Keep it simple, avoid the pitfalls
Barry Ritholtz
Washington Post, January 25 2013

 

 

 

“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will be abandoned at the first sign of under-performance.”

 

That’s from Tadas Viskanta of Abnormal Returns, a “forecast free” investment blog. He was talking about the disadvantages of complexity when creating an investment plan. Even though specific complex strategies can be mathematically shown to outperform the market over time, they often fail to do so.

The primary reason? The people running them never seem to stick with them long enough. Computer help desks have an acronym for this issue — PEBKAC, or “problem exists between keyboard and chair.” Fear, higher volatility and significant drawdowns derail all but the most disciplined investors. As soon as trouble shows up, they are gone.

We must recognize our own behavioral errors. To be blunt, you are not likely to become a cognitive Zen master anytime soon. But a little enlightenment could keep you from making some common investing errors.

Knowing these limitations, we can design an investment plan to circumvent the behavioral pitfalls. And a good step is to simplify. Toward that end, keep these 10 ideas in mind when approaching your portfolio:

1 Go passive. Here is a dirty little secret: Stock-picking is wildly overrated. Sure, it makes for great cocktail party chatter, and what is more fun than delving into a company’s new products? But the truth is that individual stocks are riskier than broad indices. Managing those positions through the ups and downs is complicated and time-consuming, and most investors lack the skills and discipline to do it well.

Consider this: The world’s greatest stock-pickers got creamed in 2008. And the world’s worst stock-pickers made a killing in 2009.

Your solution is index ETFs, vastly preferable to picking individual stocks. Lower cost, reduced turnover, fewer taxes — and much less risk.

2 Diversify across asset classes. Owning a variety of asset classes means that some part of your portfolio will be doing well when the cyclical turmoil arises. A broadly diversified portfolio includes large capitalization stocks, small cap, emerging markets, fixed income, real estate and commodities.

A typical portfolio might look like this: 33 percent big cap, 25 percent small cap, 20 percent emerging markets, 15 percent bonds, 5 percent REITs and 2 percent commodities. Younger investors will want to include technology or biotech as a class as well. Older investors might want more income-producing holdings such as REITS and lower-risk holdings such as bonds.

3 Be mindful of valuation. When making purchases, valuation matters more than anything else. What you pay for an investment is the single biggest determinant for how successful that investment will be. When equity prices are high, your returns will be lower. When they are cheap, your returns will be higher.

The valuation challenge is that stocks become cheap during a panic and expensive during a boom. Your instincts will lead you to do what feels good — buy high, sell low — the exact opposite of what you should do. Our next step solves this.

4 Dollar cost averaging. This means automatically putting the same amount of money each month or quarter into several broad indices. When stocks are high, the fixed dollar amount means you buy fewer shares; when they are less low, you end up buying more. Just about all of the retirement custodians and online brokers can automate this for you.

5 Keep costs and expenses low. Overhead is a big drag on returns. Compounding of the (noninvestment) costs and expenses adds up to be an enormous sum after a few decades.

Let’s assume that 30 years ago, you invested $100,000 and had an average annual return of 8 percent. If you put it into an ETF that had an expense ratio of 0.20 percent, it would now be worth about a million dollars. That same investment into a higher-cost fund with an expense ratio of 1.19 percent would be worth $242,079 less.

Reducing your costs may be the only free lunch in all of investing.

6 Rebalance your portfolio. I mentioned holding various asset classes in a hypothetical model of 33 percent big cap, 25 percent small cap, 20 percent emerging markets, 15 percent bonds, 5 percent REITs and 2 percent commodities. After a good run in any asset class, your model will have drifted from the original allocation. Rebalance at least once a year for smaller holdings and semiannually or quarterly for larger portfolios (in which the frictional costs won’t matter much).

Rebalancing back to the original allocations accomplishes three things: You buy more of what has become cheap, sell a little of what has become dear and keep the diversification of the original design. This should be easy to do, with most online brokers having automated tools for rebalancing.

