I tell people investing should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.
Paul Samuelson, Nobel Prize Laureate
This is the chapter where we tell you how to invest your money. We’ll look at different kinds of investments, their pros and their cons. We’ll also give you some strategies to make your own investment decisions and advice about how to control the emotions that frequently cloud our financial judgment. As you will see, successful investing involves recognizing and avoiding the illusion of control. That is, you need, first, to accept the major lesson of the previous chapter (no one can predict short-or even medium-term financial returns), and second, plot your investment strategy accordingly. But we’re getting a bit ahead of our story now. So to get the ball rolling, here’s a modern fairy tale.
Once upon a time – well, 1998 to be exact – there was a member of an exiled European royal family, who lived in New York. Although he had never fulfilled his destiny of becoming king, he was very successful and also quite wealthy, having founded a thriving import–export business some thirty years earlier. The king-turned-businessman had also married into a well-known New York family and fathered five beautiful daughters. But there was one tiny, niggling problem. And it was preventing him from living happily ever after.
The problem was that familiar old chestnut of succession planning. The king was fifty-eight and beginning to look forward to retirement. All five of the daughters had joined the family business and were doing well in different departments. But ultimately, a company can have only one leader. In whose hands would the business be safest? He pondered the question for a long time and finally decided to set his daughters a task. He gave each of the five princesses $10,000 and told them to come back in seven years. At that point, the king would appoint as his successor the one who had invested most wisely.
Being thoroughly modern princesses, the five daughters didn’t even bother looking for a golden goose. In fact, they’d all attended reputable business schools and knew (unlike Georgios in the previous chapter) that gold wasn’t a good investment at all. The king’s favorite daughter, Michelle, the one he liked to call “ma belle,” put her $10,000 into Venture Capital straight away. Michelle had expensive tastes, a penchant for fast cars, and a knack of finding Mr. Wrong, but not to the same extent as her racier older sister, “Sexy” Sadie, who – at the tender age of twenty-five – already had a string of driving bans and two divorces behind her. Sadie opted for Private Equity without a moment’s hesitation.
The youngest princess, the Lovely Rita, was a vivacious graduate of twenty-two. Like her two older sisters, she liked to have fun, but not to unreasonable excess. Her good-looking, football-playing boyfriend wanted to get engaged, but she wasn’t sure that she was ready to commit. She considered her pile of crisp dollar bills for a while, then invested it in the stock market.
The two oldest princesses were secretly a disappointment to the king. The first-born, a rather austere-looking woman of twenty-nine was known to the family (rather unaffectionately) as “Long Tall Sally.” Ironically, after much deliberation, she invested in short-term government bonds. Her devoted husband, a surprisingly handsome financial adviser, was rumored to be implicated in the decision. Her younger sister by two years was a friendly yet rather non-descript young lady, who was quite frankly a little boring, but got along well with everyone in the family. “Dear Prudence,” as they always referred to her, had recently married the handsome financial adviser’s brother. She looked at all the investment options, but, truth be known, they rather frightened her, so she put her $10,000 in three-month certificates of deposit at the bank.
At this point, the fairy tale is best continued in numbers, rather than words, as shown in table 8. This details the evolution of each of the five princesses’ investments over the seven-year period.
Our tale resumes one morning in January 2006, when the king and princesses assembled in the boardroom. Michelle was looking very smug, yet a little glazed, as she peered out from behind a huge pile of 26,414 dollar bills. She hadn’t been the same since a spell in the Betty Ford Clinic around 2002, when the value of her initial $10,000 went down to $5,297. Sadie’s smile was as broad as you’d expect for someone sitting on $17,149 dollars, but everyone knew it was the result of tranquilizers – an addiction that dated back to 2000, when she lost 37% of her investment in a single year. Rita looked quietly confident, but seemed to have aged prematurely. She’d moved in with the football player, but they’d gone through a bad patch after 2000, when Rita had turned to drink in a vain attempt to forget the falling value of her investment. He’d finally left her in 2002, when it sunk just below its original value to $9,881. Now she was dry and had a healthy $14,965, but was no longer “lovely.”
Table 8 The princesses’ results in figures
Sally and Pru looked happy, but not expectant – despite being heavily pregnant with their third and fourth children respectively. They knew their father would say that their safe investments had barely outpaced inflation, even if they’d never actually lost money in any one year. Secretly, they’d never wanted the responsibility of running the family business anyway.
