WHEN THOMAS EDISON was a child, he apparently set fire to a barn on the family’s property. After it burned to the ground, his parents were furious.
“Why would you do such a thing?” his father asked.
Young Edison replied, “I wanted to see what would happen.”
The story may be apocryphal, but I was reminded of it recently when I came across a study titled “Not Learning from Others.” A group of economists wanted to understand more about how people learn.
The researchers set up an experiment in which participants were told to estimate how many marbles of different colors were contained in a jar. There were two people on each team. To start, each team member had to guess how many red marbles they thought were in the jar. Next, one team member was permitted to draw some—but not all—of the marbles out of the jar, while the other team member observed.
Finally, each team member was asked to submit an updated guess for the number of red marbles. The team members were able to speak freely and to share information with each other throughout the experiment. The only difference was that one of the team members was responsible for pulling the marbles out, while the other just observed.
What happened? Even though the two team members were sitting side-by-side and openly sharing information, their answers differed markedly. The team members who could only observe ended up making guesses that were significantly less accurate than those of their teammate. The conclusion—which wasn’t altogether surprising—was that people learn better when they deal hands-on with an issue.
How does this finding apply to managing money? Below are five ways in which you could become more hands-on with your finances:
Look under the hood. Mutual funds and their cousins, exchange-traded funds (ETFs), offer investors a diversified basket of investments. But how exactly do funds operate? While it might sound like a cure for insomnia, I recommend reviewing the most recent annual report issued by one of your funds. These reports are available online. On this page, for example, you can find links to reports for all of Vanguard Group’s ETFs. To be sure, the reports are lengthy, but you don’t need to read every page. Instead, I’d focus on three sections:
To gain a more granular understanding of the differences between index funds and actively managed funds, you might compare two annual reports, such as Vanguard Total Stock Market Index Fund and Fidelity Contrafund. Among the interesting differences you’ll find: Contrafund isn’t limited to publicly listed stocks. It owns shares in quite a few private companies, including ByteDance, the Chinese company behind TikTok.
Make a pick or two. Is stock-picking a good idea? According to the data, no. But do I recommend occasionally doing so? Absolutely. Here’s why: Every year, organizations like S&P Global issue reports highlighting just how difficult it is for professional money managers to beat the market.
But as the marble study showed, there’s a difference between reading other people’s research reports and experiencing something for yourself. If you buy a handful of stocks and follow them over time, that will, I think, give you a truly hands-on understanding of the nature of stocks.
Follow the math. Last week, I suggested that investors work to answer three key questions as they review their tax returns:
I noted that the answers to these questions can be provided by accountants and tax software. While that’s true, I also suggest that everyone try—at least once—to follow the math on their tax return. You certainly don’t need to add up every number. Still, see if you can follow the logic behind the above three questions, as well as behind these other key figures:
I view this a little like changing the oil in your car. You don’t need to do it every time. But if you go through the steps even once, it may give you a deeper understanding of how a car works.
Check the turnover. Why do actively managed funds often underperform? One reason is because it’s so difficult to pick the right stocks. Another reason is timing: Even if a fund owns the right stocks, but it buys and sells at the wrong time, that’ll detract from returns. And if a fund manager buys and sells too frequently, that can leave fund shareholders with an unwelcome tax bill. While there’s no way to know what a fund manager will do in the future, you can use the past as a guide.
One figure to look at is the fund’s turnover ratio. It refers to the percentage of a fund’s value that the manager buys and sells each year. You can find turnover information on a fund company’s own website or on the website of research firm Morningstar. Morningstar reports, for example, that Vanguard Total Stock Market Index Fund had turnover of 3% last year, while Fidelity Contrafund had turnover of 25%. That, in a nutshell, is the difference between an index fund and a typical actively managed fund.
A related figure is a fund’s capital gains distribution rate. This is the percentage of a fund’s value that’s distributed to shareholders each year. This is important because fund managers can choose to take gains (or losses) of any size at any time. As a fund shareholder, these decisions are out of your control. That’s why it’s important to consult past distributions before buying into a fund. While not a perfect predictor, these can be an indication of what you can expect. Note: These tax considerations are only an issue for funds held in your taxable account.
Know the drivers. Part of what makes a stock-bond portfolio such a powerful combination, in my view, is that stocks and bonds are so different. More to the point, their prices are driven by different factors. Stock prices are driven by changes in companies’ earnings per share (EPS) and by investor sentiment. Investor sentiment is captured by a stock’s price-to-earnings ratio (P/E). To learn more, you might pick a company and look through its profit and loss statements, which are all available online. There, you’ll see how EPS is calculated. Then look at a chart of the company’s historical P/E ratio.
Bonds, on the other hand, are driven by changes in market interest rates, time to maturity and an issuer’s creditworthiness. Textbooks have been written on each of these factors, but there’s no need to go that far. Just be sure you understand the composition of the bonds you hold and make sure they’re aligned with your goals.