7 Avoid the noise. Our goal is to block out the things that send you down the path of pointless complexity. A good start includes dramatically paring down your consumption of online, print and TV financial news.

You don’t have to go cold turkey, but ask yourself: Has this outlet helped me make money? If the answer is yes, then keep it. Pare back 90 percent of everything else. You will be much better off spending your time reading classic investing books than consuming ephemeral market gossip.

8 Review your portfolio regularly. At least once a quarter. Check your allocations, see what is working, what is lagging. If you like to look at charts, use weekly, not daily, charts. A lesson we learned over the past century was that when markets are down 30 percent or more, you can raise your allocation to equities some; when markets are down 50 percent, raise it some more.

Throughout the collapse, I heard tales of investors who refused to so much as open their monthly account statements for three years. They missed a lot of opportunities by putting their head in the sand. The ostrich approach to investing hardly ever pays off.

9 Steer clear of venture capital and private equity. With the new rules on marketing private investments, hedge funds and other non-public forms of risk-taking, I expect to hear about a lot of losses over the next few years.

Why? These forms of investing are extremely challenging. The numbers of even the best venture investors are lots of zeros, a handful of break-evens or small winners and very few home runs. It ain’t easy — and odds are you lack the skills, capital and risk tolerance for these sorts of high-risk early-stage investments. What is available to you are the leftovers — typically, what the VCs have already picked over and passed on.

9b Most IPOs are a sucker play.

10 Avoid new financial products at all costs. New financial products are seemingly created all the time. They tend to be complex, expensive and dangerous. For the most part, they are designed primarily to capture a fee for the underwriters.

The major asset classes have hundreds of years of history. When products have proven themselves, like low-cost ETFs, you can freely buy them. Their costs, risks and downsides are known entities.

10b Don’t buy “house product,” either.

Investing has become so complicated because so many entities have a vested stake in keeping you active and paying excessive fees.

By keeping it simple, you avoid that problem. You reduce your costs and stay on target to meet your goals. But most of all, you prevent yourself from doing something rash that you later regret.

