Investor confidence is right back to where it was almost a year ago, when the markets were recovering from the worst bearish streak in recent memories.
Many investors are worried that the rally came too far, too fast. Those who sat out the rally think they might already be too late.
But this approach is wrong-headed. Both ideas assume that you should only invest if you can correctly time the market. If that were true, pretty much no one would ever be able to invest prudently. There’s a word for people who buy at the lows and sell at the highs: Liars.
If you are thinking about getting back into stocks, now might be the perfect time to avoid many of the errors that trap investors and eat away at any gains in their portfolios. In short, this time you have the opportunity to do it right. So here is our guide to investing wisely. Twelve tips that will help you avoid some of the most common mistakes.
Tip #1: Know Your Investing Costs
We’re going to start with the biggest error many investors make: they pay too much to invest. High costs of stock brokers, financial advisers, tax consultants and even mutual funds can completely destroy any gains in your investment portfolio. If you cannot figure out how to control your costs, you really might be better out not investing at all. The entire business of Wall Street often seems organized to hide the costs of investing from you. The fees are often written in small print on your quarterly statements, and you probably will have a hard time understanding them. No one will ever ask you to approve each fee after it is carefully explained to you. You don’t have to initial any boxes authorizing each fee you will be charged. So here’s how to address this problem: if you can’t figure out what fees you are being charged, you should not use that service to invest. Whether it is a brokerage account in which you buy and sell individual stocks or a mutual fund that does this for you, if the fees are not transparent and understandable, avoid it. Here are the four major sources of investing costs you should watch out for:
Brokerage Commissions. Every time you buy and sell a stock, your brokerage probably charges you a fee. Often these are flat fees, based on either the trade or the amount of stock purchased. Regardless of the way the fee is charged, the rule is the same: the lower the better.
Advisory Fees. Brokers and mutual funds will charge you a fractional amount based on the size of your portfolio. Often the number is small enough that you might not think it is a big deal to pay something as small as 2% but these costs add up quickly. In some flat years, that will eat away at all your market gains. In down years—and there are always down years—you’ll end up paying more than your earned. Together, the flat and down year fees can add up to more than the gains in a bull market.
Taxes. When your investment adviser tells you how much money you’ve made for the year by investing with him, he’s probably talking about pre-tax gains. But here’s the thing. You never get to pocket pre-tax gains. You pocket after-tax gains. That means you need to know how the tax system will treat the investments you make. And you need to anticipate what future developments in the tax code will be.
Inflation. This is the ultimate killer. If your investment gains don’t outpace inflation, you’re actually losing money in the long term as the value of your money gets eaten away.
Tip #2: Reduce Your Costs
Now that you know the costs that can tear into your portfolio, you need to find ways to reduce them. Here are five things you can do:
Invest in the lowest cost mutual and index funds available. This seems like a no-brainer. But many investors over look it. Tiny fractions of a percent can make a big difference over the years.
Pay Attention To Changing Costs. Just because you invested in a low cost fund to start, doesn’t mean the costs stay low. New products and competitors may have been introduced, and your fees may have increased. The price of Wall Street’s feedom is your undying vigilance.
Pay Capital Gains Not Income Taxes On Investments. An actively investing fund or a brokerage account with frequent sales generates a lot of high taxes on gains. You can reduce the cost of taxes by going with a passive fund that makes long-term investments. These pay lower capital gains taxes, instead of ordinary income taxes. But beware: there are some on Capitol Hill who would like to eliminate this benefit.
Invest Through A Retirement Account. If you are saving for retirement, make sure that you are using an account that has legal tax advantages that allows you avoid taxes now or in the future. This is a huge advantage. Most big employers will offer these accounts to you.
Buy Inflation Protected Treasuries. There are lots of opinions about how to reduce your exposure to inflation. Some people will tell you to buy gold, which tends to go up when the value of money goes down. This isn’t practical for most investors. A far easier way it to put part of your portfolio into TIPS—short for Treasury Inflation Protected Securities. This won’t protect you if the government of the United States collapses or repudiates its debt. But if that happens you’ll have a lot more to worry about than the effect of inflation on your portfolio.
Tip #3: Expose Yourself To Upside Surprises
One thing we’ve learned is that the markets are unpredictable. No one knew how bad things would get in 2008. And fewer people knew that the markets would boom in 2009.
