We have explored many financial strategies and much wisdom in our newsletter over the past couple of years, but there are some simple truths I return to over and over again in my work—key concepts that every investor should follow and know by heart. There are a lot of little details to watch over when you’re taking care of someone’s financial life, but if you get the big things right, you usually won’t go too far wrong.
With that in mind, here are the seven key concepts that I think anyone?whether it’s a money manager overseeing hundreds of millions of dollars or an individual investor handling his or her own retirement portfolio?should keep in mind.
The Seven Key Concepts
1. Markets Work. Sure, capital markets are not perfect and prices are not always “right,” but for the most part, Adam Smith was correct. The overall markets are so competitive that it is unlikely a single investor can systematically profit from mistakes in the pricing mechanisms at the expense of other investors.
2. Market Timing Doesn’t Work. Decades of empirical investigation into the capital markets by literally thousands of financial economists has found no widely accepted and conclusive evidence that market timing works. A successful timing strategy would require that you know three things: when to get in, when to get out and when to get back in. And you have to know these things well enough to overcome the higher costs of jumping in and out of your investments. The success rate required to beat a buy-and-hold strategy is unattainable not just for individual investors but for professionals as well.
3. There Is No Crystal Ball… and You Don’t Need One. All forms of active management presuppose that there is some sort of forecast as to where the market is going. But the future is by definition unknowable. At the same time, you don’t need to predict the future in order to have successful investments. Capitalism has shown us that there is a positive expected return on capital over the long term.
4. Risk and Return Are Related. Investments earning higher relative returns usually carry higher risk. More stable investments such as CDs or fixed-interest bonds are likely to earn less than equities. In other words, investments with greater risk have the potential for greater reward, and the more moderate the risk, the more moderate the reward. Each investor’s mix of these investments should be based upon his or her goals and risk tolerance.
5. Diversification Is the Closest Thing There Is to a Free Lunch. Proper diversification increases the likelihood that you will earn the returns you expect. It also may reduce risk by eliminating risks you are not paid for taking. Diversification washes away the random fortunes of individual stocks and positions your portfolio to capture the natural upward sweep of economic forces.
6. Bring Discipline to the Process. Capital markets are noisy; but in the face of that noise, investors must maintain their discipline and stick to a long-term investment strategy. As John Bogle, the founder of the Vanguard family of mutual funds, has noted, “Individual investors underperform the market by as much as 5 percent due to a lack of discipline that results in chasing hot stocks or hot funds or by timing markets.”
7. Costs Matter. All investors in aggregate form the market. Therefore, the average investor earns the market’s overall rate of return—minus fees and expenses. Managing costs, such as keeping control of management fees, operating costs, trading costs and taxes, allows investors to capture more of the capital market return that is there for the taking. Keeping costs down puts the odds of success in your favor.
Putting Principles to Work
If you keep these seven principles in mind, you are more likely to have a positive experience with your investments?and ultimately, more likely to meet your financial goals. All the sophisticated tools and wisdom in the world won’t make much difference if you’re not working from a solid, logical foundation.