In this month’s Market Update, we’ll examine some basic guidelines for investing, as well as some popular investing myths.
Basic Guidelines for Investing
Past performance is no guarantee of future results.
Not only is this often a required disclosure on various marketing materials, but it is well worth internalizing.
If a strategy was up 30% during the last bull market, it may not be up at all in the next bull market. You have to look carefully at years of data and evaluate different economic levers, along with how the strategy may have changed over time.
Buy low, sell high.
This one should be a given, but all too often investors want to increase their risk exposure when the market is high (perhaps wanting to keep up with the Joneses) and sell or reduce risk when the market is low (out of the fear it will never stop falling).
Remember, if you have a managed account that is rebalanced, it is systematically buying low and selling high. The highest flying stocks often have the richest valuations, and those returns are only sustainable with more hype, or with a ridiculously high level of profits to make them look fairly priced.
It’s typically better to invest in a company with good fundamentals than poor fundamentals.
We should first define fundamentals – these include:
- metrics that examine profit growth
- profit margins
- cash flows
- the use of debt
- the size and growth of expenses
If the fundamentals are strong, the odds increase that it will be a better stock to own over the long run (assuming that the fundamentals stay the same or even improve).
Give your investments the time and opportunity to compound.
If you stay invested through a full market cycle, you give yourself the opportunity to earn a return not only on your capital but also on your profits. Don’t underestimate the power of compounding. This is why banks continue to extend credit, even to high-credit-risk borrowers, year after year: They make so much money on the interest that it more than offsets any defaults.
Remember, jumping in and out of the market because of fear or greed doesn’t give your investments time to compound.
Don’t confuse luck with skill.
Just because you made a 100% return (or more) on a stock trade, doesn’t mean you’ve mastered the market. Fortunes and luck can reverse quickly. If something seems too good to be true, it probably is.
Don’t confuse trading with investing or investing with saving.
Trading can be highly speculative and is generally short-term. In baseball, it’s the equivalent of strike-outs and home runs. Investing is broadly spreading out capital and risk in a diversified way, and should be focused on the long-term. It can be compared to getting singles and doubles.
Saving is setting aside cash for a rainy day, or preparing for an upcoming cash outflow. Savings should have very little, if any, risk of loss. Investing money in an equity mutual fund that has been ear-marked for a child’s college education (in three months) means you run the risk of a large drawdown right before a large distribution.
Value investing is always better than growth investing (or any other type of investing).
There are a lot of ways to make money that work, but they don’t necessarily work all of the time. While persistent factors such as Value and Quality have been proven to work through many periods, so have strategies such as Momentum or Low Volatility. Often, investing in companies that meet multiple criteria for a factor is the best option. Buying a low beta, attractively-priced company that is improving the quality of its balance sheet and picking up price momentum may work out to be a great investment.
Economists who predicted the last recession will accurately predict the timing and severity of the next recession.
Asset managers are often quick to point out that their economist was successful in the past, which insinuates that he will be right again in the future. Rarely, however, is the same person the most accurate forecaster multiple times in a row. Often, economists or strategists claim they were right, but that they were just a little bit early. Being early or late is the same as being wrong.
Technical analysis doesn’t work.
This is generally thrown around by those only conducting fundamental analysis. Just as there are many forms of fundamental analysis, there are a wide variety of tools in technical analysis. There are:
- trend indicators
- sentiment indicators
- chart patterns
- breadth indicators
- and Fibonacci levels, just to name a few.
Both fundamental and technical analysis work some of the time, but neither of them works all of the time. Just like investing in two very different styles, such as Value and Momentum, there may be value added by applying both fundamental and technical analysis.
Investments with higher fees are always bad.
Index providers have raised trillions of dollars on this notion, as well as the notion that indexes cannot be beaten. Therein lies the sure way to consistently underperform the benchmark. It is often the case that higher fee investments can erode an investor’s capital, but it is not always true. Not all hedge funds and private equity funds are bad, and not all actively managed mutual funds are bad. Having said that, finding great investment opportunities outside of index funds is not easy and is not as simple as identifying the funds with the best star rating. We scour through thousands of funds and hold hundreds of meetings and it is still not easy to consistently find the best managers. But on a risk-adjusted return basis, it is worth it, as the excess returns adjusted for risk often more than make up for the higher fees.
We have found that by combining indexing with the strategic use of active managers and factor tilts gives us the opportunity to outperform on a risk-adjusted basis, but without deviating too much from the benchmark.
Timing investment strategies are easy to implement.
Whether one is seeking to time the markets, time factors, or time sector allocations, it is extremely difficult. Markets can remain incredibly irrational for long periods of time, both near peaks and in troughs. There is frequently a high opportunity cost to stay in cash or to stay over-weight in certain factors or exposures. It is often only in hindsight that “buy and sell” signals were clearly visible. To be successful with timing strategies, one must be consistently right on each buy and sell trade. This is virtually impossible.
Just as it is important to remain anchored to some basic guidelines for investing that will hopefully help investors stay out of trouble, it is also important to be educated about some of the myths of investing. The most successful strategies of investing require discipline and patience and being able to ignore much of the noise that is often catered towards our emotions of greed and fear. If a strategy or a process seems like a silver bullet or a sure thing, caveat emptor. Sticking with some rules and being educated about the myths allows investors to adhere to principles that should work over the long term.