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Investing should be a lot easier than it is – but you make it difficult
When it comes to investing, we’re our own worst enemies. We’re prone to illogical biases, panic and over-reaction. John Stepek explains why, and how you can become a better investor.
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Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.
It's possible to buy low and sell high but timing is tricky
Much of the financial history course I went on last week was spent looking at historical returns on the likes of stocks, bonds, cash and even property, and trying to see if there were any valuation measures you could use reliably to give a decent forecast of future returns.
The upshot is that there are ways to tell reliably if a market is cheap or expensive at any given moment (if you read MoneyWeek regularly, you'll have heard of some of them at least the cyclically-adjusted price/earnings ratio is one, for example).
The tricky thing is that, while these indicators can tell you whether you're likely to get good or poor returns over the course of 20-30 years, they're not great at timing the market. You might be sitting there for a long time with a market getting steadily more expensive before it gets cheap enough for you to buy, depending on where you set your parameters.
This is where it gets tricky, and where you're reminded that the biggest problem with markets is pretty much always the human beings that use them.
A lot of people on the course were fund managers or wealth managers they worked in the industry. So they were individuals managing money on the behalf of other individuals.
The problem is this: almost everyone says that they are long-term investors, just as almost everyone says that they are contrarian.
But most professed long-term investors don't judge their wealth manager or fund manager on their results 20 years from now. They judge them on the latest set of figures that have landed on their desk. And if those figures aren't good, particularly compared to the rest of the market, then a difficult conversation is likely to ensue.
This is what's known as "career" risk. There are many classic stories from the era of the tech bubble, but the truth is that the vast, vast majority of professional investors during that era knew the market was overvalued and expected something to happen to rectify that.
But managers who didn't take part in the bubble either lost clients' money (and so were paid less) or lost their jobs altogether.
What's the rational, self-maximising option in that situation? The reality is that certainly from the point of view of homo economicus the crazy people were the ones who consciously put themselves in harm's way by sitting the bubble out. The contrarians were the truly irrational ones.
The difference between your money and other people's money
If you are investing on your own behalf, then it's perfectly rational to sit out the worst excesses of a bubble. Because the chances are that, in the long run, being fully invested into a bubble will harm your returns, because you are unlikely to time your entrance and exit perfectly.
No one is going to take away your income or chances of promotion if you're a plumber or a GP or an entrepreneur managing your own money. It's only people who work in the business, and run other people's money, who are vigorously incentivised to participate fully in bubbles, even to destruction if everyone's portfolio collapses together, then no one pays the price (except the end client).
It's quite fascinating when you put it that way. The structure of the financial industry means that it's rational for its main participants to behave irrationally. I suspect that this lies at the heart of why momentum investing (buying what has already gone up) works consistently.
It reminded me yet again that the biggest threat to most investors is their own instincts.
If you aren't bothered about bragging to your mates down the pub about your latest hot stock tip, and all you care about is decent absolute returns rather than what "the market" is making, then long-term investment success shouldn't be that complicated. Statistically, over the long term (ie 20-years plus), stocks in the UK and the US have beaten other assets consistently.
It's also possible again based on past history to get at least a rough idea as to whether you are paying a high price or a low price for the stockmarket when you buy it. You can tilt the odds of winning in your favour by investing more at low prices and less at high prices.
Most of us are saving from current income. So we don't even really have the option or the challenge of working out the best time to stick a huge lump of money into the market. We probably save monthly or quarterly instead.
So when you do that, the best way to make sure you buy relatively low and sell relatively high is to use "rebalancing'. You allocate a certain proportion of your money (for example, 25%) to each asset class or fund or whatever you're using. Then when the time comes to add more money, you add it to the assets that are below their target allocation.
The truth is that you could do all of this while being barely aware of the news cycle. Events like 2008 would probably impinge on the consciousness of even the most ardent news avoider. But either way, knowing about it or not knowing about it shouldn't have made a difference to a rational investor's plan.
(This may sound a little self-defeating coming from a financial writer. It's not. Everyone has their own optimum level of engagement with the market, and if you're an active investor, you need to know what's going on. But it's always useful to be reminded that what's happening "TODAY!! RIGHT NOW!!" in the market is rarely as important as it looks in the long run, which is why you should avoid making long-run decisions based on it.)
How to be a better investor
The problem is that we all suffer from this short-term bias. None of us like feeling like a laggard compared to the rest of the investment world. And all of us are prone to panic and over-reaction.
There are ways to short circuit this asset allocation and rebalancing, and most importantly, having a plan in place are all ways to boost your own conviction in your strategy at key stress points in the market.
I've mentioned this to you before, but if you're interested in a simple investment plan that looks pretty much exactly like the one I've been describing here, then you should check out the Lifetime Wealth letter. You can find out more about it here.
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