However, the king, who had followed the progress of all five investments carefully over the previous seven years, was not at all happy with any of his daughters. He accused the older pair of lacking ambition and failing to get results. But he was fairly risk averse by nature too. So he was just as cross with the younger trio. Whilst he congratulated them on their final total, he couldn’t shake off memories of the bad years. Would they take the same crazy risks with the family business after he was gone? “Worse still, why on earth didn’t any of you think of spreading your investments?” he asked in despair. The king let all five princesses keep the money, but brought in a hot-shot CEO – a miller’s daughter with many years of managerial experience and a strong investment background – to lead the family firm.
The moral? Never put your nest eggs all in one basket. And beware of mixing emotions with investment.
The story is made up of course, but the figures are genuine. Although they only cover seven years, these numbers demonstrate other morals of a slightly more financial nature. First, as we saw in the previous chapter, the difference in returns between selling when prices are at their highest and selling when they’re at their lowest for certain kinds of investments can be immense. As the figures show, $5,297 can be transformed by the magic of venture capital into $26,414 in just three years. That really is the stuff of fairy tales.
Second, the fluctuations in the returns each year for venture capital, private equity, and the stock market are also immense. Returns in venture capital went from 205% in 2000 to -91% in 2001. Third and conversely, for other kinds of investment, the variability of returns is low. For short-term government bonds and three-month certificates of deposit, there was little variation between 1998 and 2005. On the one hand, rates of return never slipped into the negative. On the other, they peaked at a disappointing 6.1%. There’s no possibility of a fairy-tale ending if you invest in three-month certificates of deposit.
Investors, even professionals, usually associate great variability of returns with risk. We believe they’ve got the emphasis wrong. The flip side of risk is opportunity. Understanding this is the key to managing the financial elements of your personal Fortune.
Let’s look in a little more detail at the vehicles that provide the greatest opportunities and the most dangerous risks. But remember that these represent only 5% or so of the total sum invested globally, which is why they’re often known collectively as “alternative investments.”
First, there are the hedge funds we looked at briefly in the previous chapter. They’re the fastest growing segment of the alternative investment sector, thanks to the well-publicized success of a few funds. At the end of 2006, total investments in hedge funds had exceeded $1.2 trillion worldwide. However, empirical findings suggest that the average returns of hedge funds are no higher than those of the S&P 500 (Standard & Poor’s index of 500 stocks). Investors should also bear in mind that hedge funds aren’t regulated, which means that reporting of financial performance is voluntary. A recent article in the Financial Analysts Journal found that this leads to biases in how we perceive them.1 In other words, there are so many funds that fail completely, that much of the available data covers only the industry’s survivors thereby exaggerating overall success. The authors warn “Investors in hedge funds take on a substantial risk of selecting a dismally performing fund or, worse, a failing one.”
Second, let’s consider private equity. Like hedge funds, it’s as controversial as it’s fashionable. The total amount invested this way was approaching $1 trillion at the end of 2006. Individual investors don’t usually have access to the partnerships that are set up to run private equity funds, so they’re probably of little real interest to us. But, for the record, The Journal of Finance recently reported that average returns are “approximately equal to the S&P 500.”2 The article also notes the huge variation in performance between different funds and the cyclical nature of the industry, but concludes that funds with an established track record of success tend to do best.
Third, real estate remains an old favorite of the amateur investor. Transactions in the worldwide property market reached a record level of $600 billion in 2006. But is this money really safe as houses? According to data from the US Department of Housing and Urban Development, American real estate sale prices increased more than 56% from 1999 to 2004. During the same period, the S&P 500 price index dropped by almost 6%. But over the last sixty-five years, the reverse happened. Property prices increased, but only a quarter as much as those of the S&P 500. And these figures don’t take into account the fall in prices associated with the subprime mortgage crisis that started in 2007 and saw huge reductions in the price of real estate that in some areas exceeded 30% in just one year.
Fourth and finally, we come to venture capital, which has been very much in vogue since the late 1990s. In 1999 returns skyrocketed to over 300% for investments in start-ups at an early stage of financing. By 2000, there were 1,600 venture capital firms worldwide with annual investments approaching $120 billion. Pop went the dotcom bubble and returns fell below -40% for several years.3 Overall, the average return of venture capital investments is the highest of the four alternative investments we’ve looked at. But it also fluctuates the most. This means the potential for returns well above the average is higher – and so is the risk of huge losses. As we said the flip side of substantial risk is huge opportunity.
