The Solution - ONLY follow financial strategies that are scientific, passive, diversified, savings focused, risk controlled, low cost, and tax efficient
A previous article, “The Problem - Straight answers about personal financial and investment planning are difficult to find,” summarized important reasons why individuals may experience difficulties, even if they are intent upon doing better with their personal financial planning. This article summarizes some general decision rules to address those problems. This article also introduces a series of additional articles, which will discuss these decision rules and related financial practices in more detail.
In general, individuals will benefit greatly and get more enjoyment out of their financial affairs, if they decide ONLY to follow financial and investment strategies that are: a) scientifically grounded, b) completely passive, c) thoroughly diversified, d) savings focused, e) risk adjusted, f) cost effective, and g) tax efficient. While this might seem very challenging to do, in reality all these factors are interrelated. In fact, when you choose financial strategies with these characteristics, your financial life tends to become less complicated. When the complications of personal finance diminish, you can get on with living. You can plan to live and not live to plan.
First, you should always demand that your financial strategies be scientifically valid. Far too many financial and investment strategies have no objective basis and are in fact contrary to what has been established in the financial science literature. Second, the more passive your strategies are, the better they are. Motion without real purpose in finance wastes both your money and your precious time. Motion in finance is futile, because asset price setting is generally very efficient, and the costs of making changes push you backward.
Third, thoroughly diversified strategies eliminate unnecessary risk. In addition, fully diversified strategies usually are completely passive, and they tend to have lower investment risk. Fourth, by earning more and spending less, most people will have much more impact on their future financial well-being than they ever could by trying to be more clever investors. Investment cleverness tends to be counter-productive for individual investors. In contrast, another dollar saved is another dollar to invest. (See: What is the cost to individual investors of sub-optimal portfolio diversification?)
Fifth, investing is about risk-adjusted asset returns. Securities markets tend to pay a premium for risk taking, but only for market-oriented risk taking. Securities markets tend not to compensate for the risks associated with holding the securities of individual companies. Individuals need to understand this. There is no risk free money in investing.
Sixth, your financial and investment practices need to be cost effective. Cost reduction is the single most important factor that will improve investment returns for most people. In addition, when you cut out investment costs, you also cut out the incentive for someone to sell something to you. When you stop listening to financial sales people and start looking proactively for low cost, passive, risk adjusted, and fully diversified investments, you simplify your choices. You will still have plenty of investments options. Furthermore, the scientific evidence indicates that these choices will be the most favorable to your interests. Finally, greater tax efficiency simply tends to be a by-product of following the other decision rules listed above. More risky, poorly diversified, active strategies tend to incur higher taxes.
To cover these decision rules and some related subjects in more detail, The Skilled Investor intends to publish sequentially, the eighteen “viewpoint” articles listed below. These financial planning and investing articles will give you a better understanding of why you should ONLY follow financial and investment strategies that are: a) scientifically grounded, b) completely passive, c) thoroughly diversified, d) savings focused, e) risk adjusted, f) cost effective, and g) tax efficient.
As these articles are published, we will add links to the list below. If you do not yet find a link below and you wish to be informed when these articles are published, you can stay tuned by selecting our RSS feed from the side column.
Forthcoming financial decision rule articles from The Skilled Investor:
1) Your financial and investment strategies should have a scientific basis.
2) Your personal earnings, expenditures, and savings are the most important determinants of your family’s long-term financial wealth.
3) There is no such thing as risk-free money from investing for individual investors.
4) You need to allocate your financial assets in a manner that reflects your relative tolerance for investment risk. You need to stay in the securities markets to earn market risk premiums.
5) Build asset buffers to protect yourself from market volatility.
6) You should always completely diversify your portfolio.
7) Own investment funds and not individual securities.
8} Spending your valuable time on the wrong financial activities is just plain bad for you.
9) Passive, index-oriented investment strategies tend to be superior, because they narrow the range of outcomes, and thus, they reduce the total investment risk associated with your portfolio.
10) Unfortunately, you cannot reliably identify beforehand professional investment managers who will deliver superior performance in the future, and you cannot hire them at a price that is lower than their potential value-added.
11) Never invest solely because of superior past performance.
12) Tax-advantaged investing is very good for most people at most times.
13) Excessive visible and hidden investment costs can reduce the potential value of your portfolio unnecessarily and dramatically.
14) Direct and indirect advisory costs and the expected value of the strategies that you are encouraged to use will determine your total return from advisory services.
15) If financial behavior control is difficult for you, then carefully hire a good advisor.
16) Do not ignore other risks that could destroy your best-laid financial plans.
17) Your portfolio assets are simply your evolving estate. You need to prepare appropriately for the day, when your assets become your estate.
18) Nobody and no tool can predict the future.
Comment by Tom in TX
1 April 2, 2008, 4:38 pm o'clock |
The reason that passive investing is so popular is that most people are afraid to make a mistake, therefore they do nothing. Most investors have no clue how and when to sell. Therefore they go by this mantra that passive investing costs less and thus is superior. Those investors have done poorly over since 1999. What passive investing ignores is that risk changes in sectors and industries. Investors who have solid buy AND sell strategies will take less risk than passive investors and make more money.
Comment by The Skilled Investor
2 April 4, 2008, 3:22 pm o'clock |
Tom,
Thank you for your comment. Unfortunately, I must disagree.
The evidence from scientifically constructed statistical studies uniformly indicates that amateur and professional investors are not prescient. Furthermore, if a minority have skill, they cannot reliably be identified beforehand. Furthermore, if they are professionals who offer their asset management services through actively managed mutual funds, their fees far exceed their value-added. There is no such thing as affordable alpha for retail investors. (Note that actively managed ETFs are just being introduced to the market, so there is not record to evaluate.)