Simplicity is a virtue.

~~~

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz.

Category: Apprenticed Investor, Investing, Rules

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “Keep Investing Simple”

  1. NMR says:

    All great advice Bazzer particularly if you don’t make your living at this or don’t want to sit in front of a computer all day trying to beat electronic trading systems. That said the last few years have presented dip buying, stock klutzes like myself with great opportunities. Really, did you have be Warren Buffett to recognise it was time to pull the plug in early 2007, that Cat was worth more than 21 bucks in March 2009, or that Facebook was a scam. You’re also right about the info overload, 99% of the media commentary on data is totally worthless, particularly the politically motivated stuff which is criminally worthless. The same people who in 2007 were telling us we were in a Goldilocks economy have spent the last 18 months yelling that Armageddon was around the corner. My philosophy is fairly simple, understand what are the fundamentals and keep your eye on them. It’s not foolproof but works most of the time. Great blog Barry, always enjoy your sane insights.

  2. MayorQuimby says:

    My advice- next 50 years will be unlike last fifty. 7 pct equity returns are not going to happen. You will be lucky to get your money back.

    50 percent cash
    15 percent equities
    20 percent bonds
    10 percent commodities
    5 percent foreign $$$

    A Barry mentioned, after run-ups you shift so if we see SPX 1,200 I think that is a great point to increase equity exposure to 20 percent. SPX 1,700 to 10 percent etc.

    The problem for most people is they do not realize gains and do not understand other methods of creating cashflow from positions.

  3. jimmy jeblonski says:

    I wish I had read some of those 10 years ago, especially the venture capital advice – I’ve had some zeroes and no wins. Taught me a lot.
    I suppose I would disagree in one area. Not everybody should be buying ETFs in a balanced portfolio in my opinion. There are some who can actually develop financial skill in evaluating companies and their share valuations, and then apply this in an objective fashion to a process of buy and sell. I know this because I have come across a number of investor-club types who quietly sequester themselves in their basements with balance sheets and investing manuals. They tend to see it as a hobby I think, and the ones I have come to know have beaten the market over long periods of time.
    But I can understand BR’s reluctance to give blanket financial advice that relates to developing these skills – what would be the use of preaching to the 1% of investors who can or will be able to do this?

  4. AndrewShaw says:

    Amen.

    Well-chosen farmland (find a depressed area where you have connections), high cap-rate rentals (find a depressed area where you have connections), and Pimco Total Return.

    RE #3: If you buy used cars, boats, and toys, they can be near-investments, esp in relation to new over-priced crap that loses value so quickly. The relative gain from smart spending can make a huge difference (Millionaire next door).

    Avoid any financial product with an NYC or CT address when possible (I know all roads lead there, but its worth trying. :))

  5. mad97123 says:

    I would like the board’s thoughts on the dollar cost averaging question. Tax free account scenario.

    Investors X & Y each end 2007 with $100,000. Investor X gets defensive and avoids most of the 2008/2009 crash while Y remains fully invested.

    Investor X now has $125,000 due to some participation in some of the rally off the lows. Investor Y is now almost even at $99,000.

    Investor X is now 100% on the sideline. Investor Y is “all in”, always has been.

    Investor X is inclined to return to a normal allocation as outlined above. Investors Y, A, B & C all tell X it’s too late to jump all in at once, you must average cost in now, you’ve missed the rally. Yet they all remain 100% in because they have been all along.

    Should I re-establish my model allocation all at once, as if I was never out, permanently capturing my lead from my one foray into market timing? Or do I dollar cost average from here?

    If dollar cost averaging from here is recommended, why don’t all the 100% invested sell everything now (tax free accounts) and average back in themselves? I haven’t found anyone who is fully invested who can answer that. “You always average in with ‘new’ money” is the answer, but this is ‘old’ money from 2007.

  6. VennData says:

    Pretty good, except:

    1) Having 2% of your portfolio in commodities will do nothing for you. Drop them. A waste. They are zero sum assets.

    2) Don’t worry about valuation. Why? Because if you allocate 1/3 to US equities and 1/3 to foreign equities -through a dirt cheap total market product – and you will be re-balancing the market will take care of your over/under valuation and you will be selling automatically when assets are “high” and buying when low.

    3) Include your house and its financing in your allocation theoretically at first. In the design of your particular asset allocation. If you are house heavy, go light on REITs, if you are not, go bigger. If you have a big mortgage, you are short bonds. Can your job/career/business stand a few down years and still pay the mortgage, taxes maintenance? If so adjust you equity/bond holdings accordingly.

    4) Try keeping income spinners in tax free accounts.

  7. danm says:

    mad97123:

    I’d say it depends on the markets… if you started investing in Japan at the peak of the market and dollar cost averaged the whole time, not sure your portfolio would have done so well!

