the stock market.
Now, before you race out and throw your hard earned money at some hot stock or another, I’m going to ask you to slow down. Slow way down. To show you why this is so important, let me share an email I received from a subscriber awhile ago:
Can you give me some investing tips? When Facebook went public, I got interested in investing but I wasn’t able to buy shares. That worked out OK but I don’t understand why the stock has done so poorly. How should I get started? Should I buy stocks? Should I get a broker or a discount broker and trade online? Should I go back and buy Facebook now? If not, when? And how much should I invest?
I don’t know about you but when I read this email I felt dizzy. Pat’s mind was racing 1000 miles an hour. I’m certain that at least half of the questions Pat asked were planted in his mind by various talking heads in the media. That’s why he’s all over the map.
If you are busy up in your head with these kinds of questions it will be difficult for you to succeed because you will have no method. To solve that problem, I suggest you do two things:
First, commit to a process. It feels like Pat is clutching at straws here. Maybe I’m reading too much between the lines but if feels like he is looking for a way to make a fast buck. I never endorse this approach to investing. This is like the person who wants to lose weight and jumps on a new diet/exercise program every other week. Can such a person actually expect success? No. And the same thing can be said about becoming a successful investor. Slow down. Understand you have to go through a process to hone your investment skills. This is going to take time.
Second, educate yourself. Before jumping into action, you need the proper knowledge. Fortunately it’s very easy to get educated about investments. You can get a ton of free information about investing on the internet (like getting my free e-course on How to Invest Like a Genius! by signing up for my free newsletter). Take the time to understand:
How bonds work
What a mutual fund is
The pros and cons of owning individual stocks
You can also master these topics (and more) by studying the investing guides I’ve prepared on this site.
My advice is not to do anything unless and until you have a clear understanding of each of these investment alternatives – at the very least.
Finally, start slow. You are going to make mistakes and you can’t beat yourself up when you do. You will learn more from doing (and making mistakes) than by reading and talking. Do your homework and start small. But before you go off and start, I have some bad news. Even if you do everything right, there will be times when the market beats you up and you absolutely must be ready for this.
Can You Predict The Stock Market?
The stock market is volatile for a number of reasons. The forces that cause market turbulence differ depending on what’s happening at the time. Here’s a quick video I put together during a particular period of difficulty a couple of years ago:
As smart as I think I am sometimes, the reality is nobody knows what really moves the market at any one time. Of course, that doesn’t stop people from trying. And even if you do “get it right” and figure out what’s going to happen in the market, your “clairvoyance” may actually cost you a lot of money over the long-term. I’ll explain that in a bit.
When we try to predict the stock market it forces us to define ourselves; we are either investors or speculators — or something in between. The type of investor who says they “see ” a correction coming and changes their investments as a result is in fact a speculator. When you say, ” I KNEW IT!” – the reality is, you didn’t. Maybe you speculated (guessed) and got it right… but that’s it. There is nothing wrong with being a speculator but it’s important to call something what it really is.
If you try to forecast how certain events will impact the future as it relates to the stock market you are a speculator. There are no two ways about it. The person who could “see it coming” in 2008 should have “seen it going away” in 2009. Not many people did. I met many people who “got it right” and pulled out of the market in 2008 and avoided the financial crisis. The only thing is, they kept their money out of the market far too long and ended up losing more than had they invested and rode through the decline. If you speculate on the market getting out, you are obliged to speculate on getting back in. Not many people are consistently good at that.
So this issue forces us to decide what kind of investors we want to be.
Having said this, I will admit that there are “speculators” and then there are “speculators.” Some speculate all the time and others do so less often. Some speculate on large amounts and others on small amounts. But if you base your investments on how you think some current event is going to impact the future, please understand that you are speculating and taking on a lot more risk.
Here are some questions you can ask yourself when you’re thinking of how to predict the stock market:
1. Are you an investor or speculator?
Do you make investments based on current events or based on your long-term goals? Both have pros and cons. Which is the best way to protect your assets?
2. If you consider yourself an investor, don’t ever speculate.
This doesn’t mean you have to invest blindly or buy and hold your positions forever. You can use different strategies that are market-sensitive. That means you invest when the market is strong and refrain from investing when the market is weak. Like everything else, it’s not perfect. But such systems may help you avoid catastrophic results.
3. If you consider yourself a speculator, have realistic expectations.
There will be times when you’ll get it wrong. That goes with the territory. And when you get it wrong it will cost you. If you can’t accept that, don’t speculate. Many experts say that more money has been lost anticipating the next bear market than has been lost when the market actually fell.
Should Investors Stop Investing During Wars?
When war breaks out it is of course a catastrophe for humanity. And when something that bad happens, it may feel better to sit on the side-lines as an investor. You are probably feeling terrible for all the people who are suffering and dying. And beyond that, you probably have a little financial fear as well. How is this war going to impact your own financial future? With things so bad, who wants to invest?
I understand those sentiments. But the question is does it make sense to shut down as an investor when the world seems to be falling apart? We can’t predict the future of course. But we can look at the past and see how the market did in times of war. Did it make sense to refrain from investing during times of military conflict in the past?
I looked into this myself and the answer surprised me. Here’s a graph that plots a few major conflicts and how many people died on a chart of the S&P 500 in the recent past. Of course this is no guarantee of future results and you can’t really invest directly in the S&P 500. But none-the-less, the graph tells a pretty interesting story.
As you can see, past military conflicts were terrible in human cost. But they didn’t necessarily doom the market. Quite the contrary. The market actually did pretty well once military operations began. That conclusion may seem counter-intuitive to you. It did to me. That’s why I did more research.
I found a unique study done by some well-regarded European academicians who did their own research. They wanted to understand how the threat of war impacted markets vs what effect actual war had.
They looked at large military conflicts dating back to World War II. The looked at how the market performed leading up war and how the market did once the war started. They concluded that the prospect of war usually led to stock market declines. But they also found that once war actually broke out, the market tended to do pretty well.
This is not to say that war is good or that every military conflict leads to prosperity. But I think it’s fair to say that war doesn’t always spell disaster for investors. Other forces are far more important.
Let’s look at what some of those forces are and what you should do about market drops.
What is a stock market correction?
Experts refer to certain stock market declines as “corrections”. But what exactly are corrections and what is the difference between a correction, pullback and bear market? Glad you asked.
When the S&P 500 index declines 10% to 20%, it’s known as a market correction. If the market drops less than 10% it’s called a pullback. And if the market falls more than 20% it’s labeled a bear market. What do these terms have in common? And what should you do about it?
Experienced investors know that dips and drops are par for the course. If you put money in the market you have to be ready for tough periods. But just how often do these hiccups happen? Market research firm Birinyi Associates of Westport, Conn did the digging and came up with the data.