Where does that leave you, the investor? We’ve told you that everything between becoming super-rich and losing all your money is possible. But we admit that’s not terribly useful. Your task is clearly to find the balance between the levels of return you want and the risks or opportunities that these imply. If you enjoy gambling and aren’t relying on your investment to see you through retirement, then venture capital might be a good choice. But if you can’t afford to lose the money, you should pick less “alternative” mechanisms.
Bonds traditionally offer a spectrum of adequate to low returns and much smaller risks. Stocks, meanwhile, are in between bonds and the alternative investments we looked at – in terms of risk and therefore return. Both stocks and bonds can be swiftly liquidated if necessary and, crucially, they are sufficiently regulated to protect you against fraud. Most importantly, there is a wide range of choices in both vehicles, allowing you to target different levels of risk and earnings. But the average investor usually relies on experts to do this for them. Here’s a normal story of everyday investors, to compensate for our earlier excursion into the land of fairytales. As before, the characters are fictional, but the figures are real.
Norma is a divorced librarian with a grown-up son and daughter. She lives in New York, but doesn’t move in glamorous social circles and has never met any exiled kings or princesses. Norma started saving way back in 1980 when she inherited $50,000 from the sale of her deceased father’s house. Being sensible, Norma believed in entrusting her money to the experts. After all, she knew little about stocks and investments. But she did know she’d need to supplement her pension after retiring. And now she thinks she has done very well thanks to the mutual fund she invested in. Her investment grew, on average, by 7% a year and, by the time she retired in 2005, it stood at $271,372. Of course, there were some unavoidable costs. When she joined, there was a 4% up-front fee for some funds, then an annual management fee of over 2%. But that’s a small price to pay for such expertise.
Or is it? Over the same period the S&P 500 grew by an average of 13% a year. This means that if Norma had invested her $50,000 in a portfolio covering all S&P stocks her money would have grown to $1,061,527. (This figure is reached by calculating the compound interest at 13% on $50,000 over twenty-five years.) Of course, buying stocks this way isn’t practical for a small investor, but there are plenty of index funds available that track the S&P 500 as closely as possible. These typically charge an annual fee of 0.5% or less with no up-front charges.
In fact, Norma’s younger sister Jean, who is also a university librarian, invested her 1980 inheritance of $50,000 in an index fund – on the advice of a visiting finance professor from Europe. She too retired in 2005, but five years earlier than expected, when her investment hit a value of a little over a million dollars. She liked her job, but who’s heard of a millionaire librarian?
Jean hasn’t told Norma exactly how much money her investment made in the index fund. She’s a little bit embarrassed, to tell the truth, especially when she hears Norma talking about the huge success of her mutual funds. But she does remember the visiting professor from Europe telling her all about the “illusion of control.” In her sister’s case, that pesky illusion has a lot to answer for. Not only did it lead Norma to put her faith in an unknown expert with a seven-figure salary and huge bonus, it also made her lie to herself.
Back in the real world, it’s time to look at this question of expertise in more detail. Bill Miller, the manager of the Legg Mason fund, has beaten the S&P 500 for fifteen years in a row – from 1991 to 2006. This is a spectacular achievement that makes him a superstar fund manager and a darling of the popular business press. All credit to him. But would it be possible to achieve this by luck alone? Time for a few very simple calculations.
Let’s assume there are 8,192 funds in the USA (actually, that’s not far off the truth). Now suppose that the chance of each fund beating the S&P 500 in a given year is exactly 50%, the same as tossing a coin, and that each fund’s performance is independent of all the others. This means about 4,096 funds can be expected to beat the S&P 500 in a single year. About 2,048 of these will beat it again for a second year, then 1,024 for three years in a row, 512 for four years in a row and so on, dividing by two each time . . . until you get to one fund that’s made it for a whole thirteen years. If Bill Miller is the only “survivor,” then his achievement of getting to fifteen years already sounds less impressive.
Now, it’s important to remember that one fund out of 8,192 beating the S&P for thirteen years is just an average outcome of our original assumptions and that in reality the actual number can fluctuate above and below the average. Finally, if we look more closely at the record of Bill Miller’s fund, we see that in 1994 its returns more or less tied with the S&P 500. So it’s perfectly reasonable to claim that he beat the S&P only eleven years in a row, rather than fifteen – a performance well within the limits of pure chance. In fact, his subsequent performance was below the S&P 500 for three years in a row bringing the returns of the fund to those of the early 1990s. Sorry Bill, luck does not favor anyone in the long run.
