Ten Time Tested Money Making Tips

Many individual investors just play the market, and their results reflect it. If you are ready to stop playing and maximize your returns, then there are ten key things you need to understand, accept and follow to become a real investor.

1 – Markets Know Best

To begin, you must first accept that global security markets are highly efficient.  Every day millions of buyers and sellers with access to almost the same information make judgements and arrive at a reasonable assessment of current asset prices.  Some daily bets are wrong, and some are right, but the wisdom of the crowd has been accurate in study after study.  This is the basis of the “Efficient Market Hypothesis” which states that market prices reflect all publically available information (although not with 100% accuracy on a moment to moment basis).

The market is a lot like a contest for guessing how many jellybeans are in a jar.  Individual guesses may be all over the place but, as shown in numerous examples, the aggregate of all the guesses is uncannily close to the actual number.

Even critics of the theory do not think that you and I can take advantage of short-term inefficiencies.  Nobel Laureate Robert Shiller, one of the biggest detractors of the Efficient Market Theory, stated in 2013, “It is unlikely that the average amateur investor can get rich quickly by trading in the markets based on publically available information.”

The market may not always be 100% correct, but its collective wisdom is greater than yours.

2 – You Can’t Pick ‘Em

Real investors are smart enough to know they can’t beat the markets.  When pitted against trading firms with powerful computers, mathmatical models, and hyper-fast communication networks, you can’t possibly hope to out-trade them.  When competing against multi-billion-dollar hedge funds, many of which may be trading on insider information, you are destined to lose.

So, instead of battling the professionals, why not hire them using actively managed mutual funds?  Many of them claim to have past market-beating performances, and they couldn’t say it if it weren’t true, right?  

Unfortunately, it is not as simple as that.  It is true that, at any given time, there are hundreds or even thousands of mutual funds that beat their benchmarks, but study after study has shown that their performance is likely not due to their investment skill.

A Swiss Finance Institute and University of Maryland study of active fund managers’ performance between 1975 and 2006 found that just 0.6% of active fund managers exhibited stock picking skills, after adjusting for the effects of pure luck.  A similar study by Fama and French, published in 2010, placed the percentage of fund managers exhibiting possible skill at around 2%.

Additionally, when you take into account research that shows only a small fraction of the funds that perform well one year end up being among the best performers even five years later, and the odds of you picking a consistently winning active manager are stacked against you.

3 – The Past is not a Prologue for Results

Every mutual fund prospectus and most investment advertising contains some version of, “Past performance is not a guarantee of future results.”  There is a reason why this statement is so prevalent.  It is because it is true.  Just because something has happened doesn’t mean it ever will again. For example, very few people win large lottery prizes, but that doesn’t mean that you will.

The disclaimer should read, “Past performance doesn’t tell you a darn thing about how this investment will perform in the future.  In fact, it is more likely the exact opposite.  What is hot today will likely cool down tomorrow, so quit investing based on previous returns!”

Do not expect to read anything like this in real life since it would kill sales of most hot investment products, but it is pretty darned accurate.  According to the CRSP Survivor Bias-Free US Mutual Fund Database, of the approximately 2600 US stock fund existing in 2000, just 20% outperformed their benchmarks between 2000 and 2010.  Of those 541 winning funds, 63% of them failed to beat their benchmarks through 2015.  Even Morningstar, a firm which has based its success on reporting and rating mutual fund’s past performance, has found that there are very few funds that, having done well in the past, continue to do so in the future.

4 – Risk Leads to Rewards

Although stocks are one of the riskiest types of investment, for as far back as we have records, stock markets (not individual stocks) have rewarded long-term investors with some of the best positive real returns.  What kind of reward?  Let’s start in 1926 (the earliest we have data) with a single dollar and see what it would have done over 90 years, though 2015, in different types of investments.

If the dollar simply grew at the rate of inflation, it would be worth about $13.  If you had put it in very safe, very liquid one-year Treasury bills, it would have grown to about $21.  If you took more liquidity and volatility risk in long-term T-bonds that $1 became $135.  If the dollar spent 90 years invested in the Fama/French US Large Cap Stock Index it would have grown to almost $5,400 and if it sat in the very scary stocks of the Fama/French US Small Cap Stock Index, it would have soared to approximately $17,000.

Individual stocks may be risky and scary, but as a group, over enough time, they have built serious wealth.

5 – Dimensions of Return

Real investing is, and must be, based on science.  As with most scientific endeavors, incredible amounts of tedious research are required to determine whether attributes of a good investment can be validated.   Unfortunately, most of what Wall Street sells is based on flimsy science at best.

However, massive peer-reviewed research, based on over 50 years of data, have led financial scientists, including many Nobel Prize winners, to identify four well-established “Dimensions of Return” in the stock market.  All of them seem obvious in hindsight, but it required the research to substantiate them properly.  

These “Dimensions” include:

Market -  There is an equity premium in the market.  Because of their additional risk, stocks, in the aggregate, have dramatically outperformed bonds.

Company Size – Over time, small company stocks have outperformed large company stocks by wide margins.

Relative Price – Undervalued companies (value stocks) have outperformed those with growing earnings (growth stocks) 100% of the time, over any 20 year period.

Profitability – Surprise!  Academics have found that highly profitable companies outperform less profitable firms.

For real investors willing to add risk to their portfolios, overemphasizing these “Dimensions” has been shown to improve results.