They found that between 1962 and 2011, the S&P 500 shed 20% or more on 9 occasions. That’s just about once every 5 plus years. During that same period, the market fell into a correction (losing 10% to 20%) 16 times – or once every three years. And even during good years, the market has its rough spots. On average, the market drops a little over 7.5% during the year even when the market ends in positive territory for the year.
What Should You Do With This Information
I believe this data can help you and I gain better perspective on our investing. I’ll get to that shortly. But I don’t think it makes sense to have a fixed response to “pullbacks”, another for “corrections” and yet another for “bear markets”. The labels the pundits ascribe to market movement isn’t that helpful.
What difference is there between a 19% “correction” and a 20% “bear market”? Not much. And a 2% loss is very different from a 9% loss. Why are they both are called “pullbacks”? So the first thing I suggest you do is forget about terminology – it won’t help you make more money or protect your account any better.
What can help you as I said above is to have perspective. Market drops happen all the time. You can either hold through these difficult periods or use a market sensitive approach to try to minimize the damage. Either way, there is no guarantee of better results. The buy and hold approach works well for some people and for not for others. A smart market rotation style can be great but it’s not foolproof. Using any particular approach you probably won’t beat the buy and hold investors every year.
If you look at the S&P 500 you can plainly see that it has a history full of pullbacks, corrections and a few bear markets as well. None-the-less, long term investors who are able to stick with it, have done nicely. This is no guarantee of future results but it helps maintain perspective.
Corrections happen all the time. We might be in one now. Or it might start tomorrow. It’s impossible to predict friend.
Instead of trying to become a fortune teller, pick an investment strategy you feel comfortable with and stick with it. If you are a buy and hold investor, don’t get spooked. If you shift your positions as the current market changes, rely on your system to adjust your holdings. The one thing I strongly caution you against is to react emotionally to a pullback, correction or even a bear market.
What is a bear market?
A bear market describes a very unpleasant situation during which stock prices decline over a painfully long period of time. According to the pundits, a “Secular Bear Market” is measured in years – not days, weeks or months. A “cyclical bear market” is much shorter.
While the long term trend of the market is up, bear markets rear their ugly heads periodically. And when they do, they are costly and agonizing. By definition, whenever the index drops by 20% or more, it’s described as a bear market. But it can be a lot worse.
During the granddaddy of all bear markets, the Great Depression of the 1930s, the market dropped 90%. Aye Chihuahua!
How To Spot A Bear Before It Claws You To Pieces
Historically the market does poorly in anticipation of a weakening economy. So if GDP is slowing and inflation and unemployment are going up a bear might be coming your way. If you watch these numbers over several quarters and see things going in the wrong direction, it could mean big trouble ahead. Bear markets rarely happen as a result of one specific event but occur as a result of general and widespread weakening economy.
Are you puzzled by what to do with your investments right now? Feel free to ask me your questions. I’ll be glad to help if I can.
The Problem – Bears Wear Camouflage
Bear markets are easy to spot in hindsight but exceptionally tricky to identify real time. Remember, when some stock market genius tells you we are currently in a bear market, that’s just his or her opinion. Let’s look at a few examples to illustrate.
Here’s a chart of the S&P 500 courtesy of Yahoo! Finance. It depicts market performance from 2007 through 2009.
The economy wasn’t just slowing at that time – it stopped. GDP turned negative in 2007 and 2008 and we lost 9 million jobs during that period. Although inflation wasn’t a problem, the United States clearly was in a steep and harsh recession.* The market lost more than 50% almost overnight. But were we in a bear market? Take a look at the next chart and you tell me.
As you can see, when the situation was most bleak, the market started doing really well. Had you concluded that we were indeed in a bear market in 2008, you might have taken your marbles and gone home. Of course, that would have been a huge mistake. The market did nothing but make money for investors over the following 4 years.
That shows you the real danger in declaring a bear (or bull for that matter). Again, you can absolutely describe a historical situation with these terms but you can’t possibly do so while you are in the thick of it.
Beware of The Media
I can’t predict the stock market but one thing I do know is the media is really terrible at helping us make good investment decisions.
Here is a graph that circulated a few years ago. It shows the pattern of the market through 2013 against the pattern leading up to the 1929 crash. The suggestion was that our market was just about to go over the ledge. Take a look yourself:
When you first see this, what is your reaction? Is it fear? If so, you aren’t alone. Lots of people got the wits scared out of them when they first saw this graph.
But was it true or helpful? As it turned out, no. The market returned 11.14% in 2014. And 2015 was a little bit below break even. In other words, the parallel that the media tried to draw was all smoke and mirrors.
And by the way, the folks who put that visual together used different scales to match up the graphics. If the patterns had been drawn to scale they would look nothing like each other. See for yourself.
And even if the patterns were to scale, it wouldn’t mean a thing. The conditions that resulted in the Crash of 1929 are very different from the conditions today.
Why This Is Important To You
Even if you didn’t see the naughty little graph, you can learn a lot by observing your own reactions when you first see this suggestion that doomsday is just around the bend.
It’s only natural to be frightened once in a while if you are an investor. In fact, that was the intent of the people who finagled this data. They did it in order to kidnap your attention and sell advertising. The problem is that some folks might be swayed by their fear and make investment moves they will later regret. Don’t fall into this trap.
Yes, the stock market is frightening at times. The short-term future is unknown and unknowable. But if you believe that (which I hope you do) you must also accept that a graph can’t accurately predict the future either.
Just because some geek knows how to manipulate data on an excel spreadsheet doesn’t mean he or she knows a thing about the market. Stick to a good investment method instead. Make sure you measure your risk tolerance and then allocate accordingly. You’ll be far better off in the long-run.
What You Should Do About Bear Markets
In my opinion, you should not alter your investment approach just because somebody tells you we are in a bear market. If you are a buy and hold investor (which I do not recommend), you should probably hold on and suffer through. What I would prefer you do is have a strategy that adjusts your portfolio to a more defensive position as the market shifts. If you reallocate your assets and reposition them based on market strength and weakness you will already be actively repositioning your investments long before the pundits make a bear declaration.
The bottom line is that bear markets describe the past and don’t tell you anything about what lies ahead. Rely on a good investment system and stick with it rather than shift all your assets around when a bear or bull market is declared.
Because this is so important, lets look deeper at the issue of investment declines.
Understanding and Preparing For Market Losses – Why This Is Critical
In order to understand how to make money in the market, you simply must understand the concept of market losses. This way, when the market takes a dive, it won’t catch you by surprise and you’ll know what to do.
To get started, please look carefully at the picture of the bell curve above. It is the key to understanding why most people lose money investing. The good news is that once you understand this picture it can help you avoid making catastrophic investment mistakes.
Don’t worry. This isn’t a statistics lesson. But even if it were, you know a lot more about statistics than you think. In fact you draw these bell curves all the time…at least in your mind. But you may not be doing it correctly.
Let me show you what I mean.
