Category Archives: Investing Blog

The High Cost of Bad Timing

Missing the market’s top-performing days can prove costly to a portfolio’s worth. Let’s consider an investor who missed only the 10 top-performing days during the 20-year period from 1993–2012. That’s 10 out of 5,040 trading days. That investor who was out of the market for those 10 days would have earned half as much as an investor who remained in the market for the entire period. They would have left 50% of their potential gains on the table by missing 10 days out of twenty years.

Constantly buying and selling not only has its own costs (commissions and transaction costs) but also risks missing out when an investment begins to move up again. The same thing is true on the downside, but over time, the market has consistently risen, so the opportunity cost on the upside exceeds the downside in the long run. Over time, the stock market tends to transfer money from greedy and fearful speculators to vigilant and rational investors.

Let’s consider an example. Let’s say Irving the Investor put $10,000 into his portfolio. If he held that investment for that same 20-year time period 1993–2002), it would have been worth $44,087. But another investor who missed the 10 top-performing days during that period would have only $22,050 to show for it—still a gain, but only half as much as Irving’s investment was worth, and less than he could have earned via a safer investment in T-Bills. When it comes to long-term wealth, being out of the market can be very expensive.

By accepting that nobody knows exactly how stock prices are going to behave, we can let go of some of the anxiety of speculation, and turn our focus to responsible investing.

This brings us to our second investment rule: Buy and Hold.

Dispelling Investment Myths: Market Timing

The Myth: Money managers are able to utilize market timing to predict when markets will rise and fall.

The Truth: It’s virtually impossible for even the most experienced traders to consistently jump in and out just in time to catch the best days and avoid the worst days.

nobody knows what stocks are going to go up next week. Not your cousin, not your broker, not your advisor. Over time, the performance of 99.9% of stock pickers is indistinguishable from luck. That’s why I advise investors not to try to time the market.

A stock’s price is based on the earning potential of the company that issued shares. The way the market views a company’s earning potential depends upon several factors, including the company’s ability to earn profits, the state of the company’s sector, and changes in the economy.

Money managers who rely on market timing look at the various economic indicators and try to guess how the market is going to react to new information. They also try to predict exactly what that information is going to be (employment statistics, inflation, interest rates, currency exchange rates, commodity prices, etc.). They believe that by predicting how the market will react, they can buy or sell before the market rises or falls. But nobody can move your money in and out of the markets at precisely the right time over an extended period. For a market timing approach to succeed, you have to be correct twice—first, when you leave the stock market, and second, when you jump back in.

Market timing doesn’t work as an investment strategy. When news is made public, the market almost immediately analyzes the effects it may have on a particular company, and the share price changes accordingly. Unless the fund manager finds out about the news announcement before everyone else (which is known as “insider information”), he will get the information at the same time as everyone else.

This is also our first rulefor successful investing: Don’t Try to Time the Market.

Dispelling Investment Myths: Stock Picking

The Myth: Investment advisors can consistently add value to your portfolio by exercising superior skill in individual stock selection.

The Truth: Regardless of how intelligent or talented a financial advisor is, his past ability to pick stocks has little or no correlation with his ability to repeat stock-picking success in the future.

Here’s a question I get all the time: “Hey David, what do you think about [insert company name]?” Usually, they are excited about a company or product they’ve just read about (or, more likely, heard about on TV), and have come to believe this certain company’s stock is a sure bet. They want me to confirm their instinct to invest. I understand the desire to get in on something early and strike it rich, but the likelihood of it working out the way they expect is miniscule. Unfortunately, the financial media preys on this desire on both the micro (individual stock) and macro (mutual fund) levels.

The most prominent investment philosophy in the financial world is based on the idea that financial markets don’t properly price individual stocks. Some investment firms convince clients they have the ability to consistently predict the future. You may have heard an advisor say something like, “This stock is the new Apple!” to entice buyers to invest in a low-priced stock that they believe will skyrocket. By buying these allegedly mispriced stocks, they suggest that you can profit from the new price when the market corrects itself.

On the surface, it seems to make sense that these advisors can really predict stock values. We see advertisements for mutual funds that earned 10% over the S&P 500 during the past 2–5 years. Financial firms with advertising power appear trustworthy because they employ some of the brightest and most financially savvy minds in the world, from MIT mathematicians to Harvard MBAs.

The truth is that most mutual funds earn less over a 5-year period than a benchmark index, such as the S&P 500. If managers were truly able to identify mispriced stocks, bonds, and other financial instruments, then the majority of mutual funds would offer better returns than a benchmark index. Yet more often than not, fund managers are unable to beat the market. Even the handful of actively managed funds that do outperform the S&P 500 index can’t demonstrate that their active management was the reason for the fund’s superior performance. The fact is that fund performance is overwhelmingly indistinguishable from luck. Of course, the fact that taking credit for fund performance is like taking credit for an eclipse doesn’t stop fund managers from touting their track record to lure investors.