6 – Diversify, Diversify, Diversify

Real investors create diversified portfolios.  However, there is diversification, and then there is real diversification.  Diversification is not owning a handful of stocks, or even the very popular S&P 500 Index of big U.S. firms.

To create a properly diversified portfolio, you should own as many stocks from the global market as possible in the riskier part of your portfolio.  You should also slightly overweight your equity exposure to those types of securities that have been scientifically shown to increase returns, such as small company and value stocks.

To create a balanced portfolio for either your volatility needs or tolerance, most investors will want to keep some percentage of their portfolio in high-quality, shorter duration bonds (long-term bonds fluctuate too much).  This is best accomplished using no-load, low-fee, passive mutual funds from firms like Vanguard, DFA, Schwab, or Fidelity.

Your real diversified portfolio should be regularly rebalanced to maintain diversification and only modified as your circumstances change.  Real diversification involves more thought and effort but provides valuable benefits such as potentially lower volatility and slightly higher long-term returns.

7 – You Can’t Time the Market

Danish physicist, Neils Bohr, once said, “Prediction is very difficult, particularly if it’s about the future.”  We can take this one step further; accurately and consistently predicting the future isn’t just hard, it’s impossible.  This is true for any method predicting the financial future and why market timing is so foolish, even timing that just requires picking the best market segment one year at a time.

In 2001, the top performing asset class was small company U.S. stocks as markets were still heady from the growth stock euphoria of the nineties.  The next year the stock market plummeted, and bonds were the top asset class.  Throughout that gloomy 2002, hardly anyone was excited about stocks and virtually no one was predicting that over the next two years, small international companies would outperform everything else.

After the 2008 crash, very few market timers were rushing out to place their chips on the hottest asset class of 2009, the very scary emerging markets stocks.  Even more surprising is the fact U.S. Real Estate Investment Trusts have been the top performer in 5 of the last 15 years.

Way back in the 6th Century BC, the Chinese philosopher Lao Tzu may have said it best when he wrote, “Those who have knowledge do not predict.  Those who predict do not have knowledge.”

8 – Control Your Emotions

Try this.  Before even thinking about investing, take a deep breath and chant the following mantra:

It’s all in the past.  It’s all in the past.

Remembering this idea is critical to you controlling the biggest enemy of real investing: our emotions.

After the market has been rising for a while, we think, “The market is going up.”  After we have suffered through a bear market, we think, “The market is falling.”  In both cases, our experience of what has happened in the market influences our perception of the future.

No one feels good buying stocks that are falling and most people are euphoric when stock prices are rising.  However, you need to change your thinking.  It is a great time to buy when stocks have already fallen, and it is still a good idea to invest when they have risen because stocks have risen historically 75% of the time.

Emotional investing is the primary reason why investors feel that they rarely make money when investing.  Dalbar Research annually looks at equity investors true returns versus the S&P 500 and found, again, last year that emotional investors made approx. 1/3 of the return of the index.  Our emotions, left unchecked, make us buy high and sell low, and that is a terrible way to make money.

9 – Ignore the News

There are two reasons to ignore the news as a real investor.

First, the media likes to emotionalize financial news.  Time magazine is particularly known for its emotional financial covers.  In 1992 one cover featured a modern man selling Apples to a depression era man with the headline “How Bad Is It?”   At the market peak in 1999, Time called tech investing, “getrich.com.”  In 1998, after the market crashed for the second time, they ran a cover implying another Great Depression was around the corner by showing a 1930s soup line with the caption, “The New Hard Times.”  None of these covers accurately predicted what was to follow.

The second reason to ignore the news is the media is constantly telling you how to invest your money.  Some try to entice you with rapid wealth: “Why gold is poised to break $10,000 an ounce.” “Make 12% per month.”  Others try to scare you: “How to hedge against the coming crash.” “10 bear market stocks to own now.”

Every hour of every day you are bombarded with hot tips, bombastic outbursts and complex, often confusing, jargon.  All of this is designed to distract you from the potential problems and typically high fees associated with most of Wall Street’s products and strategies.  In the end, you will be better off ignoring them and sticking with a disciplined and sensible “real” investing strategy.

10 – Focus on What You Can Control

Becoming a real investor comes down to the final key; focus.

When planning next year’s vacation, you know that you can’t possibly know what the weather will be.  Sure, you can reasonably assume that summer will be warmer than winter and, with a little research, find out whether you are visiting during the wet or dry season.  What you can’t do is change the weather, you can only plan for possible eventualities.  The possibility of rain?  Take an umbrella.  Plan for the worst and expect the best because the odds are in your favor.

When you invest, you can’t know the future, period!  Stock prices will fall, sometimes dramatically, but they have always risen far more then they have fallen.  So, plan for the worst-case scenario, but expect to make money more often than you will lose it.

Focus on those things you can control:

• Create an investment plan for both your tolerance and need for risk

• Overweight those assets that have posted consistently high yields in the past

• Try to diversify globally and across asset classes

• Keep expenses and fees low and minimize taxes

Becoming a real investor is not easy, but following these ten keys can help position you for success. If you need reinforcement, Stanford professor, and Nobel Prize winner, William Sharpe told Sensible Investing TV that his three rules of investing are, “Diversify, diversify, diversify.”  To those you can add three more, “Keep costs low, keep costs low, keep costs low.”

Don McDonaldComment