For more than a decade, Brad has had the privilege of hearing many of his colleagues discuss the fundamentals of investing in simple and effective ways. Everyone puts their own words and music to this set of ideas, but the following are what Brad considers the top ten greatest hits, with a few of his own verses added to the mix.
Greatest hits aren’t new, by definition; therefore, this article merely aims to chronicle and arrange them in a storytelling sequence, where one connects to the next, rather than in order of importance or priority. Trends change and fads come and go, but investing is like music in that true classics stand the test of time and remain relevant long after they were initially composed.
6) Everyone Can Win
It is not necessary for someone to have a lousy investment experience for you to have a successful one. Everyone can win because with capitalism there is always a positive expected return on capital. The expected return is there for the taking, and as a provider of capital, you are entitled to earn it. That doesn’t mean it’s guaranteed to be positive, but only that it is always expected to be positive.
Realized returns are uncertain because the market can only price what is knowable. The unknowable is by definition new information. If it is considered bad news, or if risk aversion increases and investors require higher expected returns, then prices will drop. This is the market mechanism working to bring prices to equilibrium where, based on the new information, the expected return on capital remains positive and commensurate with the level of risk aversion in the market.
The opposite would be true if the new information is considered good news or if risk aversion declines. This is how well-functioning capital markets maintain a strong and pervasive relationship between risk and expected return. There is no free lunch.
7) Effective Diversification
However, not all risks generate higher expected returns. Markets only compensate investors for risks that are “systematic” and cannot be eliminated. For example, the Green Bay Packers won’t pay Aaron Rodgers more money to play football without a helmet. It is a risk that can easily be avoided if he puts on his helmet and buckles up the chin strap! Similarly, investors shouldn’t expect an additional reward for taking the risk of concentrating their portfolio in a few securities, industries, or countries because the increased risk of doing so is easily eliminated through effective diversification.
To diversify effectively, investors allocate capital across multiple asset classes around the globe to suit their unique circumstances, financial goals, and risk preferences. Ineffective diversification, on the other hand, includes concentrating a portfolio in a few securities, diversifying by broker, or dividing up assets among money managers in an uncoordinated way that does not eliminate risks they shouldn’t expect compensation for bearing.
8) More Than a Map
Travelling the road to a successful investment experience requires more than just a map. Building a portfolio that puts these ideas to work is one thing, but staying on route is something else altogether. Keeping your hands on the wheel and your eyes on the final destination requires the emotional discipline to execute faithfully in the face of conflicting messages from the media and the investment industry.
Investors are bombarded with information designed to lead them off course and toward more conventional means that involve excessive trading, higher costs, and frequent detours based on the latest prognostication from talking heads or so-called gurus.
The simple message to let capitalism be your guru quickly becomes stale and completely lost among the attention-grabbing headlines of the day. A constant reminder that the media is in the entertainment industry and their objective is not to give sound advice but to attract an audience may help tune out the noise.
Tuning out the noise is even harder when it is amplified by an investment industry thriving on complexity and confusion, while frequently shunning simple yet effective solutions. After all, the most lucrative products to sell are often the ones in which investors don’t really know what they are getting or how much it costs.
9) Behaving Badly
Investors ought to periodically review their plan and stick to it if the approach is still the right one. But adhering to a prudent investment strategy often becomes elusive in a world of continually streaming news and complex investment products. These forces can overwhelm human emotion and lead many investors astray.
A vast amount of research into how the human brain is wired documents tendencies known as behavioral biases. These biases make even highly intelligent investors particularly susceptible to the conventional approach of Wall Street and the messages purveyed by the media. An entire field of study known as behavioral finance, a mix of economics and psychology, has discovered biases that influence investment decisions. They have technical names like overconfidence, mental accounting, regret avoidance, extrapolation, and self attribution bias.
What do they all mean? In a nutshell, investors may not be rational, but they are normal—meaning they’re often their own worst enemy.
10) Simple but Not Easy
A prudent investment approach following these fundamentals is like a steady diet of healthy food—simple, effective, boring, and difficult to maintain. It is well documented that good food, exercise, avoiding too much alcohol, and sufficient sleep will improve the odds of being healthier. It is also well documented that accepting that markets work, avoiding stock picking and market timing, effectively diversifying a portfolio, and paying attention to costs will improve the odds of being wealthier. It sounds simple, but it isn’t easy.
The helpful comments of Eduardo Repetto are gratefully acknowledged.
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