The Key to a Successful Investment Plan is Avoiding These Common Pitfalls
David Swensen, chief investment officer for Yale's endowment since the mid-1980s, has one of the greatest investment track records among managers spanning several decades. In his book, Pioneering Portfolio Management, he says there are effectively three ways to maximize your investment returns: 1) time the market, 2) pick the best stocks and 3) establish an optimal asset allocation that best meets your long-term financial objectives.
Posted in Money & Credit on Friday, June 14, 2019
Swensen’s view is that the most important driver of your investment success is number three, a long-term oriented asset allocation. In fact, he considers timing the market and trying to pick the best stocks as mostly a waste of time and where you are likely to find most of investing’s pitfalls. The quality of your retirement can greatly depend on your ability to avoid these pitfalls when investing your 401k or IRA money.
As it turns out, timing the market proves to be an extremely difficult task. Investors often succumb to a number of emotional and behavioral biases that can turn into poor investment results. Investment anchoring is a common example of a behavior that can lead to irrational decisions. For example, an investor who may be trying to time the market may hold off on making an investment in Company X because it is currently trading at $21 a share but recently was at $18. Not wanting to “overpay” for the stock, even if she thinks it could be worth $30, the investor may wait until it goes back to $18. Conversely, an investor who bought a mutual fund at $50 and wants to sell it may decide to hold on because the current price is only $47. Hoping to avoid a small loss, he risks incurring a much larger loss by holding the fund.
A better, more proven long-term approach to investing is to methodically dollar-cost average into your investments. Whether you invest at every pay period, or monthly or quarterly does not really matter. The power of dollar-cost averaging comes from investing the same amount of money each time you invest. If the stock or the market is expensive, you buy fewer shares. If the price goes down, you get to buy more shares. Market volatility actually becomes your friend! This is particularly powerful for younger investors who have plenty of time to ride out the market’s ups and downs. But even older investors benefit from this approach as well.
Trying to outperform the market by picking the best stocks has its own challenges. The market for public stocks is incredibly competitive with many firms hiring the brightest research analysts who then use expensive analytical resources to select stocks. All of this competition limits the potential to “beat the market.” Similarly, choosing an actively managed mutual fund can lead to persistent under-performance. Managers have difficulty beating markets consistently, especially when you factor in the extra fees and expenses they charge. Investors who are lucky enough to find top performing managers can still succumb to bad decisions. When a fund has a period of poor performance (even the best managers have them!), investors often get nervous and sell the fund right before it is about to recover. Clearly, there are many pitfalls to trying to pick the best stocks or even the best mutual funds.
Focusing on establishing a low-cost asset allocation that meets your long-term objectives while taking on a level of risk that is comfortable can help you avoid most of the pitfalls that claim so many investors. Constructing a diversified portfolio based on your level of risk tolerance and sticking with it regardless of market fluctuations gives you the best odds for a successful outcome. A simple asset allocation typically blends high-quality fixed income with equities to arrive at a portfolio with an acceptable level of risk and return. Typically, the higher the allocation to equities, the greater the risk and potential for return and vice versa. A more diversified, more complicated approach might include some additional asset classes such as high yield, real estate and commodities. While there is no one-size-fits-all approach to investing, if you can find an approach that is comfortable for you, you are more likely to stick with it. Consistency is the hallmark of a great investment plan. Good luck!
Stay tuned for upcoming posts to help you create a solid foundation for your practice so you have what you need to succeed now and in the future.