Let’s say you are considering making an investment in a mutual fund. You look at the fund performance over many years and there is plenty to like. You find that over the last 20 years, it had a number of great years. And you perk up even more when you see that it returned a profit of 30% or more several times. At the same time you notice some bad news. During the worst years investors lost 30% or more. That also happened a number of times.
That being the case, you could draw a bell curve like the one I created above. If you did draw that bell curve it would accurately describe the past performance of this hypothetical fund. Most of the returns fall between +30% and -30%. And if you were a statistics freakazoid, you could conclude that if you buy this fund, your returns will fall between +30% and =30% 95% of the time. If you did come to such a conclusion, you’d be right.
The problem is that you’ve failed to consider the other 5% chance of an outlying event occurring otherwise known as “the tail”. Sure you acknowledge that there is a 2 1/2% chance of something really great or really awful happening intellectually. But in your heart, you dismiss it. “It won’t happen to me” is what you tell yourself.
Of course, the 2 1/2% to the right of +30% is wonderful. It represents those years when the return exceeds 30%. According to our bell curve, that’s going to happen 2 1/2% of the time.
But 2 1/2% of the time, the performance will be much worse than -30%. Yikes! 2008 was one of those years. Need I say more? The reality is that these “bad surprises” are a possibility and nobody can predict how “bad” they might be or when they might occur.
The Big Problem
Some people make the mistake of forgetting about the extremes as I mentioned above. Others think that once the extremes happen, those extreme returns are the new norm. Both of these conclusions are flawed, dangerous and expensive.
If the market tanks and you decide to never invest again, you’ll be selling low and forgoing any potential for future growth. You also potentially jeopardize your financial future and retirement. Ouch.
When your investment returns fall into the right tail, it’s equally as dangerous to expect those sky-high returns to repeat themselves year after year. You might chase return without considering risk. Some day that chicken will come home to roost and you’ll be the one who gets cooked.
So what is an investor to do?
1. Be clear on your financial situation and time horizon.
Create a portfolio allocation based on your real time horizon. Say you are 57 years old and you want your money to last until you reach 85 years of age. What is your time horizon? It’s 28 years. Even if you get clobbered with a terrible market, it may not mean that much in your overall plan. Don’t make the mistake of changing your time horizon when things get difficult and uncomfortable. That usually works out to be a very costly mistake. Acknowledge worst-case scenarios and be willing to accept them or use an investment strategy with less risk.
2. Use the right asset allocation to reduce risk.
It’s very dangerous to take on more risk when things are good and suddenly become very conservative when things are bad. Select a portfolio allocation that will pass the “sleep at night” test in tough situations. This will allow you to stay invested longer.
3. Understand that things may not work out as you planned.
If you get caught in “the tail” too soon or too long, your plans may not work. The chances of this happening are low – but they are there. If you build your whole investment strategy as if the worst will happen, you’ll be ignoring the other 97 1/2% chance that things will be much better. That’s like staying inside all day because of the slight chance you might get hit by a bus. Is it possible? Yes. Is it likely? No.
And if you do get hit by a “financial bus”, you still have options. You can reduce spending and/or work longer. If that happens, it doesn’t mean you made a mistake. You could have made the best decision possible with the information you had available and things still could have turned out poorly. Have a “Plan B.”
Don’t get me wrong. I believe that you can and should use an investment strategy that recognizes risk and adjusts your portfolio accordingly. But no matter what you do, there is no guarantee that it will work.
4. Beware of your confirmation bias.
Confirmation bias is a very important concept – especially for investors. It is the tendency you and I have to look for proof that we are right rather than look for the truth even if that means we are wrong. Along the same lines, that same bias leads us to downplay information if it is counter to what we already believe is right.
On the face of it, this may seem like a pretty natural thing to do. The problem is that because we are confirmation biased, we tend to ignore competing truths that might help us make smarter investment decisions.
Here’s an example outside the financial realm. Let’s say you happen to be a libertarian. You’re going to read what other libertarians write. You will talk to other libertarians and listen to other libertarians as much as you can. This is fine except that once in a while a conservative or liberal person might have a better idea you hadn’t considered. This shuts you off from the potential to learn and grow and maybe take a different (better) course of action. This concept is at work of course no matter what your political views are.
If this phenomenon only related to politics it would be bad enough but confirmation bias also extends to how we invest. And if you want to make smarter investments, it’s crucial that you isolate that problem a.s.a.p.
Let’s say you are convinced that the price of gold is going to the moon this year. If you allow that opinion to influence your research, you’ll ignore any contrary opinion or facts and gather as much support for your notion as possible. That could be a very expensive error.
What happens to people under the spell of confirmation bias is that they don’t see when the tide has changed. They are so stuck with their own beliefs that there is basically nothing you could show them or say to them to help them get a balanced view.
How expensive could this problem be?
I met a man a few years ago who was convinced that the government was going to take his 401k and nationalize all retirement accounts. I have no idea where that stroke of genius came from but he was absolutely convinced this would be our fate. What did he do?
Despite all the proof I laid at his feet to the contrary, the man took all his money out of his retirement accounts to keep it “safe” . Meanwhile he incurred a huge income tax penalty as a result of this move and lost the ability to take advantage of continued tax deferral for the many years ahead.
Are you suffering from confirmation bias?
Of course I can’t tell you but I can share a study done by the American Psychological Association a few years ago. They concluded that people look for information that confirms what they already believe to be true twice as much as they look for information contrary to what they already to believe to be true. In other words, it’s highly likely that you and everyone you know suffer from this problem.
How do we overcome this problem?
What can you do to get out from under this problem? Two things:
1. Handle the truth.
Admit that this phenomenon is real and examine your own behavior. Make sure that when you do your research, you aren’t just looking for facts that support your existing opinion.
2. Get out of your comfort zone.
Go out of your way to look for opposing views. Actively try to find some value and truth in ideas you generally disregard. Ask yourself, “what if I’m wrong?” “What would someone with a different opinion think about this?” “What would they say?” And if all else fails, talk to your investment mentor.
If you want to make sure you are making smart investments please look for the opposing view and thoroughly consider the opposite opinion.
Why Your Definition Of “Successful Investments” Needs To Be Crystal Clear
You may think that it’s easy to know if you are making profitable investments ; if you make money, the investments are successful. If they lose money they are not profitable investments. Right?
While this model of performance is generally true, many investors apply this incorrectly and make huge investment errors as a result. Here are the three top ways many people evaluate “profit” that can get them into trouble:
1. Time Frame
If you determine that the only way your investments are successful is if you make money each and every month, the only investment alternatives available to you are bank CDs. With interest rates for one-year bank deposits coming in about 1% (before taxes and inflation) it will be difficult to reach your financial goals even though your investments are “successful” (according to your primary directive and definition).
This is just an interesting twist on the theme of “winning the battle and losing the war”. Clearly, defining investment success as never losing money (the flip side of always making money) is a non-starter.
So the first question you must ask yourself when you define a profitable investment is, over what time frame? And the problem here is that if your time frame is long, you have to make decisions today about a future you are uncertain about.