Even studies that show gains in the broad market through history cannot tell us for certain what will happen in the future. In fact, there’s a lot of recent evidence that we’re underestimating the uncertainty of the future.
That’s a problem for investors because you cannot invest in the past. You can only invest now for gains you hope to make in the future. In short, you are always speculating on uncertain future events.
One way of handling the radical uncertainty of the future is to create upside exposure to really uncertain events. This means that you have to be willing to put some money down on one number on the roulette wheel. Don’t be a fool and make a huge bet and don’t do it completely randomly.
Here’s what you should do. Find an event that looks really unlikely in the future. Something everyone you ask tells you is almost certain not to happen. Make a small investment in that event happening. But be sure that the odds against you.
Let’s use an example. Buying a lottery ticket for a dollar isn’t a good way to exposing yourself to the upside of winning because the initial investment of a dollar is too much for almost any imagine jackpot. But if you could buy that lottery ticket for a few pennies, it would make sense. The point is that risky bets are fine if the cost of making them is low enough.
Tip #4: Limit Your Exposure To Downside Surprises
Just as you should put a small (tiny!) portion of your portfolio in very risky investments, you should also have a large portion in something very, very safe. Treasuries are the typical answer for this. This will protect you against the market doing something really unexpected.
The size of your safety net should depend on how old you are (if you’re younger, you have longer to recover from a big loss), how much you expect to need to withdraw from your portfolio in the next few years (you need more safe investments if you are saving for a house or your kids college), how psychologically well-prepared you are to handle losses in your portfolio (what investment advisers call “risk tolerance”) and how likely you think unlikely events will be.
Nassim Taleb, the author of the Black Swan, thinks unlikely events are far more likely than anyone expects. So he advises that you avoid “conservative” stock and bond investing altogether and put something like 95% of your money in Treasuries. That's pretty extreme. If you’re not as worried as Taleb, you might consider a smaller share.
Tip #5: Diversify
Everyone knows that they are supposed to diversify. But very few people understand how hard it is to really diversify. Here are some pointers on how to effectively diversify.
Asset Mix. You are not diversified if you own twenty stocks or even a hundred stocks but nothing else. You need a variety of assets classes—stocks, bonds, gold, Treasuries—to truly diversify.
Time preference. You portfolio should also contain assets that you expect will appreciate along different time lines. This is important, and widely overlooked. This will help you avoid having all your investments keyed to one time—a time when the market could be crashing.
Have More Than One Manager. The clients of Bernie Madoff believed they were diversified because they had so many different kinds of assets listed on their monthly statements. But many of them were exposed to a different kind of risk—the risk of getting ripped off by their asset manager. It’s not just outright thievery you need to worry about—investment managers can fail and take your portfolio with them. In short, diversification needs to happen at every level.
Tip #6: Beware Of Your Own Riskiness
Here’s another lesson made clear from the recent financial catastrophe. The sources of risk to your portfolio are not just what the market does, but how the market reacts to you.
Let’s take AIG as an example. It had insured billions of dollars of subprime mortgages, and it thought it would be safe because most of those would still be in the money even if the housing market tanked. So far, that’s still true. But what killed AIG was that as both the risk on those mortgages increased and the perception of the riskiness of AIG itself grew, it’s customers had the right to demand more money as collateral for the insurance policies they bought. AIG couldn’t afford to put up the collateral, which is why it went hat in hand to Uncle Sam.
AIG never considered the risk that its customers would demand more collateral. You shouldn’t be that dumb. While you aren’t selling derivatives, there are lots of ways you could find yourself squeezed into having to sell assets at the very worst time. If you don’t have enough cash on hand, you might find yourself having to sell stocks during a bear market to pay for your mortgage. If you bought in a margin account, you might get squeezed by your broker.
Overall, remember that you are exposed not just to your investments going up and down, but to other demands on your assets that could force you to sell investments when you don’t want to.
Tip #7: Engage In Insider Trading (Legally).
If you have a very important piece of information about the market or a company that no one else has, you should consider trading on that information. There’s nothing illegal about trading on secret information that you discovered through your own hard work or just dumb luck. In fact, this is one of the only ways anyone can ever beat the market.
Here’s the catch: Don’t do this if the information is about a company you work for or your spouse works for. And don't even do this if you have an obligation to another third party, like if you work for a financial publication that's about to write a favorable article about a company. If you got the information from someone related to you or who expects to gain from your trading, be aware that that also could violate SEC rules governing trading on non-public information. If you are uncertain, talk to a lawyer (who will probably tell you not to do it) or just don’t trade.
