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4 Ways to NOT Build a Portfolio

2 | The Professor | 2010/05/31 | Print |
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4 Ways to NOT Build A Portfolio

As children, many of us will remember watching news bulletins showing video footage of traders at the New York Stock Exchange feverishly yelling out orders to buy and sell stocks, surrounded by an endless shower of paper clippings. It all seemed marvellously fun.

This scene seems now to have mostly given way to images of spectacled Ivy League traders working for investment banks surrounded by towers of computer monitors, feverishly switching between charts, mathematical models and order screens. Stories of fantastically-sized pay cheques and jet-set lives abound –notwithstanding the financial crisis.

But, have these romanticized images led investors down the proverbial garden path? We think so. We’ve got strong views on how we think you should go about building your investment portfolio, which you can read about here. They are not the stuff that movies are made of, but they are the best for helping you plan for long-term wealth creation. What we want to do in this article is take the opposite perspective and show you just how flawed the other approaches to investing are.

Bitter and antagonistic? No – just needing to take strong measures when up against industry juggernauts that are trying to preserve the problem to which they are the solution.
So, what follows are some tips on how not to plan for investing success.

What NOT to do #1. Make regular trades (racking up large transaction costs in the process)

Every time you buy a stock, you pay approximately 1% in transaction costs, in the form of commissions and ‘bid-ask spread’. The same goes for every time you sell a stock. Now, let’s assume that the average amount of time that you hold onto an investment is two months. That means that every two months you will have paid away 2% of your portfolio in transaction costs – some 12% a year! Considering that the long-term returns for stocks are around 10%, if the stocks you choose perform in-line with the market as a whole you’ll be losing 2% a year for your efforts! That isn’t a great way to spend your time or your money.

It is, however, a great way to line the pockets of your brokerage. In the 80s and 90s, brokers made the majority of their compensation by ‘churning’ the stocks in the portfolios they managed for clients – that is, regularly buying and selling, and picking up a commission every time. The insidious effect of transaction costs on performance was recognized to be so substantial that this practice is now illegal, and brokers that are caught doing it are banned from practicing. Nobody can stop you from perpetrating this crime on yourself though.

But, our recommendation against making regular trades is really just trying to make the best of a bad world… We think that trading individual securities at all is a bad idea – our next point.

What NOT to do #2. Try to pick ‘winners’

Have you ever watched ‘Mad Money’ on CNBC? This show surely epitomizes the follies of stock picking. The host, Jim Cramer, perhaps the most widely publicized stock picker, bounces around the studio aggressively imploring his viewers to buy or sell various companies based on cursory analysis and wildly anecdotal reasoning. The show is highly entertaining and makes for riveting viewing, but in our opinion should be banned as it flies in the face of all sensible investing knowledge. How do his recommendations stack up? The best known analysis, performed by Barron’s magazine, showed that Cramer’s stock picks consistently underperformed a simple ‘buy and hold’ approach. (Cramer is also famous for derisively scolding a caller "No! No! No! Bear Stearns is fine! Do not take your money out!" just days before the firm collapsed in March 2008.)

One of the problems with stock picking is that we all have psychological preferences for specific brands and companies. But making financial decisions based on brands you know and love is irrational and irresponsible. Also, under this approach, you will only have visibility on countries in your country and therefore exposure to a tiny subset of companies worldwide – and there’s no rational reason why your investments should be limited to companies that happen to be in the country in which you live. What about companies that a chap in Australia knows and loves – what makes your latest conviction and passion more likely to succeed than his? And does your knowing of the ins-and-outs of your national champion that dad used to work for give you an edge over the collective knowledge of thousands of analysts at Goldman Sachs? (Those were rhetoric questions...)

So, what do we recommend? Much better than trying to choose specific stocks to invest in, we recommend using investment funds. Funds provide you with diversified exposure to thousands of underlying positions, and can give you exposure to economic and corporate growth in many different regions of the world – not just a few stocks that you know and like. Also, by investing in funds, your money is commingled with the money of many other investors which results in an ‘economy of scale’ in which transaction costs are spread over many investors. (Passively managed funds, such as ETFs, are the cheapest of all funds.)

What NOT to do #3. Only own Equity

All too often we see people just buying Equity, which causes us much anguish and frustration. Many readers might be somewhat baffled by this statement, unaware that any alternative exists. So deep-seated is the love-affair for Equity of the popular press that many investors consider stock markets to represent their entire universe of potential investments.

If you’re among them, please read our blog on asset classes in which we review the different asset classes – for example, Commodities and Fixed Income, in addition to Equity. Is Equity as an asset class somehow an inherently better investment than any other asset class? No! By considering just one asset class, you’re subjecting yourself to unnecessary risk, AND limiting yourself to a narrow subset of opportunities.

We believe that a portfolio should consist of a number of different asset classes, and that the proportions in which each of these asset classes are held is the primary driver of your portfolio’s performance – and the most important decision to be made in constructing a portfolio to meet your long-term objectives. If you’re interested in more of our thoughts on asset allocations, please read this.

What NOT to do #4. Have a short-term mindset

The psychological forces at play when investing – fear and greed – are extremely powerful and are seated in the deepest recesses of our make-up as humans. And while these emotional responses might be of some assistance in other aspects of life (like running from lions and plundering loot?), the intuition they bring to investing and the behavioral reactions they encourage are almost unequivocally destructive to success.

Instinctively, we all want to invest more money into something that has been performing very well recently and we want to sell positions that have fallen in value to prevent further losses. This might sound sensible at first glance, but studies show that it results in us ‘buying high’ and ‘selling low’ – the exact opposite of what we would ideally want.

This research by a leading financial services firm is staggering: Looking at performance of investors in mutual funds from 1984 to 2000, they found that the average equity fund investor realized an annualized return of only 5.3%, compared to a return of 16.3% for the market as a whole. What accounted for this dramatic underperformance? Investors moved into and out of funds at exactly the wrong times – they were buying high and selling low. Similar studies have been performed more recently, including by the National Bureau of Economic Research, with similar results.

The sober reality is that timing the market is a near-impossible feat. But, while the market is completely unpredictable in the short term, its performance is extremely reliable in the long term, and it is imperative that investors develop a discipline around long-term investing and staying the course.

We believe that the challenge of investing is at least as much emotional as it is intellectual. Investing is fraught with deep-seated emotional responses, and successful investing requires a rational head at all times – informed with the understanding of our potential behavioral pitfalls and actively guarding against them.


2 | The Professor | 2010/05/31 | Print |
  Back to all posts
2 Comments so far
Spotlight Admin
2825 days ago

Thanks to Oblivious Investor and Monevator for featuring this article in their weekly roundups: Investing blog roundup fears lies and myths

Weekend reading englands dreaming

Oblivious Investor believes that investment success can be achieved by following a few simple principles - diversification, low cost investing and ignoring market noise.

Something we certainly agree with. Monevator is a UK-based personal finance blogger with one foot in investing and the other in "spare room entrepreneurship"... which is exactly where Spotlight began too.


2835 days ago

I enjoyed the read and it is true, investing is not about emotions.

At the end of point#2 you ask the rhetorical question about knowing more than thousands of analysts at Goldman Sachs. On the surface it seems that your suggesting that the analysts might actually know more. And although they should, I'm not sure their seemingly fondness for pure greed actually allows them to give good analysis.

Also on a side note, your text (at least in FireFox) is set right against the left margin. I think if you put a little indentation there the blog will be easier to read. cd :O)


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