The same is true for the many other funds that have outperformed the market for several years in a row. Most of them subsequently revert back to an average or even poor performance. At the same time we never hear about the funds that did worse than the average for fifteen consecutive years. Who’d want to advertise results like these?
Professor Burton G. Malkiel of Princeton University, author of the classic book A Random Walk Down Wall Street, is one of several observers who claim that beating the market is due to chance, rather than skill. In one study, he compared the results of the top twenty equity mutual funds of the 1970s with their own performance in the 1980s.4 In the 1970s their average returns exceeded the average of all equity funds by a margin of 10.4% to 19% per year. In the next decade, they slumped into mediocrity. They performed worse than the average fund by 11.1% to 11.7% per year. In a second study, he made the same calculations for the 1980s and 1990s. The star twenty funds of the 1980s, whose collective results had outperformed the average of all equity funds by 14.1% to 18% a year, underperformed the average by a margin of 13.7% to 14.9% over the following ten years.
John C. Bogle, the founder and former chairman of the Vanguard Group and crusader against fund managers, carried out a similar, but shorter-term study over the two periods 1996 to 1999 and 1999 to 2002. First he looked at the top ten out of a total of 851 USA equity funds (those with assets of more than $100 million). They were paragons of success and big bonuses between 1996 and 1999. But in the following three years, the former number one dropped to a position of 841. The best performance of all ten of the formerly outstanding funds was a position of 790, out of a total of 851 funds, between 1999 and 2002. It seems fair to conclude that, as the small print so often tells us, past success is no guarantee of future performance. What’s more, it really does look as if the majority of star fund managers just got lucky.
Professor Eugene F. Fama of the University of Chicago put it this way: “I’d compare stock pickers to astrologers, but I don’t want to bad-mouth astrologers.”
Nevertheless, there are many who defend the skill of the expert stock-picker. They claim that some fund managers consistently outperform the market for such sustained periods that their results couldn’t possibly be due to chance alone. Their hero is the legendary Peter Lynch, the former manager of Fidelity’s Magellan fund, which between 1977 and 1990 made an immense 2,703% return, compared to the 574% of the S&P 500. They also cite the famous Schroders fund that, since its inception in 1993, has posted a 16.26% annual compound return, versus the 12.30% of the S&P 500. There are several other relatively successful funds and anecdotal evidence to boot.
Yet there are few academic studies to support this point of view – at least not wholeheartedly. And you have to dig deep to find any at all. A recent paper in the Journal of Finance claimed that there was strong evidence for consistent, superior performance for some kinds of funds but not for others.5 Another paper, from the Cass Business School in London, scours the previous research on mutual fund performance in the US and UK over the previous twenty years. It concludes that “only very sophisticated investors should pursue an active investment strategy of trying to pick winners – and then with much caution.”6 Instead, most investors are advised to buy into low-cost index funds that track the market average.
In other words, if there are some stock-picking skills out there, they’re of little practical use to the investor on the street. After fund and transaction fees have been included, actively managed funds just don’t perform consistently better than the market average.
So much for stock picking. What about experts who claim to have perfect timing? Mark Hulbert, whose Hulbert Financial Digest has become a highly respected source of investment wisdom, examined the claims of the financial newsletters with established reputations as the “best.” In 2003 he created a hypothetical portfolio based on the newsletters’ advice. Then he timed his buying and selling over the next twelve months (also hypothetically) according to their hot tips. The result was a loss exceeding 32%. Fortunately, that was hypothetical too. Meanwhile the Wilshire 5000 index, which included all of Hulbert’s stocks, increased by 13%.
The academic literature tends to agree with Hulbert’s findings. The researchers from the Cass Business School in London who warned against stock picking also conclude: “There is little evidence of successful market timing.” In the most comprehensive study of all, researchers at the US National Bureau of Economic Research scrutinized the market-timing recommendations of 237 investment newsletters – a massive 15,000 predictions. They concluded: “There is no evidence that newsletters can time the market. Consistent with mutual (managed) fund studies, ‘winners’ rarely win again and ‘losers’ often lose again.”7
Professor Michael Jensen of Harvard Business School was one of the first researchers to compare the performance of actively managed mutual funds with the market average over the period 1945 to 1964. He concluded:
The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free).8
Nearly forty years later, in the revised 2003 edition of A Random Walk Down Wall Street, Burton Malkiel (quoted earlier in this chapter) restated his earlier thesis that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio as successfully as a roomful of experts! His once controversial theory is of little concern to us. But his empirical findings are powerful. “Through the past thirty years that thesis has held remarkably well,” he claims. “More than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500-Stock Index.”
