Good advice for investors does not need to be complicated. In that spirit, we offer this four-part series on sound investment principles. Including these guidelines in your investment strategy could help you reach your financial goals. (You may want to refer back to Part I – Investing – The Benefits of a Disciplined Plan.)
Part II – Individual Stocks – Reasons to Avoid Trying to “Beat the Market”
- Owning individual stocks and sector funds can be unnecessarily risky.
Owning one large-cap growth stock has the same expected return as owning an index fund of large-cap growth stocks, but it entails far greater risk. (Large-cap refers to companies with a market capitalization of more than about $10 billion, which is calculated by multiplying the number of a company’s shares outstanding by its stock price per share.)
The market compensates investors for risks that cannot be diversified away – such as the risk of investing in stock versus bonds, or corporate bonds versus Treasury bonds. Investors should not expect the market to compensate them for risk that can easily be diversified away – that is, the unique risks related to owning just one stock or one sector fund. Prudent investors understand that it makes sense to only accept the kind of risk which compensates them in the form of higher expected returns.
- Each strategy has an associated cost.
To outperform the market, an investor must first identify a mispriced security and then, after the expenses of the effort, be able to exploit the mispricing. Strategies by themselves have no costs, but implementing them does. Many investors have tried to exploit what they believed were (and perhaps really were) mispricings, but found that that the trading and other costs of implementing their strategies exceeded the potential benefits.
- It is prudent to avoid investment products with “elite” appeal.
We feel that hedge funds and private equity, including venture capital, appeal to investors by offering them the possibility of achieving superior returns while appearing to extend invitations to an elite group of investors. Recently, however, the hedge fund and private equity industries have lowered their minimums significantly. Furthermore, many of these vehicles turn out to be more expensive than they are expansive for an investor’s portfolio.
Generally, investors should not invest in a security without fully understanding the nature of all of its risks. And they should avoid investing in an investment product purely for the sake of its inherent complexity or exclusive nature. Such products are designed to be sold, not bought; the complexity is likely to be designed in favor of the issuer/seller, not the buyer.
Part III. – Diversification – An Essential in Portfolio Construction
- The safest port in a sea of uncertainty is diversification across many asset classes.
It is not possible to properly diversify using only the S&P 500 Index. While there would be a large number of holdings, there would not be enough diversification by asset class. An investor would receive ownership in 500 companies, but many of them belong to the same asset class. Investors need to look further than a single index to achieve appropriate diversification.
- Diversification is always working.
Sometimes investors like the results of diversification in their portfolios and sometimes they don’t. Most investors are familiar with the benefits of diversification. Done properly, diversification reduces risk without reducing expected returns.
However, once investors diversify beyond popular indices such as the S&P 500, they must accept the likelihood of being faced with periods of time (even long ones) when a popular benchmark index, reported by the media on a daily basis, outperforms their portfolio.
The media “noise” may test their ability to stick to their investment strategy. Nothing will have changed (diversification will still be the right strategy), yet many investors will make the mistake of confusing strategy with outcome, and abandon their plan. This is a good time to remember the stick-to-it-iveness that we discussed in Part I.
Stay tuned for the fourth and final part of this series: Thoughts on Life and Investing
[Photo credit: Lendingmemo]