Let’s go on.
Let’s say you decide that investing in the bank is for the birds and that you want to grow your money relatively safely for the long run. You decide to invest in a balanced mutual fund.
You want to know if your strategy is successful so you compare your performance to that of the overall market or S&P 500 index. You do a little investigation and learn that your fund earned 10% while the overall market was up 15%. Should you conclude that your mutual fund performance was stinky?
Not really. You invested in a balanced fund which has both equity and fixed income investments in the mix. You invested in that fund because you didn’t want all the risk of having all your money in a growth portfolio of stocks. How can you come back now and compare your performance to an all-equity index? You really can’t if you want to make a fair conclusion.
If your long-term goals are to grow your money safely so you don’t have to worry about your future, you have to evaluate your performance over a very long time. Mark Hulbert is a noted follower of investment strategies. In January of 2012 he noted (in his Market Watch column) that the only way to accurately evaluate a growth strategy is to examine it over at least 15 years. That is not to say that you must hold a fund for that period of time. Mr. Hulbert is saying that you should evaluate your investment approach over that time period.
Forget the track record of the last year or two. What has your approach done over the last 15 years? You might have an approach that selects funds based on current performance or you might be a buy and hold investor. Whichever way you go, just make sure you evaluate the approach over (at least) 15 years.
Look for proof that your approach has done a good job of weathering a variety of market conditions and the only way to do that is to look at a very long-term track record.
With that in mind, let’s continue.
Why all the caveats?
The goal of investing in stocks is to grow your wealth over time. And we’ve already seen that in any one year (and often longer) the market can experience wild gyrations. If you need your money soon, the market isn’t for you.
Also, if you are have high cost credit card debt, don’t invest. Instead, get rid of that debt first because you get a high guaranteed “return” in the interest that you save.
If you don’t have any emergency money set aside and you run into a sudden, unexpected need for cash, you’ll have to sell your investments. If that happens at a bad time and the market is weak, you could be forced to sell at losses. That’s why you should first set up an appropriate emergency fund before investing.
And that’s not all. You must have the emotional fortitude to stick with your investment strategy through thick and thin to be a good investor as well. Many people aren’t able to do that. And what happens is that they react emotionally when the market takes a tumble and cash out at often the very worst times. We’ll talk about how to overcome this problem in just a bit.
JP Morgan did a study and found that for the 20 year period ending 2014, most investors underperformed the market significantly for this exact reason – they reacted emotional to the market and failed to let the ups and downs even out over time. Marketwatch did their own digging into this issue and made similar conclusions.
In the JP Morgan study, the average investor earned only 2.5% per year over this time period while a balanced fund made up of stocks and bonds grew by more than 8%. Why the difference? Because individuals often pull the plug at the exact wrong times as a result of fear.
This is not to say that if you hold on for 5 or more years you are guaranteed a great return. There are no promises. There have been many long stretches of time with little or no return in the market. In order to make money in the market, the longer you invest and the longer you stick with the right strategy, the better your chances are.
Stocks or Funds?
When people invest in the stock market they either do so by purchasing individual stocks or funds. There are other ways to invest. But by far, these are the two most prominent.
When you buy individual stocks you are making a (relatively) large bet on one company. When you buy a mutual fund your theoretical risks are dispersed. That’s because of the diversity mutual funds and ETFs offered as I explained above. A fund often owns hundreds or thousands of different stocks.
So, if you buy stock in one company, you might invest $100 and buy 10 shares of XYZ stock for $10 each.
But instead, if you buy 10 shares of AAA Mutual fund at $10 each you might own a little part of 500 different company’s stocks held in that fund. That means you have a lot less risk (relatively speaking) with funds as opposed to stocks.
Cost of Stocks vs Funds
Besides risk, cost is also something to consider when you are trying to decide between stocks and funds. When you buy an individual stock you might pay a commission when you buy and when you sell the stock but that’s about it. As you’ll see in the section on “where to buy stocks and funds” that cost is usually minimal. But with individual stocks, you won’t pay any additional fees unless you hire a money manager to manage the stocks for you.
But when you buy a fund or ETF, you incur additional costs. You might have to pay a commission when you buy or sell as well. But even if you don’t, you will still have to pay ongoing management expenses. Depending on the fund you buy, you could pay as little as .07% per year or as much as 3% per year. For a full understanding, you need to read through the particular fund’s prospectus.
Why do funds charge ongoing fees? Well, first because the fund company wants to make a profit. Without collecting money from the investors, they can’t make that profit. They have to charge you in order to stay in business.
Second, funds have expenses associated with managing money. For one thing, they have an investment committee which decides which stocks to buy and which to sell. The investment committee takes the burden of making investment decisions off of your shoulders which is great, but they have to be paid.
That’s why funds charge fees. Some funds are managed very actively; they buy and sell frequently. That frequent trading costs money so they generally charge higher fees. Those funds that are more passive and trade less typically charge lower fees.
The Importance Of Fund Fees
My experience tells me that fees are important but maybe not the way most people think they are. While you might expect the funds with the lowest cost to perform the best, that isn’t always the case. Need proof? Check out the highest performing funds in any given period. They are rarely the least-cost alternative.
Look at the following chart:
This shows the expense ratios of the 10 best performing large-cap growth mutual funds (net of fees) for the 10 years ended 9-2016 in order of performance. Yes, the lowest cost fund on this list performed best, but the second cheapest fund (charging .87%) was the 9th best performer. And by the way, there are plenty of funds that charge less than .49% that didn’t even make the list at all.
Why is that? It’s because fund performance is more important than costs.
Why aren’t there any super inexpensive funds on the list? There are plenty of funds that charge less than .1% per year. Where are they? If the cheapest fund there is charges .07% per year but underperforms the higher cost .49% fund by 2% over this period, is the cheaper fund a good deal? No. Granted, nobody can point to a fund and tell you that it will be one of the best performers over the next ten years. But if we look at the lists of the top performers and rarely see a cheap fund make the cut, it tells you something; right?
Oh….and one more thing. Performance is quoted net of all expenses. And if the goal is making money to achieve your financial goals without taking undue risk, shouldn’t performance be the determining factor? Of course it should be. That said, fund performance, risk and your investment strategy are far more important than fund costs alone.
Bottom line? It’s important to understand fees but they should not be your only criteria for selecting how to invest.
Do funds make more money than stocks?
This is a question I get asked all the time and it’s hard to answer because it depends on which funds and which stocks you are talking about. If you are good at picking stocks and enjoy it, you will likely make more money with individual stocks. However, it’s important to keep in mind that with individual stocks you have to do your own research. Also, keep in mind that if you go this route, you should plan for an ongoing time commitment to manage your stocks.
That’s because things change. You may not want to buy a stock and hold on to it forever. Stocks that are doing well today could go south tomorrow. That’s why it’s critical to have a strategy to manage your stock portfolio that tells when to buy and when to sell rather than simply buying stocks that are popular at any one time and holding on to them forever.
