The Independent Market Observer

Core Truths About Investing

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Dec 22, 2015 2:00:00 PM

and tagged Investing

Leave a comment

investingThis post originally appeared last spring in response to questions I had received about my investing approach.

Given what I do for a living, it’s not surprising that I have frequent conversations about investing. I was asked something recently that on the surface seemed like an easy question to answer: What core truths do you know about investing? There are endless factoids, trends, and theories, but what do you believe to be the basic constants?

It was surprisingly difficult to sort through what I think and pull out what I know, but what follows are the foundational ideas that have shaped my approach to investing.

Markets aren’t always logical

Markets are, at bottom, people making decisions, and those people can make mistakes. Overly enthusiastic investors can push markets into inefficient runs up (or down) to levels that make no sense—but eventually they’ll come back to reality. Markets can be efficient over the long run, but not necessarily in the short run.

In an investing context, when things look out of whack and we hear that somehow it’s different this time, it isn’t. That’s because . . .

Valuations matter

One predictor of future returns, in the 5- to 10-year range, is initial market valuations. I don’t care how you calculate it: When the market is expensive, chances are excellent that you are buying at a high and your actual returns over the next decade will be below what you expect. Over time, the market cycles around fundamental values, so if you buy at a high, you’re very likely to see a low over that time period.

It’s not quite that simple, of course, but you should respond when things get significantly above or below normal. That means . . .

No one strategy works all the time

There are many ways to deal with value swings, but one of the best is basic rebalancing. On a regular basis, sell some of your winners and buy some of your losers. This very simple take on market timing has been shown to improve performance over time versus only buying and holding.

Using other strategies along with the common buy-and-hold technique can also add risk-adjusted returns, ensuring that your portfolio can benefit in the tough times. Speaking of tough times . . .

We measure risk the wrong way

Risk should be expressed as how much money you lose. This isn’t just an emotionally based view, but a practical one as well. Even if investors are using “house money” from previous gains, a loss will hurt, affecting not just their net worth but their subsequent decisions. Losses at certain times—early in retirement, for example—may result in failure for an entire investment program. Investors need to consider the risk of failure over their entire time frame, rather than looking at short-term variations in return.

As you can see, my belief in diversification extends to diversifying among strategies as well as asset classes. Although equities are an essential part of an investor’s portfolio, they’re not always equally attractive. At times, return of capital is more important than return on capital. I believe that losing money is the real risk, not how much your returns vary.

  Subscribe to the Independent Market Observer

Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®