Friends and family know that I could go on for hours about financial matters (and sometimes do), but let’s try to measure this in minutes. These 10 lessons can make you a far more successful investor, avoiding common errors that cause financial anguish for many.
- Be open to learning. Science trumps salesmanship but you don’t need a degree. We don’t hesitate to trust the disciplines of mathematics, biology, physics and chemistry and major decisions are rooted in economics. Why then do we ignore the science of the markets and continually chase the latest trends? An understanding of financial research can forever impact the way we invest.
- Capital markets work. Only North Korea and Cuba would disagree! The markets are efficient. This means that securities prices reflect the knowledge and expectations of all investors. Traditionally, managers strive to “beat” the market by taking advantage of perceived pricing “mistakes” and attempting to predict the future. This often proves costly and futile. Instead, if we see capital markets as our ally and not an adversary, we can stop speculating and piggyback on the different ways that markets compensate investors.
- There is no free lunch! Risk and return are related in that the market rewards investors who take greater risks. Stocks are riskier than bonds, but have greater expected long-term returns. Further, performance among stocks is largely driven by two other dimensions: 1. small versus large stocks, and 2. value vs. growth stocks. This has proven true across the globe. Great portfolio design happens when we figure out that by properly designing portfolios using these dimensions, we can reduce volatility and improve long term returns.
- Diversification is critical. Returns of different asset classes are entirely random and holding a few concentrated positions will not, on average, add any additional expected return to the investor. Once a portfolio is designed along size, value and market dimensions, maximizing the diversification within those asset classes reduces risk.
- Fees do matter. The financial critics are correct. Most investors are paying far too much in fees, both disclosed and undisclosed. For instance, $10,000 invested in a fund whose underlying investments have produced a 10-per-cent average compound rate of return grew to $57,535 in 25 years after deducting a 2.75-per-cent management expense ratio (MER). However, the same portfolio with a 1.50-per-cent MER grew to $76,868. That’s a $19,333 difference that most people I know could find a use for.
- Index investing also has its flaws. Funds that mimic underlying indices such as the S&P500, the S&P TSX and the MSCI will underperform the index. Because index funds also charge fees and are continually reacting and paying hidden trading costs to track these markets, they will continually underperform the markets. Indices are simply a “snapshot” of different markets. The challenge is in finding a passive investment approach that minimizes these costs. There are a few that do this successfully.
- Excessive portfolio turnover is bad. When a manager frequently purchases and sells securities, it triggers excessive taxes and hidden trading costs. Traditional thought states that this only matters outside an RRSP or RRIF. However, every time you trade a stock, there are trading costs – especially the spread between what a buyer is willing to pay (bid price) and what a seller wants (ask price). These costs can be quite high when a manager of a large fund wants to quickly unload or take up a position.
- Long-term discipline is good for you! No one can tell the future and no one knows for sure when to be in or out of the market. Hence, we must establish our asset allocation and stick to the plan through thick and thin, regularly rebalancing to maintain our target portfolio mix.
- Trust the gurus. Many of the great financial minds of our time believe that the best way for most investors to have a successful experience is to have a highly diversified portfolio of low-cost, highly diversified and passive investment strategies.
- Get help. Work with a financial advisor who understands these truths and can help you stick to a long-term plan.
Ignoring the abundant financial noise out there and taking these ten steps should keep you on track to reaching your goals.