The same goes for investing in bonds. Professionally managed bond funds underperform the various indexes by 1% to 1.7%. Given the lower returns of bonds in general, this is equivalent to the 3% underperformance of equity funds. There has been less academic research concerning managed bond funds, but one of the earliest, published in The Journal of Business in 1993, concludes, “Overall and for subcategories of bond funds, we find that bond funds underperform relevant indexes post-expenses. Our results are robust across a wide choice of models.”9
So what about funds that aren’t actively managed? These are the so-called “index” funds that aim to track the market average, either by holding all the shares in a given listing (such as the Dow Jones Industrial average) or a representative sample of them. They’re how Jean the librarian from the earlier story got so rich. Table 9 shows the result of making an investment of $50,000 in 1980 and not touching it for twenty-five years, just as the two librarians did. It’s easiest to think of the average yearly returns as equivalent to putting the money in a savings account with a fixed annual interest rate for a period of twenty-five years.
Table 9 Cumulative returns of $50,000 invested for 25 years (using the historical returns of 1980–2005)
* This is an average estimate of the effect of bankrupt, folding, or merged funds on the average return of the remaining mutual funds
The first expensive lesson learned is that a small percentage difference in annual returns can add up to a gigantic difference when compounded over twenty-five years. But even for a statistician it comes as a bit of a shock. How can the difference between Norma and Jean’s investments be quite so big?
The answer is not simply that the experts are less expert than they claim to be. It’s that they also expect a handsome payment for their non-expertise! John C. Bogle, whose research we referred to earlier, has been a long-term and vocal critic of the mutual fund industry – from within. One of his major complaints is that the cost to the investor is huge: 2% to 3% of the assets – and that’s before you count the entry and exit fees.
Another of his criticisms is that a large proportion of mutual funds fail or are forced to merge with others – over 60% of them in the period from 1970 to 2005! But the returns of these funds aren’t included when the average is calculated. So, in addition to the risk of investors losing money, the 10% average annual return is estimated to be 0.5% to 1.0% higher than it should be. The exact figures may be elusive, but one stark fact stands out: the returns for the average investor are a whole lot less then those for the average mutual fund.
Before making our investment prescriptions, let’s look back on the conclusions which underpin them from this and the preceding chapter.
• In the very long term, the average annual return of all stocks and of all bonds is fairly consistent and positive. And it’s much higher for stocks than for bonds.
• In the short to medium term, the average annual return of all stocks and of all bonds can fluctuate significantly, with very high unpredictability. This makes profitable forecasting for stocks and bonds in the short to medium term next to impossible. What’s more, the medium term can be longer than many people’s investing life spans.
• The return on an individual stock fluctuates more than the return on a broad mix of stocks from the same category which in turn fluctuates more than the underlying market index or the average return for all stocks in that market. The same is true for bonds.
• Risk and return are positively, although imperfectly, correlated. For example, return on stocks is much more variable than return on bonds, offering a greater potential downside but also a potentially higher reward. So, there is greater risk associated with stocks but also a higher return. However, this positive correlation between risk and return is not perfect, in the sense that a riskier asset pays a higher return only on average. Similarly, alternative investments, such as private equity, venture capital, real estate, and hedge funds, are riskier than stocks and thus can provide greater windfalls but can also lead to more extreme losses.
• Experts and sophisticated models don’t perform better than the average returns of the markets they operate in. That is, the number of experts or models that outperform the average return in a given market in any given period of time is no higher than you’d expect to occur by sheer luck. Even for the few “superstar” money managers, it’s far from proven that they aren’t just the lucky ones. Let’s put it another way – the returns of actively managed funds tend to do less well than index funds, at least on average.
• Past and future performances of markets, of experts, and of models are unrelated. In other words, chasing past successes for future positive returns doesn’t seem to work.
Given all these conclusions what should you do with your money? Well, of course, that depends on why you’re investing it and what you want to achieve. All we can do is give you four pillars of investment wisdom to help you decide. These four pillars follow so directly from the conclusions above that we probably don’t even need to tell you them, but here goes.
