This an excerpt from How to Invest Wisely. To purchase the book, click here.
The goal of investors and speculators alike is to buy cheap and sell dear, but few do this with any consistency. This is so even for investment professionals. The common-stock investments of the overwhelming majority of mutual funds, pension funds, bank trust accounts, and investment advisors fail to achieve the returns indicated by the popular stock indexes. By the law of averages, some may do spectacularly well in any given year, and these are often flooded with so much new money to invest that they don’t know what to do with it. But very few investors manage to beat the market over long periods.
Skating to Where the Puck Was
Individual investors often do far worse, buying into the very peaks of a market fad, and selling out (or being sold out) after the inevitable crash. They buy the stock of manufacturers of pin-spotting machines right before the last bowling alley is built. They sink funds into oil-drilling programs in marginal areas. (Some readers may remember the “overthrust” belt in the early 1980s at the peak of petroleum prices.)
They chase after new issues and obscure companies with a story (typically some new technological wonder) in hopes of “getting in on the ground floor.” If such a company does manage to do well, they will bid its price up to fantastic levels, only to ride it all the way down when the euphoria ends. One sports-minded observer has described the strategy of the average investor as “skating to where the puck was.”
It is usual to attribute this phenomenon to the conflicting human emotions of fear and greed. When people (including the professionals, who are, after all, human beings, too) see others benefiting from an upward market move, they are prompted to get in on it, too. This process can often propel the prices of the object of speculation to previously unimaginable highs. The upward trend continues until the last buyer has been suckered in. When the inevitable crash comes, fear then drives the market and prices decrease sharply until the last speculator is flushed out. This often occurs at prices not only far below what was paid, but also well below any reasonable standards of worth.
As an aspect of human behavior, the tides of speculative price movements and manias have long been well described. But they remain little understood. In particular, no one has ever come up with a way of predicting the duration of a particular mania or to what highs or lows a mania will propel prices.
Investors need to be constantly on guard against falling in with the crowd and succumbing to the conflicting emotions of fear and greed, the main reason investors become their own worst enemies. The investment approach we advocate in this book can accomplish much in this regard.
Limiting oneself to index funds holding hundreds or even thousands of stocks, or to the mundane stocks that typically turn up in the HYD strategy, will not give you much to brag about at cocktail parties. But it will enable you to avoid the ruinous love affairs that so many investors seem to develop with their favorite stocks.
More importantly, our approach should enable you to overcome perhaps the most basic impulse of investors, which is to want to have more of whatever has gone up and less of what has gone down.
This is the impulse that presumably contributes to the manias and speculative peaks and troughs. But, the punch bowl always runs dry just when the party is getting good, to paraphrase longtime Federal Reserve Chairman William McChesney Martin. By selling into rallies and buying into declines, you will miss much of the euphoria, but you will suffer far less when the inevitable reaction occurs.
There is another important factor in investment success: reasonable expectations. As Richard Russell, famed author of the Dow Theory Letters, has written:
…the wealthy investor never feels pressured to “make money” in the market. The wealthy investor tends to be an expert on values.… And if there are no outstanding values, the wealthy investor waits. He can afford to wait. He has money coming in daily, weekly, monthly. In other words, he doesn’t NEED the market. He knows what he’s looking for, and he doesn’t mind waiting weeks, months or years (they call that patience).
What about the little guy? This fellow always feels pressured to “make money,” to “force the market to do something for him.” The little guy doesn’t understand compounding and he doesn’t understand money.
…He’s impatient, and he constantly feels pressured. He tells himself he has to make money fast. And he dreams of “big bucks.” In the end, the little guy wastes his money in the market, he loses his money on gambling, he dribbles it away on senseless schemes. In brief, this “money nerd” spends his life running up the down-escalator.
Now here’s the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than his income, if he had taken that extra income and compounded it in safe, income-producing securities—in due time he’d have money coming in daily, weekly, and monthly just like the rich guy. And, in due time he’d start acting and thinking like the rich guy. In short, the little guy would become a financial winner instead of a loser.
This is simply another statement of the principles we set forth in the Introduction and Chapter 1. First and foremost, the key to becoming a successful investor is living within one’s means.
The Deception of the Dollar
The continuing depreciation of the purchasing power of the dollar can distort investors’ perceptions. Without diminishing a portfolio’s purchasing power, a prudent investor nowadays cannot expect the portfolio to provide more real spendable income than 3 to 4 percent of the principal’s value. This is the same return that conservative bond investors received when currency values were stable. In an age of chronic inflating and punitive taxation of nominal capital gains, even that level of returns may be difficult to match.
For individuals who depend on investment income for living expenses, the issue can become crucial if they wish to preserve their purchasing power and pass on the principal to their heirs. Much interest income is not income at all, but compensation for the diminished purchasing power of the principal, and because capital gains may be simply inflationary illusions. This may lead investors to believe that their financial position has improved when it has in fact deteriorated.
A possible solution for such investors would be to follow the procedures now used for the endowment funds of many nonprofit organizations: Keep a running total or moving average of the value of your investment assets and withdraw a fixed percentage each year, without regard to the nominal income received.
Acting Like an Expert
Richard Russell is mainly a student of market timing. This is a version of active management in the belief that the market can be beaten with sufficient study and understanding of current trends, based on analyses of the available information. We question this view. In particular, his assertion that “the wealthy investor tends to be an expert on values” may appear quite intimidating. It seems to suggest that the ability to invest wisely is something a person is born with, like 20/20 vision or perfect pitch. Some people may have an intuitive flair for making sound investment decisions, but clearly most people do not.
By building a portfolio that includes a broad range of asset classes and staying with it in a disciplined manner, anyone can make the market itself tell him or her what to do. All that is required is the time, the discipline, and the effort to make it do so.