    You dollar cost average if you believe the markets go up over medium to long stretches of time and you question your market timing skills.

  8. mad97123 says:

    Thanks Damn, but my goal is not to time based on my beliefs about the market. Difficult to do because my beliefs wotked for a time in the past, but they appear out of sync now.

  9. NMR says:

    mad97123 Says:

    Investor Y isn’t even……inflation even though it’s been fairly modest ……Investor X who had the perspicacity to jump ship around 2007 before the sell off almost certainly jumped back in during 2009 which offered some of the bargains of the century and conservatively has doubled his money. If he made some good bets he could have quadrupled it. Honestly there isn’t a pat answer to your question.

  10. mad97123 says:

    Tkanks NMR, believe me I know I could have doubled my money. That’s why I don’t trust my judgement any more.

  11. stonedwino says:

    BR: Great advice as always and helpful indeed. How do small investors, like myself hold her steady, even though we feel it’s almost a losing game with HFT and all the institutional money moving the market lately. There still seems a wide disconnect between Main Street (things are improving a little) and Wall Street, Dow 14,000…really?

  12. bonzo says:

    The best way to hold her steady is to quit thinking of investing as gambling on horses where the smart thing is to back the horse that is on a hot streak, and instead treat buying stock like buying groceries. When canned food goes on sale, you want to buy more. When prices go up, you buy less or even sell back to the store in anticipation of the next sale. A really simple psychological trick (hat tip Benjamin Graham) that will fix the major behavioral bias in most people.

    Dollar cost averaging is difficult unless you have a very steady life/job, so that you can pump money into the market gradually over 25 years, then move it out gradually over the next 25 years. Maybe this works for government workers and tenured finance professors. For most people, income is lumpy and the ability to save from income even lumpier, so there is no way to dollar cost average. Like it or not, the majority of people are forced to market-time. It is therefore essential to have some way of valuing the market. Consider someone whose one and only savings and thus investing opportunity of a lifetime occurred when he received a massive bonus in Dec 1999. (The bulk of my lifetime savings occurred between 1996 and 1999. Fortunately for me, I became unemployed in 1999 and started thinking seriously about how to invest about that time, as opposed to just dumping everything into a bunch of Fidelity stock funds. I ran across a book that prompted me to became a market timer in early 2000 and move all my money into bond funds at Vanguard.)

    Most important rule: for every dollar of positive alpha, there has to be a dollar of negative alpha. If you are going to time the market (and like I noted, most people are FORCED to market time because their savings opportunities are lumpy), then make sure you do so in a way that pits you against dumb money. So-called investing professionals can be very dumb when it comes to long-term thinking, because these professionals are agents and thus subject to perverse incentives. On the other hand, the money engaged in short-term trading is extremely smart. If you make more than one trade per year (not counting sales to fund living expenses, or purchases to accomodate savings), you are asking to lose money. And even once per year is probably too much. Ideally, you’d trade once per decade.

  13. VennData says:

    A much simpler way for an investor to obtain information on businesses they may want to own is to steal it

    http://www.engadget.com/2013/02/02/eric-schmidt-china-most-sophisticated-prolific-hacker/

  14. faulkner says:

    Barry, an excellent article. Four points, a few somewhat behavioral:

    1. In a complex environment, given a choice between a simple strategy that tends to work and a complex one that doesn’t, humans, especially the educated ones, will pick the complex one on the basis of its brilliant (retrospective) account of conditions. (Storytelling strikes again.)

    2. Meir Statman amply describes in his book “What Investors Really Want” is social approval, bragging rights and other ‘rewards’ that less to do with investment outcomes than ego. Counterintuitively, this includes the right to complain about large losses than meekly keep quiet about modest gains.

    3. The advent of industrial strength efforts to assist traders and investors in making really bad and costly decisions (often). You rightly encourage investors to abandon most media and all new financial products, and this is not in our social nature. Luckily, your site and a few others offer an alternative as well as community.

    4. The “Keep Investing Simple” approach assumes the investor has sufficient time, capital and self-awareness. Many of the ‘boomers’ lack the time (as well as the capital). Many of those younger lack the capital and certainly the self-awareness. At least I know too many ‘investors’ trying to trade options to enlarge their IRA accounts.

    Keep telling the truth. It’s needed.

  15. John Clarke says:

    11. Don’t Fight The FED. And Invest Accordingly.

  16. louis says:

    Just buy Real Estate, it’s what the FED does.

  17. louis says:

    Sorry I meant to say MBS, and if it blows up tell um you F’d up. They will bail u out.

  18. victor says:

    John Bogle’s The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns explains it al;, $6.99 on Kindle, $12.09 on hard cover. If Wall Street could it would burn all editions, akin to the Nazi “cleansing” (“Säuberung”) by fire.

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