The bottom line is that many people find it more efficient and less risky to buy stock funds or ETFs rather than individual stocks.
Which mutual funds are best?
The answer to this question depends on your investment style and strategy. Also, keep in mind that all mutual funds are not alike. There are bond funds, stock funds, international stock funds, large cap funds, small cap funds, value funds, growth funds etc. The list goes on and on.
To make matters more complicated, there are passive funds and active funds as I hinted at above. Passive funds buy stocks held in an index (like the S&P 500) and hold on to those stocks until the index itself makes changes. (That usually happens about once a year). Actively managed funds trade stocks much more frequently as I mentioned above.
ETFs and Index Funds
I’ve been using the terms “index fund” and “ETF” interchangeably for a while now. But let’s take a little closer look. An ETF (Exchange Traded Fund) is very similar to an index fund. They often just replicate the holdings in the index and they do very little trading . That keeps costs very low.
There are some minor differences between index funds and ETFs however. The main difference is that ETFs trade like stocks and are priced during the day. For most investors, the differences between ETFs and index funds aren’t that important.
Stocks, funds and ETFs are some alternatives but you can also trade options. Most people are familiar with the term but exactly what are stock options?. This is important because stock options have become more common in recent years. They are often included in employee compensation packages. They are also a tool investors use to increase investment income.
An option is a type of derivative that creates the ability to buy or sell a security at a predetermined price.
Options are not securities themselves, but a play on the direction of the underlying security. The underlying security can be individual stocks, bonds, commodity futures contracts or even currencies. Let’s start with some definitions:
This is the right to buy a stock at a specific price. There are also long- and short-calls. In a long call, the buyer pays a premium for the right to purchase the stock, and can exercise his option to buy when the stock price exceeds the call price plus the premium paid for it. In this way, the buyer can make money on a rising stock price without ever owning the stock. If it never reaches a level at which he can make a profit, he lets the call expire and loses only the premium he paid for it.
This is an option used if you believe that a security will rise. You would sell a (covered) call if you own the stock and don’t think it is going to rise in value much over a given time period. If you are right, you’ll hold on to your stock – and pocket the premium. If you plan on using this strategy, you would make sure to find out if you can write calls against your shares before you decide which stock to buy.
In a short call the buyer believes the security price will fall. You will have to sell the stock to the buyer of the call at the buyer’s option. This is a risky position to be in for the person making the short call. If the stock does drop, the gain will be limited to the amount of the premium; if the stock rises, the loss can be unlimited.
This is the right to sell a security at a specific price. Just as with calls, there are also long- and short-puts. With a long put the buyer buys the right to sell the security at a fixed price with the anticipation that the security price will fall. If he figures out when to sell those shares, he’ll make a profit if the security falls below the exercise price plus the premium. If it doesn’t fall to that level he can just allow the put to expire and will only lose the premium paid for it.
A short put works when the buyer believes the security price will rise. If the security does rise above the exercise price, the buyer will make a profit equal to the amount of the premium. If the security doesn’t rise by more than the amount of the premium, the trader can lose up to the amount of the stock price.
This is the agreed upon price or security target price at which the option holder has agreed to trade the underlying security.
Essentially, this is the fee charged by the writer of the option.
Exercising, as in exercising an option
Exercising an option is simply completing the buy or sell by the option expiration date.
Options are usually taken for a specific period of time, which means they have an expiration date. After this, the options become worthless.
Confused? Unless you trade options regularly, it’s difficult to wrap your arms around the concepts completely. Options are not nearly as simple as holding the underlying securities themselves. But you can get a better understanding by studying the tutorials at online stock brokerage companies.
Stock options and employees
Stock options have become a popular form of compensation, especially for managers. They can be quite lucrative—or not—depending on what happens with the price of the underlying securities.
For employee stock options, the underlying security is most typically the stock of the employing company, though it can also be stock in an acquiring company. Employers will offer them to employees as an incentive to stay with the company and to motivate them to work harder so that higher stock prices are achieved and everyone benefits.
The options will include the right to be a certain number of shares of stock at a specified price during a limited time frame. The employer also typically establishes a vesting period of several years that restricts the employee from exercising the options. The vesting period is usually several years, which is one of the major ways that options keep employees from leaving the company.
The stock is usually offered at a discount, and when the options are exercised, the employee can sell all of the stock and realize an immediate gain, hold the stock for (hopefully) greater future gains, or sell some and hold the rest.
There are tax considerations with employee stock options that vary according to how the options are established. If your employer offers stock options you’re well advised to consult with a CPA for the proper tax treatment.
The risks of stock options
The risks of having stock options can be greater than actually holding the underlying stock or other securities. As we saw with short puts and short calls, you can lose 100% of the stock price and even more. These are NOT appropriate for conservative or even aggressive investors in my opinion. They might be a good fit if you have expertise, a lot of money you can afford to lose and classify yourself as a speculator.
The risk to employee stock options is generally lower since you don’t have to pay for the options up front. However, there can be a risk if you accepted less cash compensation in exchange for stock options. If the desired option prices aren’t reached, you could have given up substantial compensation in exchange for an investment scheme that never played out.
Before You Start Investing
Now that you have a solid understanding of how investments work, we’re almost ready to invest. Keep in mind that I don’t know your unique situation or risk tolerance. That’s why this guide is going to provide general guidelines for you. Before you implement these ideas I strongly suggest you speak with your financial advisor.
Investing Is NOT Just About Making More Money
Smart investors know that investing is not just about getting the highest return possible. What you want to do is balance your financial goals with your emotional well-being. It makes no sense to invest super-aggressively if it keeps you up at night. On the other hand, if you invest too conservatively, you may not reach your financial goals.
How do you find the balance?
My suggestion is to first get an objective assessment of your risk tolerance. One way to do that is to take this or another risk survey. This will provide an introspective look of what kind of investment mix you might feel comfortable with.
Then, test your comfort zone against your financial plan. Does this kind of asset mix have a high likelihood of helping you achieve your goals? You will only know this if you run your retirement projections – and that’s why it’s a must.
This takes a little work. Most DIY investors skip this step and in my experience, it’s the reason many fail. Please don’t repeat their mistake. What good is it having a portfolio you feel comfortable with if it doesn’t have a high likelihood of getting you where you want to be? Let me show you a crazy analogy to prove the point.
I might feel really safe sitting in a tank. But if I can’t use it to drive down to the Food Mart to pick up groceries (or anything else) what good is it? You get the picture. Investing is all about compromise.
Once you test your risk appetite and run it against your financial plan, you’re just about ready. I want to offer one piece of advice; I suggest that you start off being a little more conservative than you think you should be and monitor yourself over a period of time. In fact, stay tad conservative until the market goes through a rough patch or two.
