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 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 . . .
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 . . .
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 . . .
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.