Gambling_623

How NOT to Invest

I overheard a conversation about investing recently that made me a little crazy. I heard several perspectives that I completely disagreed with, ways of approaching investing that I think can be far more harmful to a person’s portfolio and peace of mind than helpful.

Since I didn’t feel like I could insert myself into the conversation, I saved my rant advice for this post.

A little background

I’ve been studying the principles of wise money management for more than 25 years. However, for much of that time, out of the many topics that exist within personal finance, I would be the first to admit that investing was my weakest link.

All of that changed in 2012 when I joined the staff of Sound Mind Investing (SMI), a Christian company that’s been publishing an investment newsletter for 28 years. I’ve learned a ton about investing in the past six years, and it is mostly those ideas that made me so concerned about what I overheard.

There were four main issues.

1 – Short-term thinking

I heard several comments about what certain stocks were doing on that particular day. However, the daily movements of the market or a particular stock or fund are, for the most part, nothing more than noise. Historically, the market has been positive just slightly better than half the time. In other words, on any given day, you have a 50-50 chance of making money. But the longer your holding period, the more the odds move in your favor.

Bottom line: Don’t get wrapped up in the market’s daily fluctuations; think long-term.

2 – Market timing

I heard lots of talk about selling certain stocks at their peak. But how will they know when a stock is at its peak? Or when a stock on their buying list is at its low?

Think about the market overall. In any given year, it’ll typically have lots of ups and downs on its way to its year-end result. Which one of the peaks would turn out to be the market’s high for that year? Which one of its valleys would turn out to be its low? It’s impossible to know.

Fortunately, you don’t have to. SMI once did a study that compared the results of two investors we called Lucky Lew and Steady Eddy. Both invested $3,000 each year for 30 years. Lucky Lew miraculously invested his full $3,000 at each year’s lowest point. Steady Eddy just invested $250 at the same time each month, regardless of what the market was doing.

At the end of 30 years, Lucky Lew’s average annual return had outperformed Steady Eddy’s by just 0.7%—10.1% to 9.4%. And keep in mind, Lucky Lew’s approach is impossible. Literally. But Steady Eddy’s approach is one anyone can follow.

3 – Not considering/acknowledging the downside

I didn’t hear any discussion about what they would do when the market heads south, as it will. All I heard was talk about the upside—how this stock or that is destined to grow.

But someday the market will turn. As surely as nighttime follows daytime, bear markets follow bull markets.

And it’s a well-documented phenomenon that losses feel more painful than gains feel good. That may explain why a lot fewer people have money in the market now than before the last bear market. Fear and pain drove them out.

To be sure, the losses were brutal. Between Oct. 2007 and March 2009, the market fell 50%.

Some people couldn’t take it, so they sold, thereby locking in their losses. And some of those folks never got back in. According to Gallup, 62% of adults in the U.S. owned stock before the Great Recession. Today, just 54% own stock. Those who are still on the sidelines missed out of one of history’s greatest bull markets.

If some of the people who left the stock market had decided in advance about what they would do during the next market downturn, maybe they wouldn’t have missed the incredible recovery that followed.

What can you do? Answer this question: “What will I/we do when the next bear market hits?” Make a decision (if you’re married, make sure your spouse is in on the decision) and write it down. Then, when the next bear market arrives, read what you wrote and follow your own instructions. Ideally, your answer is that you won’t make any changes at all, which means you’re following an investment strategy you can live with in good times and bad. Speaking of which…

4 – Not having an objective process in place

For the most part, what I heard in the way of rationale for choosing specific investments were opinions. If subjective criteria drive the decision to invest in a company, how in the world will you know if and when to sell?

At SMI, we have a strategy that would have actually gained more than one percent in 2008. Its strength is seen in down markets. When the market is growing, it’s designed to share in some of the gains, but it isn’t expected to grow as much. During down markets, it’s designed to minimize loss.

We have another strategy that’s designed to far outpace the market when things are good, and it has. But when things are bad, it can be expected to fall hard. Those with a strong stomach have enjoyed remarkably good returns.

I’m using these two examples mostly to emphasize the importance of following an objective investment strategy and being aware of how it is likely to perform under various market conditions. My sense/fear is that many people with money invested in the market are not investing this way.

Do you have a strategy you trust? Are you following an objective, proven process or are you picking investments based on subjective criteria? If you’re using a reliable process, you should be fine sticking with it when things get rough. But if you’re going on gut feel or a hot tip from a friend, what will you do when times get tough?

Investing can be a humbling activity. None of use should ever get too confident in our abilities or complacent about how the market is performing. Watch out especially for the four issues I just highlighted.

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