You really know what your risk tolerance is once the market turns ugly. If you can stomach it, that’s fine. You might consider becoming even a little more aggressive. But if you can’t tolerate the swings, lighten up on the equities and put a heavier emphasis on fixed income as long as the renewed allocation jives with your long-term goals.
The Last Filter
Now that you know what your risk tolerance is and what your long-term goals are, the next thing you should think about are your priorities. Are you in debt? Are you going to buy a house or spend a lot of money in the short term? How far away are you from retirement? As you’ll see, your investment plan should be customized to accommodate these very unique circumstances:
How to invest if you are in debt.
If you have significant credit card or personal debt, address that problem before worrying about investing. This is important for two reasons. First, the interest you are paying on those debts is likely far higher than any guaranteed return you could make by investing. And second, if you don’t take care of the debt problem, it will probably grow. And if it grows, you may have to liquidate your investments at some point to pay off that debt anyway.
If you have mortgage debt, car and/or student loans, you might be OK investing while paying those debts off but if the rates on any of these debts are higher than 4% – I would personally pay them off before investing. That’s because when you pay off a debt it’s a guaranteed return.
In other words, if you pay off a creditor that is charging you 4%, that means you’ll be saving a guaranteed 4% . That’s the same as earning a guaranteed 4%. The higher the rate on debt, the more profitable it is for you to pay it off before doing anything else.
How to invest if you are just starting to put money away
Let’s assume you have no substantial debt, you’ve already set up your emergency fund, and you’ve got money to spare each money that you want to invest. Let’s further assume that your main financial goal at this time is to save for retirement (we’ll talk about other goals and how to invest to achieve those goals in the retirement guide).
If that describes you and you have retirement plans at work or are able to set up your own IRA or other retirement plan, that’s where you want to sock that cash away. You benefit most by adding as much money as possible to retirement plans because of the tax benefits of doing so and because these plans keep your money safely invested so you can’t spend it. (When we get to the retirement guide, we’ll discuss the differences between the types of plans.)
For example, if you have a 401(k) plan at work and are eligible to contribute $500 a month to that plan, do it. (If you have another $500 (or whatever amount) you are not allowed to put into that or any other retirement plan, you should invest that money for long-term growth in a non-retirement plan (non-qualified).)
How to invest if you are more than 10 years away from retirement.
If you have a decade or more before you plan to retire, you’ve got time and it’s important to use it wisely. Believe it or not, your time is just as important (if not more so) than your money.
As described above, determine what your risk tolerance level is. Then run yourself a few retirement projections to determine what you need to do in order to achieve your financial goals.
In most cases, that will likely include investing for growth – at least partially. In case you think that your investment time frame is short because it only extends to your retirement date, here’s a key success nugget that most people overlook.
You have a lot longer to invest than you think. Let me explain this by way of example. Let’s say you are 50 years old and you want to retire at 65. Do you have 15 years to invest? NO. You have decades more. That’s because if you are like most people I know, you want your money to keep working after your retirement date.
In fact, you want your money to keep working as long as you live – at least. That’s the key; when you think about investing, think about how long you want your money to last/work for you rather than your retirement date. Indeed, your retirement date isn’t that important when it comes to deciding how to invest.
If you are 50 years old today and you want to retire in 15 years, you probably still want that money to work another 25 or more years after you retire. If that’s the case, you have a 40 year time horizon, not 15.
So your first step is to be crystal clear on what you want your money to do for you and for how long. Once you know the answers to these two questions, invest accordingly. Again, balance your risk against your long-term needs and invest in a way that provides the greatest chance of you achieving your goals with the least amount of risk.
How to invest if you are less than 10 years from retirement
If you are less than 10 years from retirement, you might think you have to invest very conservatively. Well…you might. But you might not. Please read the two sections above. They are important and provide the necessary background you need. What I’ve explained above should help you hold on to the right mindset while understanding your real investment time-frame. If you read between the lines, I’m saying that your retirement date isn’t necessarily that important in determining how to invest.
Think about investing from the standpoint of how long you want your money to work for you. Remember that just because you retire, doesn’t mean you can afford to allow your money to do so. Inflation marches on regardless of what you do. That being the case, resist the temptation to become too conservative.
How to invest if you are retired
Retired people still have long investment time horizons. Focus on your expected longevity and (more important) the desired longevity of your assets. I realize that’s not always so easy to do but it is important. The problem here is that when people stop working they often become hyper sensitive to short-term fluctuations in their investment accounts.
I understand this. It’s only natural. Since you aren’t working, it becomes more important than ever to protect your capital. I get it. But as we’ve discussed, investors who become over-cautious often jeopardize the long-term safety of their retirement accounts in order to minimize the short-term risk. This is a very bad and expensive trade-off.
The solution is to revisit your risk tolerance and test again. Once you do that, re-run your retirement projections as well. Invest using an allocation that exposes you to the least amount of risk as long as you still have high probability of achieving your goals.
How to invest if you are way behind.
People who haven’t saved enough for their retirement are often anxious. They sometimes feel compelled to invest too aggressively. In their minds, they do this in order to “catch up”.
I understand this of course but I caution you against being too aggressive if you find yourself in this camp. The reason is, people who take on too much risk lose money over the long-run in my experience. They get involved with speculative schemes and risky ventures.
Remember, even if you are behind, you probably still have a number of years to make up for it. And when we speak about retirement investing, it is by nature a long-term deal.
You will take far too much risk if you speculate. Don’t give in to that impulse. Instead, slow down and breathe. Revisit your plan and consider adjustments such as delaying retirement, working part-time and/or spending reductions.
My strong recommendation is not to compromise when it comes to investment strategy. Do not get in over your head or invest aggressively. The odds are definitely not in your favor if you fall into that trap.
Investment Strategies To Consider
I’ve already explained how different investments work, now let’s consider different approaches to investing. This is important stuff. It’s far more important to get your approach right (for you) than to pick one or two good funds or stocks at any one time. That’s because if you get the approach right, it’s repeatable. But making a lucky call once in a while isn’t something you can count on.
There are three different strategies that most people use. My goal is to help you make smarter decisions based on your understanding of these approaches to make more money over the long-run and have a lot less stress starting now.
But keep one thing in mind. No matter how you invest, please don’t expect stellar results all the time. And prepare yourself for losses. That’s just the price we pay to achieve our long-term goals.
With this in mind, there are a few ground rules that we need to establish. These rules are basic and the foundation on which to build a successful investment approach:
- Nobody can predict the future.
- You can point to any investment strategy and “prove” it’s either great or terrible by manipulating the time frame. What matters most is the long-term results and accompanying risk.
- Behind every investment pick there is an investment strategy and the strategy is what we’ll discuss – not the stock or fund pick.
- Before investing make sure you understand your time-horizon.
With these fundamentals clear, let’s establish a few rules:
Rule #1. You aren’t allowed to try to predict the future or listen to someone else who does.
Rule #2. You aren’t allowed to change your investment time horizon just because the market or political situation changes. Obviously, if your personal situation shifts, you’ll have to adjust your investing strategy. But if you shift your investments based on nothing more than your feelings about the economy/market/whatever, that’s just breaking Rule #1.