To be sure, stock picking can be tempting. That’s especially so when we fall behind on our savings goals and feel pressured to make up for lost time. That situation prompts many people to seek a home-run investment. For some people, stock picking is fun – while they’re ahead. But it’s stressful to be wrong. Even if you’re right in week one or quarter one, you have to continuously do your homework or else you’re just gambling. Remember: when it comes to gambling, the house (casino) always eventually wins. The hard-learned lesson is that gut instinct and hype-based investing can crush your finances.

Definition:Financial Benchmark

A benchmark is a basis for comparison. A Financial Benchmark is thestandard against which the performance of a stock, bond, mutual fund, or any other financial instrument can be measured. That’s how you know if your mutual fund is outperforming the norm for a particular category of investment.

In the financial world, there are dozens of indices that analysts use to evaluate performance. The most common ones are:

Dow Jones Industrial Average (“Dow Jones”): A price-weighted index of thirty of the largest U.S. corporations.

S&P 500 (“Standard and Poor’s 500” or “S&P”): A market-capitalization-weighted stock index based on the market capitalizations of 500 leading companies, as determined by Standard and Poor’s, that are publicly traded in the U.S. stock markets.

Wilshire 5000: This index aims to track the returns of virtually all publicly traded, U.S.-based stocks that trade on the major exchanges. Like the S&P 500, the Wilshire 5000 is market-capitalization-weighted, so larger companies have more influence on the index’s movements.

NASDAQ Composite: a collection of 4,000 technology-oriented stocks. This index fund examines the technology sector of the economy as a whole, including tech stocks that are performing well or performing poorly.

The more individual stocks and sectors encompassed by an index, the “broader” it is relative to other indices. A broader index is less susceptible to sudden shocks to a particular stock or sector. That holds true for booms and busts alike, since the risks are spread across a wider range of investments. The broadest indices are best for viewing the market as a whole. That’s why they serve as benchmarks for comparison.

Of course, you shouldn’t stop at comparing past performance to a financial benchmark; there’s more to consider before assuming that a stock, mutual fund, or financial manager is a trustworthy investment. Keep this in mind as we turn to the big investment myths.

Don’t Fall for the Hype

You’ve seen the ads for those “financial entertainment” programs. Some channels are populated by little else. There’s a whole financial entertainment industry built around “experts” screaming advice through television screens. Poised just above streams of numbers whizzing by on the screen, they bark bits of information and opinions at us. They lead us to believe we should watch the Dow like hawks, strike when the market seems hot, and pull out at any sign of trouble.

The volume is always cranked up on these shows. If you listened for just a minute, you’d think you were either in the middle of a rally or a panic.

These shows seem to have four modes (or moods):

1. Euphoria (“The recession is over!” or “… All Time High!”
2. Rally (“Don’t miss out! This [sector, stock, commodity, etc.]
is about to skyrocket!”
3. Dour (“Bears are about to roar!”), or
4. Panic (“Sell! Sell! Sell!”).

Don’t fall for the hype! It’s impossible to get the whole picture of the market from a single sound bite. There’s too much information out there, and latching onto a single piece of advice is like trying to sip water from a fire hose. In fact, the loudest voice is often contradicted by another “expert” on the same channel.

Second, even if the points you hear are valid, they’ve almost certainly been factored into market prices by the time you hear them on TV. Remember, ratings are those programs’ primary concern—not your nest egg.

Financial entertainers lead us to believe they’re talking about investing. Not so. In reality, they’re talking about speculating or trading, which is very different than investing.

The truth is that we can use our knowledge or our gut instinct to make guesses, but that’s just a starting point. It’s never a guarantee, and it’s almost always the first step in a bad decision-making process that results in buying high and selling low.

The only way to make money – in a good market or a bad one – is by adopting rational behavior and not reacting to what you hear. Successful investing is about behavior, not skill. Don’t mistake entertainment for education.

No matter what you see on TV, speculation is not investing. If you’re going to listen to financial media, you must develop a mental filter that separates speculation from wise investing. Ask yourself whether the investment fits into your overall plan. If you are committed to a plan that is properly tailored to your needs, stick with it! If the investment will take you off track, it’s probably a mistake.

An Investment in Knowledge Pays the Best Interest

As Benjamin Franklin once observed, “An investment in knowledge pays the best interest.” My purpose here is to help you understand the process of growing your funds through investment, and know what questions to ask your financial advisor.

There are no “secrets;” there are no “tricks” to learn. It is a matter of having a foundation of knowledge and understanding how to apply the rules. The goal of theinformation that follows is to help you make investment decisions, avoid financial mistakes, and figure out whom to trust with your money.

By reading this, you are already taking an important first step in your financial success. Most people avoid learning about investments as they believe the information is too esoteric or difficult to understand. It’s not; it’s really just a matter of learning a new vocabulary and the rules that apply to it. I will explain the terminology and demystify the rules.

I will also introduce you to thefive key rules of Successful Investing:
1. Don’t Try to Time the Market
2. Buy and Hold
3. Diversify Broadly
4. Reduce Your Costs
5. Don’t Buy High and Sell Low

These rules can best be understood in the context of understanding how the markets work, discovering the types of investments that can be made, and learning the vocabulary of people who earn their living by helping you grow your investments. As you read what will follow, you will understand how these five rules that seem simple depend on many things. By understanding what underlies these rules you will understand how to apply them to your own situation.