The Magic Formula for Investing
There is no secret to quick riches, you won't find one here. But the following is the closest thing to a "magic formula."
While these principles are simple, getting them right isn't easy. The human brain is programmed to think that investing should be complicated. That's one of the things that makes most people bad investors. Here are 3.
1. Don't try to outsmart the market
Do you like a trip to the cinema? Imagine constantly entering and exiting the room during a movie. You tried to leave the theater during the worst parts of the film and re-enter during the best. However, without knowing what's coming, you'd be missing out on several fantastic parts. How would you feel about that?
Many investors try to do the same thing: get in and out of investments when they think the time is right, but the best results come when we stay put.
Plenty of evidence supports this (take fund managers who, despite their claims of market timing, perform poorly over the long term). Missing the best days, weeks and months is a costly mistake.
Like a good movie, you'll sometimes be on the edge of your seat, sometimes laughing, sometimes in tears, but those who stay for the duration of the movie reap the best rewards...emotionally and financially.
2. Resist the pursuit of achievement
You know the feeling: you are standing in the longest line in the supermarket. You see the row next to you move faster, so you join that row. To your dismay, your new queue now comes to a halt. Meanwhile, the line next to you that you left is speeding up.
While this may be arbitrary in a supermarket, it is anything but arbitrary in the investment world. After all, academic research all too often suggests that fate reverses. It can be tempting to move from one mutual fund to another when it feels like there's no momentum left.
We switch lines in the supermarket, only to find out that we would have been served faster if we had stayed. No one knows what will happen in the future and the fast-moving queue probably won't stay that way.
Over long periods of time, the best performance does not come from chasing past winners. After all, that's a lot like dogs chasing tails. Instead, we should maintain a diversified portfolio of low-cost funds and rebalance them each year to maintain a target allocation.
3. Consider the drivers of return
"Remember to look up at the stars and not down at your feet" - Stephen Hawking
Many view the market universe in terms of individual stocks and bonds. This, to borrow from Professor Hawking, is looking down on your feet. But the universe, seen through a powerful telescope, consists of planets, moons, stars, galaxies, asteroids, comets... the list is endless.
Investors should think the same way about the market. Yes, there are individual stocks and bonds. But what about the often untapped broader dimensions, which have similar, relevant features? Consider geographic location, company size, relative price, profitability and currency.
Do you know what's best here?
You don't need to understand any of these, or how they work.
You just need to own a diverse universe and let the markets do the rest.
Investors need only look to the stars...