Becoming A Better Investor
NOTE: this is taken (abridged) from a column on page 28 of the January, 2007 edition of Kiplinger's Personal Finance.
Warren Buffett noted in 1999, that "success in investing doesn't correlate with IQ, once you're above the level of 25." And he's right too because investing isn't nearly as hard as most people think. And yes, proper temperament is important. But to really succeed at investing, you also need good strategy and good tactics. So as another year begins, here's a simple guide to both.
Your strategic checklist. First, decide why you're investing. You can't achieve a goal unless you know what it is. For many investors, the prize is a comfortable retirement, perhaps 20 or 30 years away. The more distant the goal, the higher the proportion of stocks you should own in your portfolio. Also, you have no business owning an individual stock (as opposed to a stock within a mutual fund) if you do not intend to hold it for five years or longer.
Second, know your pain threshold. Stocks are volatile. Standard & Poor's 500-stock index has declined in 23 of the past 80 years. The dips can be sharp, unexpected and disturbingly enduring. In one day in 1987, the Dow lost nearly one-fourth of its value. The S&P 500 fell every year from 2000 to 2002, skidding from 1469 to 880. These things happen. If you can't tolerate that kind of pain, then choose bonds over stocks, but realize that your returns will inevitably be about half as much, if history is any guide.
Third, develop a view about the economy and stick to it. If you are continually shifting your opinion of the economy, you will also be continually shifting your portfolio, and you can't be a good investor. Don't pay attention to the Fed or to the unemployment rate. If you buy for the long term, think long term!
Fourth, be a partaker, not an outsmarter. Markets are generally efficient, so do not expect to beat the historic averages by very much over time. The annualized return for the S&P 500 since 1926 is a little over 10% -- figure 9% with expenses. If you can beat that mark by one or two points a year, you are doing spectacularly well.
Your tactical checklist. Construct a portfolio and know what's in it. Stick with stocks and bonds and don't buy commodities.
Approach the investing process systematically. The exact proportions of stocks and bonds are determined by your goals, age and risk tolerance, all of which may change over time.
Balancing act. Keep your allocations consistent by rebalancing. Over time, it's likely that the value of stocks will rise faster than the value of bonds, so a 60-40 stock-bond portfolio will eventually become 80-20. To avoid this "allocation drift," you'll need to sell stocks and buy bonds. And don't forget to reallocate within broad asset categories.
Be a partner. Don't trade stocks. Think of your purchases as making you a long-term partner in great businesses. And when you buy, jot down the reason you bought and save the note to retrieve should your resolve weaken. Of course, if the business stumbles badly, new competition develops, key products fail or changes in management produce poor results, then consider selling. Otherwise, hang on to what you buy and prosper with the company.
Owning stocks and bonds inside of mutual funds or exchange-traded funds is a perfectly acceptable alternative to owning individual securities. But understand that, large-company stock funds consistently fail to earn a return equal to their benchmark. Research found that through 2005, in only three of the preceding 20 quarters did the average large-company fund beat the Russell 1000 index of large companies - even before expenses. In addition, the returns of mutual funds are more similar to one another.
Play the tax angle. Finally, remember that everything you do in investing has tax consequences. Tax rates on dividends and capital gains dropped to 15% in 2003 but are scheduled to rise again in 2011 unless Congress acts. Meanwhile, opportunities for tax-deferred investing through 401(k) plans and IRAs are expanding. What counts is what you ultimately put in your pocket.
* * * * *
Warren Buffett noted in 1999, that "success in investing doesn't correlate with IQ, once you're above the level of 25." And he's right too because investing isn't nearly as hard as most people think. And yes, proper temperament is important. But to really succeed at investing, you also need good strategy and good tactics. So as another year begins, here's a simple guide to both.
Your strategic checklist. First, decide why you're investing. You can't achieve a goal unless you know what it is. For many investors, the prize is a comfortable retirement, perhaps 20 or 30 years away. The more distant the goal, the higher the proportion of stocks you should own in your portfolio. Also, you have no business owning an individual stock (as opposed to a stock within a mutual fund) if you do not intend to hold it for five years or longer.
Second, know your pain threshold. Stocks are volatile. Standard & Poor's 500-stock index has declined in 23 of the past 80 years. The dips can be sharp, unexpected and disturbingly enduring. In one day in 1987, the Dow lost nearly one-fourth of its value. The S&P 500 fell every year from 2000 to 2002, skidding from 1469 to 880. These things happen. If you can't tolerate that kind of pain, then choose bonds over stocks, but realize that your returns will inevitably be about half as much, if history is any guide.
Third, develop a view about the economy and stick to it. If you are continually shifting your opinion of the economy, you will also be continually shifting your portfolio, and you can't be a good investor. Don't pay attention to the Fed or to the unemployment rate. If you buy for the long term, think long term!
Fourth, be a partaker, not an outsmarter. Markets are generally efficient, so do not expect to beat the historic averages by very much over time. The annualized return for the S&P 500 since 1926 is a little over 10% -- figure 9% with expenses. If you can beat that mark by one or two points a year, you are doing spectacularly well.
Your tactical checklist. Construct a portfolio and know what's in it. Stick with stocks and bonds and don't buy commodities.
Approach the investing process systematically. The exact proportions of stocks and bonds are determined by your goals, age and risk tolerance, all of which may change over time.
Balancing act. Keep your allocations consistent by rebalancing. Over time, it's likely that the value of stocks will rise faster than the value of bonds, so a 60-40 stock-bond portfolio will eventually become 80-20. To avoid this "allocation drift," you'll need to sell stocks and buy bonds. And don't forget to reallocate within broad asset categories.
Be a partner. Don't trade stocks. Think of your purchases as making you a long-term partner in great businesses. And when you buy, jot down the reason you bought and save the note to retrieve should your resolve weaken. Of course, if the business stumbles badly, new competition develops, key products fail or changes in management produce poor results, then consider selling. Otherwise, hang on to what you buy and prosper with the company.
Owning stocks and bonds inside of mutual funds or exchange-traded funds is a perfectly acceptable alternative to owning individual securities. But understand that, large-company stock funds consistently fail to earn a return equal to their benchmark. Research found that through 2005, in only three of the preceding 20 quarters did the average large-company fund beat the Russell 1000 index of large companies - even before expenses. In addition, the returns of mutual funds are more similar to one another.
Play the tax angle. Finally, remember that everything you do in investing has tax consequences. Tax rates on dividends and capital gains dropped to 15% in 2003 but are scheduled to rise again in 2011 unless Congress acts. Meanwhile, opportunities for tax-deferred investing through 401(k) plans and IRAs are expanding. What counts is what you ultimately put in your pocket.
* * * * *
posted by Bob Moser at
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