Rule #3. You can’t win them all. Every decision has its benefits and drawbacks. You have to accept that you will suffer losses in order to gain the long-term benefits of any investment strategy you employ.
You might be telling yourself that these rules are all self-evident. And if so I congratulate you. But before we accept that, let me ask you a few questions just to make sure:
Have you ever changed your long-term investments as a result of a political, economic or historical event because you “knew” the market would melt down as a result? If so, you broke Rule #1.
Have you ever read about a very promising new stock and bought stock based on their very bright future without doing any research? Or have you ever said, “I know the market will never come back from this” and sold out? If so, you also broke Rule #1.
Have you ever complained about the low interest that banks pay? That’s breaking rule #3. You wanted the safety of the bank but aren’t willing to accept the downside – low interest.
You see? Adhering to these rules isn’t easy – but necessary if you want to achieve long-term results. Using these three rules, we’re going to proceed and take a deep dive into three investment methods: asset allocation, buy and hold and timing the market.
You probably already understand the benefits of not putting all your eggs in one basket, right? If so, you understand the basics of asset allocation. Yay!
People who invest using this concept have a variety of different funds in their account representing different indexes or areas of the market like large cap, mid cap, international etc. But since asset allocation calls for having fixed percentages of their account in specific parts of the market, these investors have to tweak their holdings periodically.
Let me clarify this by way of example. Let’s say your asset allocation model calls for you to hold 10% of your account in large cap index funds, 10% in international and the other 80% in various other funds and that you start with $100,000. That means you’d invest $10,000 in large cap and $10,000 in international and $80,000 in other funds.
Assume that by the end of the year, large cap did particularly well relatively to your other positions and is now worth $12,000. If the total account value is still $100,000 at the end of the year, it means you have 12% in large cap and that’s too much.
Going back to our example, assume that international, is only worth $8000 and makes up 8% of the total account at the end of the year.
If you were an asset allocator, you would sell off $2,000 of the large cap and buy $2,000 of the international fund to bring the holdings back into line with your 10% targets.
If you noticed, using this approach, you sell high and buy low. Selling off some of the positions that do well (which appreciated in price) and buying other positions that fell in price and are cheaper. Asset allocators invest this way because they feel that nothing does well forever and it’s impossible to predict when any one index will do better than the other. This technique takes all the guess work out of investing because it has lots of eggs in lots of different baskets and they are constantly being updated.
Asset allocators might hold bond funds, real estate funds, commodities etc. It depends on how much risk the investor is willing to take. The more aggressive you want to be, the more you would skew your allocation towards equity. If you are interested in taking less risk, you might put more in fixed income.
Does Asset Allocation Work.
According to Wikipedia, during the 2000 – 2002 bear market, an investor who had 80% in stocks and 20% in bonds lost 34% while an investor with the inverse allocation made 6%. This makes sense. A person with a more conservative portfolio will do much better during very bad markets. Duh.
Now let’s look at 2008 and see how asset allocation funds did:
As you can see, asset allocation didn’t help investors that much. The overall fixed allocation (how much in stocks, how much in bonds) did help. But the periodic rebalancing did not really add value – at least in this case.
Asset allocation funds are designed to protect investors against steep losses but you can see that they don’t always do the job. That doesn’t mean they are bad funds. It means the concept isn’t foolproof.
Of course nothing is perfect. And no investment strategy will work every single time. And it doesn’t make sense to decide about your investments only from the “worst case” standpoint. That would have you keep all your money in the bank and probably not achieve your goals.
The real benefits of asset allocation are that they take the emotions out of the process, it leads to a diversified portfolio and can help protect investors from losses at times. But there are also downsides.
First, many investors are under the impression that asset allocation shields them from danger and risk and that’s just not true as we saw above. On top of that, this approach sells off the strongest funds and buys the weaker ones. I prefer to buy more winners and sell off losers. That’s why I’m not a big fan of asset allocation with static percentages. Let’s move on.
Buy and Hold
Buy and hold sounds simple enough; You buy an investment – you hold on to it. That’s it. What could be simpler than that?
Well, there is more to this than meets the eye. Let’s explore so you can really understand the pros and cons of this style of investing. For our purposes, we will use the S&P 500 index to demonstrate. (As I explained above this is an index made up 500 American stocks with the greatest market value.)
A Big Problem With Buy and Hold
Lots of people say they are buy and hold investors. The problem is, very few people can actually do it. Buying is easy. Holding is the difficult part.
That’s because at some point, people’s emotions get control over them. As a result, they make emotional decisions and override their “buy and hold” strategy. Often, this happens at the worst possible time.
To understand better, please review the following chart:
This shows that when times are hard (as depicted in the first column) it’s really tough to focus on the long-term. Look at 2008. Most people were thinking about 39% loss instead of the 25-year average gain of 9.61%. That’s natural. I get it. But it often leads to decisions that make your financial situation far worse.
At this point, I think it would be helpful to remind you of our 3 investment rules:
Rule #1. You aren’t allowed to try to predict the future or listen to someone else who does.
Rule #2 You aren’t allowed to change your investment time horizon just because the market or political situation changes.
Rule #3 You can’t win them all.
Buy and holders often find it difficult to honor these rules when the market hits a rough patch and that’s why the strategy fails. When times are good, it’s easy to have a long-term view. But when the bear market hits, people often shift their time frame (see Rule #2), decide that the market is going to continue falling (see Rule #1) and forget that every investment fluctuates in value (see Rule #3).
Consider the rolling 10-year periods over the last 75 years. The market has gone up 95% of those 10-year periods. So, if you are investing over a 10-year period, isn’t buying the S&P prudent? Of course it is. Even though 5% of the time, the 10-year hold lost money, so what? Should you build your future with the odds in your favor (95%) or should put everything on the line based on the 5% outliers?
Buy and hold can work in theory. But I believe that the emotional build-up is too great a force to overcome for many investors. In other words, this approach doesn’t fit most people’s mentality. Let’s consider a third alternative that might.
Many investment professionals will tell you that market timing is risky and doesn’t work. For the most part, they are right. But it depends on how you define “market timing”. In my experience, there are strategies which, when employed correctly, may help reduce risk and grow your wealth.
Let me clarify. When I say, “market timing” I am not talking about day trading. I’m talking about using objective data to determine when risks are higher (and therefore a good time to become more conservative) and when opportunity is greater (and therefore a good time to become less conservative). This might mean changing your portfolio once a month or once a year – it depends on your technique.
At the same time, it’s important to remember that even the best techniques won’t shield you from losses all the time and they won’t beat the market all the time either. This is true no matter how you invest.
Let’s take a moment and revisit the purpose of this exercise; to help achieve your long-term goals over the long-term, with the least risk possible. This is not about short-term performance but long-term fulfillment.
