The following will make sure you are clear on the basic truths of investing.
It goes without saying that successful investors understand and tolerate the vagaries of investment markets. However, to be successful one needs some investment education – and to review it whenever necessary.
Based on over 28 years in the financial services industry – below is my list of investing truths:
My 21 tips to financial freedom
1. Over long periods, stocks will have greater total returns than bonds.
There is ample evidence to demonstrate that, over time, stocks perform better than bonds. It is an economic principal that increased risk must offer increased return, or no one would willingly take the risk. The premium is the excess return (compared with the less risky alternative) that investors receive in return for accepting the risk. This premium has averaged roughly 8.0%, evidenced in Ibbotson’s data for 1926 through 1999. This number can be used to rationally estimate expected returns, i.e., the risk premium added to the less risky alternative.
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2. Over long periods, bonds will have greater total return than Guaranteed Investment Certificates or money market investments.
Numerous charts support the assertionthat bond total returns are greater than money market returns. This can be violated when the yield curve is inverted, but under normal economic circumstances, the individual willing to lend his funds for long periods receives a premium for the risk taken.
3. Over long periods, money market returns will slightly exceed inflation.
This is important to realize if your only goal is to keep pace with inflation. This is assuming that you have more than adequate money to live the life you want. Most individuals do not, which is why they must take on some sort of increased risk. However, when tax is factored into the equation the investor is losing in the wealth creation game.
4. On average, stocks are much riskier than bonds.
This seems obvious for professionals, and most investors would agree. The problem is that their perception of risk may be very different from the risk they will experience. Many investors experience is based on recent investment history. Ibbotson’s data for 1926 through 1999 suggest that in any given year there is roughly a 30% chance that the broad-based stock market will be down rather than up.
5. On average, bonds are riskier than money markets.
Bond risk is normally not appreciated by investors. They feel that if prices go down, they can hold on until it matures. The reality is that bond total returns are negative almost as frequently as stock returns. They do not lose the same value as stocks, however. Since the value of a bond is the sum total of all of its future coupons and maturity value, discounted by some interest factor then adjusted for the potential of default, it is obvious why bonds would frequently decline when stocks decline. In fact, the two have a surprisingly high correlation when it comes to losing value.
6. Money markets are, for the most part, safe.
Most investors do not question the safety of money markets. Using money markets in a portfolio is a way to reduce the volatility of the overall portfolio value.
7. Income trusts and managed futures are risky investments.
On their own both asset classes are possibly more volatile that traditional stocks and bonds. However, by adding these non-correlated asset classes such as income trusts and managed futures to a portfolio does bring down the overall portfolio volatility and enhance returns.
8. You will make investments that go down immediately after you buy.
A clear reminder that this will happen sooner or later is appropriate, and that when it does not, the investor has luckily avoided the downside risk associated with investing – in the short term.
9. You will sell investments that continue to go up after you are out.
It is virtually impossible to pick a top. It is good advice to not watch a stock after you have sold it, but many investors do—it’s human nature—and some, unfortunately, will use it as an evaluation tool.
10. You will stay in some holdings too long.
This is similar to not knowing exactly when to sell. If things go well, the will find and buy investments that go up. Securities tend to be driven to emotional extremes around a central value. So you will almost inevitably own something that will reach a price peak, decline, and then you will decide to sell. Some investors (again, unfortunately) will view selling a security below its high as lost money, even if they purchased it at a much lower price.
11. The value of the opportunities you miss will far exceed those you take.
This is subtle, but it exists with almost all investors. For example, if investors had only invested in Microsoft when it first went public, before it became the large company it is today, then they would all be rich. The investment that they passed on has almost always made much more than the one they are in.
12. Someone, or some group of people, will always do better than you.
This is easy to understand. Anyone who researches past performance can find an index, mutual fund, or individual investment that did better than what they owned. It is virtually impossible to be the best, but human nature strives for perfection. It is important to understand that there will always be someone or some investment that performs better.
13. Someone, or some group of people, will always do as well as you with less risk.
This is particularly true when the equity market has a bad year. It sounds similar to truth 11, but there’s an important distinction. Money market investors and bondholders may be able to say that they did as well as the stock market, even though they took a lot less risk. The common line you’ll hear is: “I could have been in GICs and done as well—or better.”
14. Yours is the only relevant time frame, not other investors’. Hypothetical mountain charts plotting past performance, for example, are irrelevant to your performance.
Many investors are presented with hypothetical performance numbers. Based on past performance, these numbers are assembled into a graphic illustrating what might have happened had clients’ at-risk funds been invested for some standard period. A mountain chart,for example, might demonstrate the way a dollar figure invested in a mutual fund over the last 65 years could have turned into an amazing end value. The only way most investors could obtain these hypothetical results would be if they had invested $10,000 20 years before they were born and paid no taxes since inception.
15. The investment market is a rapidly adjusting environment, where past performance is an extremely poor predictor of future success.
Investors often become preoccupied with past numbers because they are readily available and easy to understand. In response, people in the investment world say, “Past performance is no indication of future success.” If past performance were a successful predictor, anyone able to read could easily achieve investment success. There are countless examples of highly positive one-year track records followed by significant under performance.
16. You are not paying for information but for knowledge.
We all like to think that we know something others do not, especially when it comes to investments. This is rarer than ever. The Information Age has made information readily available to a large number of people simultaneously. This means that you are not paying for information but for the reason and knowledge that an adviser applies to that information. This does not mean that all information is meaningless, but it is fair to say that most has already been factored into the price of what we might buy.
17. Money can only be made in the future; it is impossible to buy past returns.
As obvious as this is, it is worth repeating.
18. The principal cause of change in investment prices is change in consensus expectation.
Most investors do not have a clear understanding of what causes security prices to move. If all investors agree upon a growth rate for a company, and the company meets its expectations, the price of the company will not change. Prices change when unexpected information surfaces, or when something comes out that the consensus was not considering, such as surprising company earnings reports. This is called a catalyst for change.
19. Get used to uncertainty; like it or not, every investment decision is based on multiple guesses about the future.
I have suggested that readily available information is of little investment value. Advisors make educated guesses about the future, and every decision they make involves concrete details and some guessing. Deciding to fund an RRSP for the next 10 or more years versus investing outside the tax-deferred vehicle, for example, entails making some guesses about the expected long-term return of the assets you will own, the stability of the current taxation laws, and the assumption and probability of future tax rates for distributions.
20. Advisors increase your chances of investment success.
It is no coincidence that prospective clients seek experienced advice. Advisors increase your odds of success by using their understanding of investment fundamentals, knowledge of the past, and, most importantly, sound reasoning about the future.
21. Increasing your odds doesn’t always mean 100% success.
Every investor must realize that there is something random to investment success. Even the application of knowledge and sound forecasting may not work. Financial advisors do increase the probability that you will reach the goals you formulated together at the start of your relationship.
By going over these investment truths and internalizing them you can establish a more realistic basis for YOUR success!
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