1. Be average. Don’t try to pick individual stocks or bonds to outperform the market. Invest in as many as possible so that you can match the market average. If you can’t buy stocks on your own, invest in a vehicle like an index or exchange-traded fund, which tracks some market average of your choice (e.g., growth stocks, value stocks, emerging markets, BRICs, etc.).
2. Be patient. Don’t be tempted to sell at the “perfect” time. Chances are you’ll lose out. All the evidence suggests that you should adopt a buy-and-hold strategy. The more often you trade, the lower the returns. If nothing else, the transaction costs of trading – commissions to brokers – really dent the returns of heavy traders.
3. Be risk-aware. Note that this isn’t the same thing as being “risk-averse.” For most readers, the stock market average will provide all the risk and opportunity you could ever want, especially if you’ve got a decade or two on your hands.
4. Be balanced. Rebalance your portfolio periodically – at most once a year – to keep your objectives on track. If you’ve invested in a fund that tracks the market average, then this will happen automatically.
Of course, the third and fourth pillars aren’t quite so simple. The key is good asset allocation. In other words, you have to build a portfolio of investments that matches the market averages as closely as possible, while minimizing the risk you’re willing to accept. In particular, what mix of stocks and bonds should you pick? For those of us who aren’t investing directly, and who prefer to use off-the-shelf products such as pension plans, it’s still worth asking these kinds of questions about the composition of the fund you’re buying into.
As we saw before, bonds – especially short-term bonds – don’t fluctuate anywhere near as wildly as stocks. This means you have the option of selling to cover unexpected needs for cash. Try this with stocks – and you might find yourself having to sell when the price is low. On the other hand and in the longer term, the average returns of bonds are less than half those of stocks and there’s little chance of returns above that average. A rule of thumb often used in asset allocation is that the percentage of bonds in your portfolio should be about the same as your age. If this is starting to sound a little ageist, the rationale is that you can afford to wait for high returns when you’re young. But when you’re older, security will be more important. Of course, whatever your age, you might fancy a bit of a thrill, in which case how about – say – 10 or 15% of your portfolio in something a bit riskier? Around 10% in venture capital could be your little bit of Las Vegas.
Here, then, is a balanced portfolio for Norma the librarian’s forty-year-old daughter, Marilyn, who’s a bit more switched on than her mother: a total of 60% in stocks and 40% in bonds.
• 15% S&P 500 (fairly safe, large US companies)
• 10% Value Stocks (somewhat speculative)
• 10% Small Stocks (some small companies can become real winners)
• 15% International Large Cap Stocks (in case the US economy goes a bit pear-shaped)
• 10% Emerging Market Stocks (as far as she’s willing to go for her 10% thrill)
• 20% short-term bonds (in case of emergencies)
• 20% long-term bonds (for that nice, warm, secure feeling)
Younger investors, such as Marilyn’s thirty-year-old brother, may want to reduce his proportion of bonds to 30% and put his 10% in small-company growth stocks. Norma’s son-in-law (Marilyn’s husband), meanwhile, is a lot more conservative than his wife, even though they’re both the same age. He’s put 50% in bonds and doesn’t have time for any emerging-market nonsense. In other words, your own asset allocation decisions should be based on your particular investment objectives, your investment horizon, the amount of your assets, and your tolerance of risk – tempered by your attitudes to getting higher-than-average returns.
Having done all this, sit back and do no more (apart from the permitted “rebalancing”). If you must insist on following the progress of your investments, adopt what we call a “Ulysses” strategy, in memory of the mythical hero. As his boat approached the island where the beautiful yet dangerous sirens sang their songs of seduction to passing sailors, he commanded that the crew tie him to the mast . . . and fill their own ears with wax. One way of doing this would be to program a computer to handle your investment according to simple rules that you input at the very beginning. But of course, you’re not a mythical hero or a dumb computer. You’re a human being in a media-rich world. And that puts you at a psychological disadvantage. And so we conclude with a list of dangers to avoid – the songs of the sirens.
Warren Buffett, who is almost as famous for his witticisms as his investment successes, once said: “The principal enemies of the equity investor are expenses and emotions.” We’ve already seen the cost of the expenses taken by fund managers. Emotions are harder to quantify, but often more dangerous. As in other areas of life, our good intentions can be drowned in the Bermuda triangle of greed, fear, and hope. Moreover, like all effective lures, they take on different forms that are hard to recognize. Here are the main ones.