And before we dive in too deeply, I want to differentiate between adjusting your portfolio based on your gut feeling (see Rules above) vs. using objective, measurable data. If you are going to get in and out of the market based on how you feel when you wake up in the morning, I can’t help you. However, if you can stick with a formula to guide your investment decisions based on objective data, you could be going in the right direction.
For example, below is a hypothetical simple moving average system. You buy when the S&P rises above a moving average and you sell when the market drops below its average. You can see that over the long-term, this hypothetical system has rewarded investors richly.
However, this is hypothetical and is not based on real experience. I am only showing this example to explain what market timing is and how it might be used. Also, this hypothetical system beat the market for many years but it didn’t beat the market every year. There were times where this method did worse than the market. There were also years where you would have lost money had you used this technique to guide your investment moves. And there were years when those losses were substantial. Of course, the past is no guarantee of future results.
Again, you have to keep our third rule in mind – there is no free lunch and nothing is perfect. In other words, there are timing systems that have done better than buy and hold over the long-run IF the investor was able to stick to the system. Often, people can’t.
When you are agitated (either because of external events or because of your personal situation) it’s easy to shift your time frame, think you know what’s going to happen and reject the notion that sometimes as investor, you have to go through hard times.
Market timing isn’t for everyone. It may not be for you. And if you do go this route, please expect that there will be periods of underperformance and losses as I said. It may also involve spending more time and learning by trial and error or hiring someone to do this for you. But as we saw above, the right approach could deliver when it comes to risk reduction and help you achieve your goals over the long run.
Using Graphs To Guide Your Investments
I have already explained that market losses are a part of investing. But big stock market declines do sting. In fact, they hurt you twice. First, when the market crumbles it can take a big chunk of your money with it. And if you’ve ever gone through a steep market decline, the mere thought of going through another one might make you gun-shy with your money. As a result, you might invest far too conservatively for years thereafter. That often ends up costing you more than the loss you incurred during the market drop itself and it’s one of the big problems buy and hold investors face.
It would be great if there was a way to grow your money while reducing the risk. Is it possible to invest with a safety net to help you get out before the market implodes? Is that asking for too much?
Of course there is no fool-proof investing method. Everything has risk But some people try to time their investing by using moving averages. This is a type of trend following method. And some (but not all) of these people have great results*. Again, there are no guarantees – but let’s take a closer look to see if this strategy holds any water.
What Are Moving Averages?
This is just an average price of a stock or index. To illustrate what a moving average is, let’s look at the 200 day average for the S&P 500 index. All you have to do is add up the closing prices of the index for the past 200 days and divide that result by 200. Each day you update this by adding the most recent day and dropping the oldest date. Then you plot the results on a graph and compare it to the current price of the stock or index. That’s all there is to it.
And if you don’t feel like doing the math yourself you can also just look up the 200 day moving average (AKA MA) in Yahoo Finance! You can use that site to plot the current price of an index (or stock) against this 200 day MA. Check out the graph below. The solid red line is the moving average while the squiggly blue line is plots the daily price.
How Are Moving Averages Used?
You can use these moving averages to help you decide to buy or sell a stock or index fund. What some people do is buy an index fund when the daily price is above its 200 day moving average and sell if the current price is below the average. You can see that as the blue line goes below the red line, the investor would sell and once it goes above the red line, the investor buys the index fund again.
What Have Been The Results Of Using This Buy/Sell Rule?
There have been numerous studies that looked at this investment approach and many suggest the system has merit*. I was intrigued by this, especially for investors who depend on their investments for income.
This theory was tested by Jeremy Siegel in his book, Stocks for the Long Run. He concluded that an investor who used this strategy with the NASDAQ index from 1972 through 2006 would have outperformed the index by 4% per year with 25% less volatility*. That’s a lot of money Pilgrim.
Another study back tested this approach from 1901 through 2012*. They also found that a hypothetical investor using such an approach could have made a lot more money over the entire period. That’s mainly because the person using the moving average to guide their investments avoided some (but not all) of the worst market declines over the last 100+ years. (Again this is hypothetical only.)
Neal’s Notes. Does this seem like too much work? If so, you may want to hire someone to do this for you. If so, let’s talk.
Interestingly, this “timing” approach underperformed the buy and hold investor 50% of the time which is a lot. Specifically, during strong bull markets, the buy and hold investor did better. But during market crashes, the moving average approach protected much more of their capital. It’s really a question of picking your poison. No one approach is better for everyone. Each investor has to weigh the pros and cons and decide for themselves.
Why Doesn’t Everyone Do This?
This approach isn’t for everyone. First of all, the past really is no guarantee of future results. Second, keep in mind that there are many years (one out of two) where this underperforms buy and hold. Also, there are many “false positives” – or times when this system tells you to cash out and it quickly reverses itself. So that short-lived exit and re-entry into the market can be costly.
I think this approach can be smart for the right person. My experience tells me that buy and hold often fails because investors are human and often flee frightening situations – that is just our nature. Using this approach, an investor could be shielded from some of those terrifying situations and thereby, stay invested longer.
Which approach is right for you?
For most of us, investing isn’t an option; it’s a requirement if we want to ultimately achieve our long-term financial goals. Unfortunately, every approach has its flaws.
Asset allocation can help reduce risk on the macro level but it can also lull investors into a false sense of security thinking that they are safer than they really are.
Buy and hold can work well theoretically but usually fails because emotions often overtake investors who break the 3 rules and end up on the short end of the stick.
Market timing tries to bridge this gap. On the one hand, it can help you grow your money and it may also help protect your assets when the market demonstrates weakness. But on the other hand, this is no guarantee of future results. You probably will underperform using this system during certain time frames. There is no way to escape this.
Still, for many people, this is an easier route because they know that they have a safety valve and don’t have to sit there and watch the red ink pile up. Knowing they have a mechanism to steer them clear of potential trouble may help investors hold on just long enough to avoid falling victim to their emotional selves and that is often our greatest financial hurdle.
In order to determine the best approach for you, revisit why you are investing – probably to achieve long-term goals with as little risk as possible. If you think you have 10 or more years to live, we’ve seen how important it is to consider inflation. And if inflation is important, we should consider equities as a potential tool to combat that problem.
Bottom line? If we are resigned to the fact that we’re going to need equities in our portfolios, we have to also be ready for tough times. If you are very interested in avoiding all risk, determine how much you need to invest in equities at a bare minimum and consider an asset allocation strategy that exposes you to the least allocation to stocks you can find that still allows you to reasonably expect to achieve your goals.
If you are the kind of person who never looks at their investment statements, buy and hold might be your ticket. Just remember to dust off your statements at least once a year and re-evaluate your holdings.
If you are very focused on making sure you take the least amount of risk possible while growing your money safely, consider market timing as I’ve defined it. You may want to do this yourself or hire someone to do this for you as I suggested. Just remember that nothing is perfect and no matter who invests or how they do it, there are times that will involve losses.