Thoughts on How to Invest

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on May 15, 2018 4:22:05 PM

and tagged Investing

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investGiven what I do all day, you might imagine I have this investing thing all figured out. In fact, I probably wrestle with it more than most people. Part of what I do is think about many different types of investments and strategies. With all of those options in my head, it can be hard to make decisions about what is best, for me, at any given time and situation. Right now, for instance, I am in the process of putting what is (for me) a largish amount of cash to work. Do I buy in, despite my concerns about valuations? Do I wait and forgo any interim returns? If I decide to buy in, what should I buy?

Of course, these are the concerns that any investor wrestles with. So, my problem is just like everyone else’s, but perhaps spread over a wider basis of choices. Given that, I reasoned it might be useful to lay out some of the thought processes I go through when deciding how to invest.

Investment expectations

Let's start with expectations. What should we expect from our investments? Briefly, over the next 7 to 10 years, returns on financial assets are likely to be less than they have been in recent decades—certainly less than over the past 7 years or so. When I am evaluating alternatives, my hurdle rate (i.e., the rate I have to beat to make an investment worthwhile) should therefore be somewhat lower than recent experience would suggest. I should also lower my expectations for what is likely to be achievable.

Fear versus greed

Even with suitably lowered expectations, though, I still face the challenge of what to do. The opening paragraph above puts that decision as buy in now versus wait, but it can also be cast as fear versus greed. Greed has me buying in now, while fear has me waiting. I am genuinely stuck in between the two, so I will be using the strategy we often recommend here: dollar cost averaging, or putting in money on a regular schedule over time. If the market rises, I participate; if it falls, I lose less and have cash available to buy at cheaper prices.

This strategy also works well with lowered expectations. The reason those expectations are lower is because valuations are so high and interest rates so low. If both adjust over time, as I expect, money invested in the future—at lower valuations and higher rates—will have higher expected future returns than will money invested right now. In other words, by phasing in the cash over time, rather than putting it in all at once, I not only minimize my potential losses but also enhance my potential gains.

The risk, of course, is that if the market takes off, I will miss much of it. But I can accept that risk. Opportunity risk, to my mind, is less dangerous than actual cash risk. In the end, I guess I am leaning more toward fear than greed—and I am okay with that.

What should I buy?

The next step, of course, is deciding what to buy. Here, the question ultimately boils down to passive versus active. Do I invest with the indices, on the idea that no one can beat the market? Or, do I try to actively invest—using my own analyses or those of others—and try to do better?

This decision depends on two things: how I feel about the efficient market hypothesis and whether I think I or others have the skill to invest actively. Both of these are somewhat more subtle questions than they initially appear, and we will take a look at them tomorrow.

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Tune into CNBC's Squawk Box on Wednesday, August 29th to hear Brad talk markets.

 

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