What’s the market doing today? Are interest rates going up again? Should I believe the predictions from the talking head on TV? Should I sell that one investment that hasn’t been doing well lately?
It’s easy to get caught up in the minutiae of investing. However, it’s also easy to NOT get caught up in it. Understanding the fundamentals of investing and having a game plan will allow you to tune out the noise and enjoy a better investment experience.
1. Embrace Market Pricing
The market is an effective, information-processing entity. Millions of participants buy and sell securities in the world every day. The real-time information they bring to the market helps set and constantly update prices.
2. Don’t Try To Outguess The Market
The market’s pricing power works against individuals and mutual fund managers who try to outsmart other participants through stock picking and/or market timing. According to research by Dimensional Fund Advisors (DFA), only 17% of U.S. stock mutual funds have survived and outperformed their benchmarks over the past 15 years.
3. Resist Chasing Past Performance
Some investors select investments based solely on past returns. However, funds that have outperformed in the past do not always persist as winners. Past performance alone, especially with actively-managed funds, provides little insight into a fund’s ability to outperform in the future.
The performance of different areas of the market will vary as well. The following chart looks at performance of U.S. Large-Cap stocks vs. International Large-Cap stocks (similar size companies, just different geographically). It is unclear whether U.S. markets or international markets will outperform in any given year.
|S&P 500 Index||MSCI EAFE (International)|
|YTD (through 6/30/17)||8.2%||11.8%|
4. Let Markets Work For You
The financial markets have rewarded long-term investors. People expect a positive return on the capital they invest, and historically, the stock and bond markets have provided growth of wealth that has more than offset inflation. It will not happen every week, month, year, or span of years, so keep a long-term perspective. Patience is a virtue.
5. Consider The Drivers Of Returns
Academic research has identified several stock and bond dimensions, which point to differences in expected returns. These dimensions are pervasive and persistent. They can easily be implemented in cost-effective portfolios.
Basically, the research states that over time:
Stocks tend to outperform bonds
Small-cap stocks tend to outperform large-cap stocks
Value stocks tend to outperform growth stocks
Stocks of companies with high profitability tend to outperform stocks of companies with low profitability
Longer-term bonds tend to outperform shorter-term bonds
Lower credit quality bonds tend to outperform higher credit quality bonds
6. Practice Smart Diversification
The expected return of an individual large-cap stock vs. the S&P 500 index is basically the same. However, there is a lot more risk with individual stocks. Diversification helps reduce unnecessary risks. Diversifying within just the U.S. market is not enough though. Global diversification broadens your investment universe. It can expose you to the drivers of returns in international markets and potentially lower the volatility of your overall portfolio.
7. Avoid Market Timing
You never know which market segments will outperform from year to year. By holding a globally diversified portfolio, investors are well positioned to attain returns wherever they occur.
The following quotes come from the magazine Institutional Investor discussing a new study called “Can Hedge Funds Time The Market?” (co-authored by Michael Brandt of Duke University):
“Less than a fifth of hedge funds successfully time the market – and even those may be no good at predicting the next big recession.”
“Not only did the most procyclical market-timing hedge funds still suffer losses during a recession, they actually performed worse compared to peers that displayed little to no market-timing skill.”
8. Manage Your Emotions
Many people struggle to separate their emotions from investing. Markets go up and down. The moods investors experience can go from optimism to elation to nervousness to crippling fear and back to optimism. Reacting to current market conditions may lead to making poor investment decisions at the worst times. It’s common to experience emotions when investing, but recognize what you’re feeling (is it fear or greed) and try to avoid reactive investment decisions.
9. Look Beyond The Headlines
Daily market news and commentary can challenge your investment discipline. Some messages stir anxiety about the future while others tempt you to chase the latest investment fad. When tested, consider the source (are they trying to sell you something or increase viewership) and maintain a long-term perspective.
10. Focus On What You Can Control
You can’t control the markets, but there are certain aspects of investing that can be controlled and managed to improve your overall financial success. Our acronym for this is ACTION.
(A)sset Allocation – You can decide to invest aggressively or conservatively and whether to include or exclude certain asset classes.
(C)osts – You can decide whether to implement your portfolio with lower-cost or higher-cost investments, and whether to hire a professional financial advisor or not.
(T)axes – Hiding tax-inefficient investments (those that pay higher dividends and interest) in tax-deferred accounts and limiting trading in taxable accounts are examples of how you can control the taxes that your portfolio generates.
(I)nflows – You can control how much you contribute to 401(k) plans and other investment accounts.
(O)utflows – Likewise, you can manage your spending and the need for unsustainable withdrawals from your portfolio.
(N)erves – Although covered in #8, it won’t hurt to hear it again. You could be the biggest risk to your own portfolio. Manage your emotions; it’s a long ride. Set yourself up for success, and tune out the noise.
Terry Green, CFP® is the owner of Blue Water Capital Management, LLC, a fee-only financial advisory firm in Apex, NC.