But don’t fall prey to the common misconception that you cannot trade on non-public information. You can and you should. Having knowledge that others lack is a very, very good investment strategy.
Tip #8. Don’t Buy The “Hot Stocks For 2009”
It seems almost unavoidable. Every year business magazines run features on the hot stocks or hot sectors for the coming year. You shouldn’t even read these.
The only thing these will do is distract you. By the time the story is in the magazine, the knowledge is already widely disseminated. Markets are efficient enough to price this in as well.
The same goes for investing on the advice of a guy like Jim Cramer. By the time the market opens the next day, a hot stock from Cramer is already priced too high.
If you must invest in “hot stocks,” here’s how to do it: wait a month or two. If the stock drops back down and you are persuaded it’s a good investment, go ahead. But the key is to avoid the initial rush of dumb and manipulative trading that goes on after the tip is first announced.
Tip #9: Read Your Quarterly Statement. Ignore Most Of It.
No one likes to read the statements from their financial statements when the market is down. They’re ugly. They make you feel stupid. They make you feel poor.
But you need to read your statements. Just not for the reasons most people think. You shouldn’t read them for the returns from the last quarter. That’s just noise that may make you panic and sell at the wrong time. You need to read them to keep track of the fees. Believe it or not, some funds and brokerages know that people don’t read statements during bear markets and they will raise fees during that time hoping investors won’t notice. So read the fees section and ignore the returns.
Tip #10: You Can Negotiate Anything.
If you are signing on to a big mutual fund, you will have to pay the fees they require. (Remember: most mutual funds are rip-offs, so only go with low fee funds.) But if you are opening a brokerage account, you will have room to negotiate your fees.
Financial advisers will tell you that the fees are fixed. They’ll say that they can’t change them. They’ll show you where this is all written down.
Don’t believe them.
There are many different fees brokerages offer, and they are not obligated to give you the cheapest one. The rules just say it must be appropriate to you. You should haggle with your broker to get the lowest fee you can.
When they give you a quote on the fees, start by telling them: "These aren't the fees I'm looking for."
Tip #11: Invest In Low Cost, Passively Managed Life Cycle Funds. Reinvest Your Dividends.
If all this seems like a lot of work—welcome to investing.
The single best thing you can do is probably invest in a low-cost, passively managed “life cycle” fund that adjusts your asset allocation as you age. This is really, really boring. But unless you are willing to do a lot of hard work, it is the absolute best thing you can do. Even if you are willing to do a lot of hard work, you should consider it. You might be over-estimating the value of your hard work.
If that’s too boring for you, find a brokerage that offers a low cost investment account offering a variety of services. Beware, however, that some of those with reputations for offering low cost accounts also offer high cost accounts. You need the lowest cost account at the low cost brokerage with a good reputation.
You should reinvest the dividend in your fund. Every year you should re-examine the fees and every five years ask them to help you analyze the asset allocation. If you get married, lose your job, buy a house, get divorced or have a child, you’ll want to re-examine the allocation.
Tip #12: You Can't Beat The Market And You Don't Want To
Now here are the three most important things you should know.
You can't beat the market. If you were hoping that you'd learn how to "beat the market" by reading this investment advice, you'll be sorely disappointed. Nothing here will help you beat the market. At best, if will help you not fall too behind the market. Very few people can actually beat the market--and most who do just got lucky.
You don't really want to beat the market anyway. The good news is that you don't have to beat the market. That's actually a pretty arbitrary measure. What you really want to do is save some of your money for later, and not let it lose value thanks to the passage of time and the cumulative effect of inflation. That's your real goal with investing. Not beating something or someone. Not getting rich quick. It's investing prudently for the future.
Returns Might Be Worse Than You Expect. In the past, diversified investing strategies have paid off moderately well even after taxes and inflation. But in the future this might not hold true. In fact, because of demographic changes, changes in the spread of information, changes in the age of the average investor, and a decade of stagnant or declining stock markets, we may be in for a long bear market. Spikes will reward the lucky market timers, and you may occasionally get lucky. But don’t count on stocks or bonds to go up along historical trend lines forever.
By John Carney - Prior to joining Clusterstock, John served as Editor-in-Chief of Dealbreaker.com a Wall Street online tabloid
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Right, invest for success!
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