Risk is ever present in investing. It just manifests itself at different times in different sectors. However much one might hope, nobody has a crystal ball to say when. If someone did, over time they would own the world.
To determine whether passive investors have done poorly since 1999 consider the evidence. For example, Standard and Poors tracks active versus passive performance. It is not a pretty picture for those who advocate active strategies. For example, see the The Standard & Poor’s Index Versus Active (SPIVA) quarterly reports. Here is the link: SPIVA
The Skilled Investor
Comment by Steve Selengut
3 April 17, 2008, 4:43 am o'clock |
Predicting Stock Market Movements
I’ve been thinking about starting a stock market prediction business. Clearly, there is a huge market for timely and accurate information of this type, and just as clearly, predicting the future is much easier than dealing with the realities of whatever is actually happening at the moment. If investors could know what’s going to happen next, they could develop a plan to deal with it in the present. Maybe Wall Street could help me get this new business up and running!
What’s that? Wall Street institutions already spend billions predicting future price movements of the stock market, individual issues & indices, commodities, and hemlines. Really? Is that right also? Economists have been analyzing and charting world economies for decades, showing clearly the repetitive cyclical changes and their upward bias. Funny then, or strange would be more accurate, that the advice generated by the oracles of Wall Street seems to assume that the current environment, good or bad, will be everlasting. Isn’t it this kind of thinking and advising that prolongs the downturns and “bubbles” the advances—in all markets?
If it were true that our favorite pinstriped product pushers can actually predict the future, why would investors do what they do in response to the predictions? Why would financial professionals of every shape and size holler: “sell” at lower prices, and “buy at any price” when market valuations surge upward? Shouldn’t lower prices be the call to the mall? Most Wall Street soothsaying has a short-term focus that dwells upon today’s market conditions; most Wall Street glossies emphasize the long-term nature of investment programs, and encourage investors to apply patience to the program they decide to use for goal achievement. Why is the advice so out of sinc?
The reason for the emphasis confusion is simple: it’s easier to play to the emotion of the moment than it is to look beyond— even though we all know that a directional change will be along eventually. Regardless of the direction, Wall Street advice will always fuel the operative emotion: greed or fear! Wall Street’s retail representatives never go against the grain of the consensus opinion— particularly the one projected to them by their superiors. You cannot obtain independent thinking from a Wall Street salesperson; it doesn’t fill up the “Beemer”.
Here’s some global advice that you will not hear on the street of dreams: Sell into rallies. Buy on bad news. Buy slowly; sell quickly. Always sell too soon. Always buy too soon. And by the way, who do you think is buying and selling the securities you have been told to dump or to hoard?
No self respecting guru would ever refute the basic truths that the market indices, individual issue prices, the economy, and interest rates will continue to move in both directions, unpredictably, forever. Hmmm, this is where you need to focus your attention if you want to get through the investment process with your sanity. You need to expect and plan for directional changes and learn to use them to your advantage. Tranquilizers may be necessary to get you through the first few cycles, but if you have minimized your risk properly, you can actually thrive on the long-term predictability of the markets.
The risk of loss cannot be eliminated. A simple change in a security’s market value is not a loss of principal just as certainly as a change in the market value of your home is not evidence of termite damage. Markets are complicated; emotions about one’s assets are even more so. Cyclical changes in all markets are just as predictable conceptually as knowing approximately where you are within a cycle is knowable actually. The key is to understand what your securities are expected to do within the cyclical framework. Now there’s a knowledge business with no Wall Street practitioners!
Predicting individual stock prices is a totally different ball game that requires a more powerful crystal ball and an array of semi legal and illegal relationships that are unavailable to most investors. There are just too many variables. Prediction is impossible, but probability assessment has enormous potential. Investing in individual issues has to be done differently, with rules, guidelines, and judgment. It has to be done unemotionally and rationally, monitored regularly, and analyzed with performance evaluation tools that are portfolio specific.
This is not nearly as difficult as it sounds, and if you are a shopper, looking for bargains elsewhere in your life, you should have no trouble understanding the workings of the stock market. There are only three decision-making scenarios that investors need to master if they want to predict long-term success for their portfolios.
The “Buy” decision has two important steps: Step one allocates the available investment assets, by purpose, between Equity and Income securities, based on the goals of the investment program. It is done best using The Working Capital Model. Step two establishes strict selection quality measures and diversifies properly within each security class. Investment Grade Value Stocks are the low-risk equity champions; long-term, non-gimmick, managed CEFs produce the best income/diversification mix available in readily tradeable form.
The “Sell” decision involves setting reasonable targets for profit taking for all securities in the portfolio. Loss taking decisions must not be undertaken out of fear, and must be avoided during severe market downturns. Understanding the forces causing market value shrinkage is important and a highly disciplined hand at the emotion control button is essential. There is no such thing as a good loss of capital.
The “Hold” decision is most common, and it regulates and moderates the process, keeping it less than frantic. Continue to hold onto fundamentally strong equities and income securities that are providing their normal cash flow. Hold weaker positions until the appropriate cycle (market, interest, economy) changes direction, and then consider whether to sell or to buy more.
Wall Street spins reality in whatever manner it can to make most investors unhappy, thus increasing new product sales. Your confusion, fear, greed, impatience, and need for a quick panacea fuels their profit engines, not yours. Learn how to deal unemotionally with Wall Street events and shun the herd mentality… that’ll fix ‘em.
Steve Selengut
http://www.sancoservices.com
http://www.valuestockindex.com
Professional Portfolio Management since 1979
Author of: “The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read”, and “A Millionaire’s Secret Investment Strategy”