Investment Principles, Part 1   1 comment

Yesterday I talked about investment vehicles you can use to reach financial independence (ie, have the ability to retire). Today I’ll go over some basic investment principles.

Do not try to beat the market

What exactly is the market? I guess technically the (US) market would be all publicly traded companies. However, people substitute a market index, such as the S&P 500 (top 500 public US companies, ranked by market capitalization – the total value of the company’s shares), or the CRSP US total market index, which includes almost 4000 US companies (and also the index used by one of the funds I invest in). From here on out, when I say the market, I mean one such market index.

Countless people have tried to beat the market. And there are people who have, such as Warren Buffet or Peter Lynch. But that takes a lot of time and skill that I, and most of you, do not have. I’d rather spend my time doing other things. Now, if you do put in the time required, you may be able to beat the market. But I don’t think it’s an endeavor for the faint of heart, because you could severely underperform the market and lose a lot of money. Also, I’m pretty sure that if you’re coming to this blog, you’re not looking to put in too much effort.

Similarly, do not try to find a mutual fund that claims to beat the market. There are two types of mutual funds from a management perspective.

Actively managed mutual fund – A mutual fund for which a team of people decide on a regular basis when and in what quantity they should buy and sell their managed assets

Indexed mutual fund – A mutual fund for which the management team has decided to just follow an index. They only buy and sell their managed assets when such assets come into and fall off of the chosen index.

You should avoid actively managed mutual funds like the plague. The overwhelming majority of actively managed mutual funds cannot outperform their appropriate index. Why? Well some of the managers themselves do not have the skill to beat the market. Some other managers do. But, any mutual fund (or ETF, for that matter) incurs an expense ratio.

Expense ratio – The fee for a mutual fund or ETF. If the expense ratio is 0.7%, then the fund management team takes 0.7% of all assets under management to cover their expenses. This money comes at the expense of the investors holding that fund.

There are some fund managers that manage to beat the market. But when you take into account the expense ratio, the majority of them cannot beat the market by a wide enough margin to make up for the expense ratio.

Now of course in any given year, there will always be some actively managed mutual funds that beat their appropriate index. And that’s just what probability tells us – the chance of nobody beating the market by pure luck is essentially zero. The problem here is that for an actively managed mutual fund to be worth it, it should beat its appropriate index more often than not (and by the appropriate amount, too). To do this after taking into account expenses over long periods of time (at a bare minimum, for a decade) is exceedingly rare.

And I will say this – you tend to see more buzz about actively managed mutual funds, particularly the ones that beat their index. But you have to keep in mind that sites such as marketwatch.com want to have articles to write. And examining the winners is always exciting. Whereas the way I think you should invest, with low cost index funds, is very boring.

Low cost index funds

Low cost index funds are the alternative to actively managed mutual funds. As in the definition above, the fund only buys and sells according to an index. An appropriately chosen index will reflect the broader market (whether that market is the US stock market, the international stock market, the US bond market, the US real estate market, etc.).

With an index fund, you’re guaranteed to get just under the market return. You’re settling for a little bit less than average. And who wants to settle for average? Well, in this case, if you settle for just under average, you will do just fine. More than fine, really. Do not be tempted by actively managed funds that have performed well in the past, because…

Past Performance is No Guarantee of Future Results

Sorry for the big font there. But it’s that important.

On any fund’s prospectus (the document explaining past performance, expenses incurred, assets under management, and some other things), there is always a disclaimer about how past performance is no guarantee of future results. It is the single most important statement on a prospectus. It is also, unfortunately, the most ignored statement.

Just because a fund, whether it’s an index fund or actively managed, performed well in the past, it does not mean it will continue to do so in the future. Do not concern yourself with past performance. When I evaluate a fund, I do not care about past performance. I don’t even look at it. Because it’s irrelevant. The only things that matter are whether it’s indexed or actively managed, what type of assets it invests in, and its history of capital gains distributions and proportion of dividends that are qualified (I’ll explain what these means after I explain taxes).

Diversification

You do not want to have concentrated risk in your investment portfolio. Investing all of your money in one company is one such example of that. There is the risk that the company could go bankrupt and you could lose all your money.

You want to spread your money over different companies, and different asset classes. This generally means holding some stocks and some bonds (there are some arguments to be made for holding purely stocks if you are young). Stocks have historically had the best returns, and we expect that to be the case going forward (I realize this is somewhat contradictory to the principle above. But here I’m talking about centuries of history, whereas examining the past performance of a fund typically only goes back a couple decades at best). But stocks also have the highest risk. So I recommend you hold some bonds, which are much safer and have a lower return. Typically, these assets are not correlated–when the stock market crashes (and I guarantee it will crash sometime), bonds generally hold their value pretty well. And vice versa.

Diversification should also be applied to the stocks you buy. As you’ll see in a later post, I recommend VTSAX, which tracks the CRSP US total stock market index. It covers companies from all sectors (such as technology, health care, and energy) and of all market capitalizations (large cap, mid cap, and small cap). And not only that, but I also recommend diversifying across countries as well. There are index funds that will track international markets.

Now, there are some arguments against international funds. The major ones are

  • International funds carry currency risk. International stocks are already intrinsically risky because stocks themselves are risky. But now, there is the added risk that fluctuations in the value of the US dollar relative to other countries could cause your international funds to lose value.
  • Many US companies sell in international markets, providing international market exposure.
  • The US economy is a large enough part of the world economy that when you combine this fact with the other two reasons, international funds aren’t worthwhile.

The counter arguments, which I think are more convincing, are as follows:

  • There certainly is currency risk. But there’s also the chance that the fluctuations in the US dollar will work out in your favor. Even though the underlying assets haven’t risen in value, your fund’s value may increase because of currency fluctuations. And predicting which scenario is more likely is quite difficult.
  • Multinational companies do not equate to international companies. There are plenty of large international companies that are not listed on the US stock exchange.
  • To say that the US economy is a large enough part of the world economy comes off as incredibly arrogant. Also, the US share of the world economy is shrinking. Look at places like China with rapid economic growth.





I think that’s enough for today. Tomorrow, I will talk about some more investment principles – discipline, assessing your risk profile, rebalancing, and your time horizon.

Advertisements

Posted January 9, 2015 by Fiby in Uncategorized

One response to “Investment Principles, Part 1

Subscribe to comments with RSS.

  1. Pingback: Retirement Accounts, Part 2 | Financial Independence by 40

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: