EVERYTHING I KNOW ABOUT INVESTING I learned in court. As part of my litigation practice, I represent investors harmed by the misconduct of stockbrokers, investment advisors and financial planners. Some cases can be brought in court. Most have to be arbitrated before the Financial Industry Regulatory Authority. Many of these cases have common themes that teach important lessons about investing.
Lesson No. 1: Wall Street Doesn’t Have a Crystal Ball. We all know predicting the future is impossible. But when Wall Street breaks out its technical charts, and its highly paid analysts discuss P/E ratios, EBIDTA, relative strength, quantitative analysis, momentum plays, valuation, trading strategies, market timing and the like, it sounds as if they have discovered a window on the future.
The reality: Stock price movements are unpredictable and random, because stock prices react to news, which by definition is unpredictable and random. The resignation or indictment of a CEO, a product recall, an “earnings disappointment,” the failure of a new product to generate significant sales, or an international crisis all will affect stock prices.
These events rarely can be anticipated. Contrary to what Wall Street’s aggressive marketing would have you believe, those who beat the market in the short term do so because of luck, not skill. Academic research has shown that there is a very low probability that any one broker, money manager, or financial newsletter can pick investments that consistently outperform benchmark market averages.
Lesson learned: Avoid actively managed investments. Stock picking and market timing are losers’ games.
Lesson No. 2: One Size Doesn’t Fit All. When you shop for clothes or shoes, there are a variety of sizes and styles, because each of us is physically different and has an individual fashion sense (or lack thereof). Similarly, investing choices should be tailored to fit you as an individual. A conscientious and knowledgeable advisor will carefully evaluate you to determine which investments are appropriate and how much to invest in each.
An advisor should ask about your investing time horizon, liquidity needs, income and savings rate, net worth, tax bracket, and investment experience and knowledge. Most important, the advisor needs to understand what level of risk gives you discomfort. Can you tolerate a 20% decline in your portfolio without panicking, or do you need to construct a portfolio that, based on historical data, is likely to fluctuate up or down only 5% a year?
Lesson learned: Run, don’t walk, from any advisor who tries to sell you something without first learning about you and your risk tolerance, or who has the same solution for everyone, or who recommends putting all your assets into a single type of investment.
Lesson No. 3: Wage War on Expenses and Taxes. Over long periods—10 to 20 years—well-diversified portfolios have almost always had a positive return. But fees, expenses and commissions, imposed year after year, substantially reduce the eventual long-term net investment return. And in a taxable account, the taxes generated by trading for short-term capital gains are also a drag on returns. Because of compounding, even a small difference in expenses can make a significant difference to long-term investment results.
For example, a $100,000 portfolio earning an average 9% a year for 10 years, with 1.25% in annual expenses, will grow to $208,755. That same portfolio, but with 2% in annual expenses, would be worth $193,431, or $15,324 less. That is money that should have been in the investor’s pocket, not Wall Street’s coffers.
Additional fees, commissions, expenses and taxes, by themselves, can make it difficult to beat the market. As I’ve noted, the vast majority of brokers cannot select investments that beat the market over the long term. The probability of market underperformance is necessarily increased when the advisor tries to do so in an account also being hit with fees, commissions, and taxes.
Lesson learned: Keep expenses as low as possible.
Lesson No. 4: Don’t Chase Winners. Mutual funds, Wall Street firms, and financial newsletters love to tout their recent successes. Investors often flock to the fund, firm, newsletter, or investment category with the highest recent returns. But what happened in the past is a poor predictor of the future. The fund, firm, or individual advisor that “beat the market” last year isn’t likely to repeat that success this year, and they’re highly unlikely to consistently outpace their peers over long periods.
Lesson learned: Don’t chase last month’s or last year’s winners.
Lesson No. 5: Be Leery of “Investment Products.” Wall Street loves to sell “investment products” like limited partnerships, real estate investments, investment trusts, annuities, and mortgage-backed securities.
Often, these products pay huge commissions to brokers and insurance agents. When I see the phrase “investment product,” I usually find an investment with a variety of fees and expenses, and one that’s too complicated for the average investor to understand.
Lesson learned: Before buying an “investment product,” make sure there is full disclosure of fees and expenses. Don’t be shy about asking how much your advisor will make if you invest. Those payments come out of your investment, either directly or buried in the overall expenses borne by the investment. If the investment is very complicated, ask yourself whether you should risk your hard-earned money on something you don’t understand.
Lesson No. 6: Make Sure Your Money Lasts as Long as You Do. In retirement, many baby boomers suddenly have access to significant lump sums, accumulated through savings, pensions, IRAs, and 401(k)s. There is a temptation to spend those assets freely, without considering that they may have to last 20 to 30 years.
It is critical for investors to structure retirement investments, and manage withdrawals, so they don’t outlive the money they have accumulated. As a rule, holding the rate of withdrawal to 4% or less, adjusted for inflation, will help ensure there won’t be a shortfall. Of course, each investor must consider their own life expectancy, the composition of the portfolio, any other sources of funds (such as Social Security) and spending habits.
Lesson learned: The higher the withdrawal rate from your retirement assets, the greater the risk you will outlive your money.
Lesson No. 7: Tune Out All the Noise—and Invest for the Long Term in Low-Cost Index Funds. An index fund is a passively managed fund which seeks to emulate a specified benchmark, such as the S&P 500, the Wilshire 5000, or A-rated corporate bonds, by buying representative amounts of each stock or bond in the index. Other index funds (many of which trade on the stock market as exchange-traded funds) focus on one industry, such as the telecommunications or health care sector, or a single geographic area, such as the leading publicly traded companies of South America or Japan.
These funds don’t try to beat the market by actively trading. Instead, they simply capture the total market return of the fund’s benchmark index. As we have seen, only a small percentage of active money managers beat the market over the long term. That means an investment that matches the market year after year is more likely to provide superior long-term returns.
Much of the superior performance of index funds is due to their low expenses, which average 0.25%, or about one-fifth of the expenses charged by actively managed mutual funds. Additionally, most index funds necessarily provide diversification (e.g. owning the 500 companies in the S&P 500) and are tax-efficient, since there is no active manager trading for short-term capital gains.
Lesson learned: Allocate your long-term investments among a variety of passively managed stock and bond index funds, both domestically and internationally, based upon your risk tolerance, goals, and financial needs.
Robert Port is a partner with the Atlanta law firm of Gaslowitz Frankel LLC. He is fascinated with understanding how people deal with and manage money—the emerging field of behavioral finance. When not in a courtroom or before an arbitration panel, he prefers to be cycling, skiing, hiking, or swimming.