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WHEN WE’RE YOUNGER, we tend to focus almost exclusively on our portfolio’s performance. But as we grow older, risk becomes a bigger concern. The irony: That greater focus on risk is often the key to better long-run investment results.
Want to make wiser portfolio choices? Keep these nine notions in mind:
1. Bad results happen to good investors. Let’s start with one of the most counterintuitive notions in investing: Just because we score spectacular short-term gains doesn’t mean we made smart decisions—and just because our portfolio struggles in the short run doesn’t mean we got it badly wrong. Indeed, spectacular short-term results are almost always a sign of idiotic investing rewarded by dumb luck.
2. The possibilities are endless. We have just one past, but we face all kinds of possible futures—and we don’t know which one we’ll get. Or, to put it another way, more things can happen than will happen. If we roll the dice and bet big on one part of the financial markets, we’re ignoring a host of other possible scenarios and our overconfidence may come back to haunt us. That, in a nutshell, is why it’s prudent to diversify.
3. Good odds aren’t everything. If history is any guide, the stock market should post gains in three years out of four. Those are pretty good odds. But what if this isn’t one of those years—and stocks come crashing down? We need to consider not just probabilities, but also consequences.
For instance, number-crunching investment experts will argue that, if we have a lump sum earmarked for stocks, we should invest it right away, because the odds suggest we’ll do far better than if we spoon the money into the market. But such advice is reckless—unless we also ask about consequences. If my financial future hinges on a $1 million inheritance that I’m looking to invest, and I’ll be ruined if I dump it all in stocks and the market immediately crashes, then playing the probabilities is the height of foolishness—and, instead, I should reduce risk by easing slowly into stocks.
4. Aiming to win means we’re likely to lose. I suspect almost every reader of HumbleDollar understands the logic behind indexing: Before costs, investors collectively earn the market averages. After costs, investors—as a group—must inevitably lag behind. The upshot: If we capture almost all of the market’s return by buying low-cost index funds, we’re guaranteed to outpace most other investors. That advantage, while modest in any given year, compounds over time, leaving us far ahead of most active investors.
What if we stray from an indexing strategy? There’s a chance we’ll beat the market, but there’s an even greater likelihood that we’ll fall behind, as our higher investment costs take their toll. That failure looks even more damaging once we factor in not only taxes—active management tends to generate big tax bills—but also time. Indexing is, in more ways than one, a no-brainer. By contrast, picking stocks and timing the market involves countless hours of effort, for which we’ll likely get punished rather than rewarded.
5. Knowledge is dangerous. To be fair, true knowledge isn’t dangerous. Instead, what’s dangerous is thinking we know something that’s unknowable—like which way stocks and bonds are headed next, or which individual stocks will outperform, or which fund managers will come out on top. This, of course, doesn’t prevent so-called experts from issuing an endless stream of predictions.
Don’t think you’re influenced by such forecasts? Next time you watch CNBC or Fox Business and there’s some astrologer—I mean, market strategist—pontificating about the stock market’s direction, ask whether you find yourself feeling a tad more bullish or bearish. Almost all of us are susceptible to a compelling market narrative. The big risk: It’s so compelling that we act on what we hear.
6. The difference between amateur investors and the pros is that the pros think more about risk. To be sure, for the pros, this is partly about career preservation: If they make a big investment bet and it backfires, they’ll likely be out of a job. But it’s also because it takes time and experience to become a veteran investor—one who fixates less on short-term performance and focuses more on risk.
I’ve seen no evidence that amateur investors, as a group, own a collection of stocks that’s any different from that owned by the pros. So why do a minority of amateur investors fare so poorly? In their lust for big short-term gains, they fail to consider risk.
7. Terrible results are the death of compounding. How do these amateur investors blow up their portfolios? Blame it on some combination of leverage and lack of diversification. That leverage might take the form of margin borrowing, selling naked put and call options, or perhaps owning leveraged exchange-traded funds.
If such bets go bad, they can be hugely difficult to recover from. Meet the brutal math of compounding: If you lose 50%, you need a 100% gain to get back to even. If you surrender 75%, you need a 300% gain to recover. What if you lose it all? Let’s hope you’re a good saver.
8. Just because it’s in the news doesn’t mean it should be in your portfolio. We can only sell investments that we already own (unless we short-sell, which is not advised) and we only buy investments that we hear about. And the investments we hear about most are those that are in the news. This year, that would include special purpose acquisition companies (SPACs), ARK ETFs, bitcoin, nonfungible tokens (NFTs) and GameStop. Meanwhile, total market index funds don’t regularly make the news because they aren’t especially newsworthy—unless the focus is on earning impressive long-run returns without taking unnecessary risks.
9. The answer never changes. Every trading day, the Wall Street-Media Industrial Complex offers up a new horror movie. It might be higher taxes, or deflation, or tightening by the Federal Reserve, or recession, or the budget deficit, or inflation. What happens next? If today’s big fear comes to pass, stocks will tank—and then they’ll recover and go higher.
What does this mean for our portfolios? There’s no need to listen to the blathering of the talking heads, because the answer is always the same. We need a core position in stocks so we notch healthy long-run gains, while keeping enough in bonds and cash investments to make it through the rough periods, both financially and emotionally. That advice won’t get you three minutes on CNBC. But, yes, it really is that simple.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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>> “To be fair, true knowledge isn’t dangerous.”
True knowledge is often dangerous, because it often takes wisdom and experience to apply it safely.
>> “keeping enough in bonds and cash investments to make it through the rough periods, both financially and emotionally.”
Wouldn’t that only be true for those financially and emotionally dependent upon the size or their retirement portfolio? Earlier in one’s career one is financial and emotionally dependent on potential for earning income, which is why many at that stage are 100% stocks during that time.
Many folks who are heavily invested in stocks sell in a panic during market declines — even though they’re years from retirement. They often need little or no bonds and cash for financial reasons. But they clearly need them for emotional reasons. Those of us with high tolerances for risk shouldn’t assume others are equally tenacious in the face of short-term losses.
The very recent experience of 2020 should be a humbling example to all investors of how hard it is to anticipate risks and rewards, both because of the dramatic size of the stock market plunge in the first quarter, and the unexpected resurgence of the market in the last half of the year (which continues in 2021).
An excellent summary. Good reminders for many of us while being accessible to those less experienced. I’ll be forwarding this.