1. Following the herd. Unfortunately, statistics show that the average investor buys when the market is high. Added to this, Mr. and Ms. Average are often attracted to the more aggressive equities, such as NASDAQ technology stocks, which fluctuate most in value. They panic when their investments drop more than the overall market and sell at just the wrong time. Sometimes this turns into a stampede. Even when it doesn’t, the herd is tempted by alternating greed, hope, and fear to trade just too often. Finally, the average and understandable reaction is to chase and buy into the best-performing funds. But, as we’ve already seen, today’s star fund managers are all too often tomorrow’s failures.
2. Not following the herd. If it’s wrong to follow the crowd, it’s tempting to adopt what is often called a “contrarian” strategy. This means doing the precisely the opposite of the market. However, given that we can’t predict where the market is going anyway, it seems a little rash. And in the long term, the market is at least headed up, which means a true contrarian’s investment would be headed down.
3. Believing what you read in the papers. The media are historically implicated in many buying and selling frenzies, from the Wall Street crash to the dotcom boom. The trouble is that journalists are more interested in an interesting story than a boring truth. This leads not only to distortions of reality, but huge gaps in the information that appears in the financial press. In addition, following fluctuations in stocks is like living on a roller-coaster. If you need that thrill, follow the fortunes of a professional sports team. But take our advice: don’t read the financial pages – or at least, only very occasionally. You’ll be much happier, and probably richer.
4. Unconscious connections. You hear that Amazon is doing well and suddenly you start thinking about other online retailers. Sometimes there’s some good logic underpinning this thought process, but you need more specific information before investing in a given company. This kind of thinking is a particular danger for those who persist in picking individual stocks.
5. Short memories. We tend to remember the most recent things that happened to us. It’s only natural. If it rained this morning, it’s a good idea to carry an umbrella this afternoon. But short-term thinking is bad in a long-term business. At fashionable London dinner parties in 2007, everyone was talking about how their house had tripled in value since they bought it. They’d forgotten the misery of negative equity and repossessed homes in the last UK property crash that occurred less than two decades previously. By 2008, prices had started falling – suddenly bringing back all those bad memories.
6. Fear of losses. For some people, losing money is a form of bereavement. In fact, most of us fear the possibility of losing money much more intensely than we imagine the pleasure of gaining it. This emotional asymmetry leads investors awry. They tend to sell “winning” stocks but hang on to “losers” for too long – only selling when the price gets back to what they paid (if it does at all).
7. Wishful thinking. Again this is the kind of erring that’s just human. Any dedicated fan of a hopeless sports team will understand the need for optimism. Ask any Chicago Cubs fan. Also, as the irrepressible English soccer anthem goes, “Thirty years of hurt never stopped me dreaming”. True, there are many circumstances where misplaced hope can bring temporary benefit and a sense of security. But, with the magnifying effects of greed, investing isn’t one of them. When it comes to investing, realism is always healthy.
8. Imagining patterns. In particular, seeing causal patterns where there aren’t any. Your hopeless football team suddenly wins . . . and the value of Amazon shares goes up. The same thing happens the next week . . . and the next . . . and the next! Could these two phenomena be related? It’s difficult to see how. But some people will find illusory correlations everywhere they look – and invest accordingly.
In short, if you want to be like Ulysses and hear the songs of sirens, you really need to be bound firmly to the mast. Most people can’t cope with this. But when it comes to investments, it (literally) pays not to listen to alluring distractions, no matter how melodious they might sound.
We invite you to build your investments on the four pillars, to allocate your assets wisely, and to tune out any mysterious or magical music. For investments, the dance of chance involves accepting the inevitable uncertainty, defining an appropriate policy, and, above all, sticking to it. In fact, investments are a perfect illustration of the paradox of control. By investing in index funds or randomly selecting your portfolio, you give up control over which stocks are picked. But you also make better returns, thereby gaining more control over your financial Fortune. This is because your investment behavior acknowledges that neither you nor anyone else can predict the market, at least in the short and medium term. Indeed, the recent subprime crisis and the accompanying credit crunch are perfect examples of our inability to predict even major economic and financial events.
We hasten to add that this won’t make you super-rich, but it should ensure that your money plant grows steadily. Who knows? You may even be able to retire early, like the librarian in our story. Don’t expect any excitement, though. As our opening quote suggests, if you must gamble, go to Las Vegas. In the meantime, let’s see what experts in business can tell us.