According to a recent Pew Research report, more than one-half of people aged 30 or older have investments in the stock market and 80% of those making $75,000 per year or more have equity investments. These investments include individual stocks and bonds, as well as mutual funds and exchange-traded funds (ETFs).
While many suffered from the sharp decline in the market in 2008 – it lost 38% of its value – the S&P 500 closed above 1,800 on November 22, 2013, more than doubling its low of 721 on March 11, 2009. As investor confidence returns, many analysts predict that the market is going to continue its bullish behavior well into 2014 and beyond. Whether you select individual stocks or bonds or rely upon an investment manager to do it for you, it is important that you choose an investment approach fitting to your attitudes and goals.
Components of Investment Success
The optimistic outlook for stocks provides a great opportunity for existing and new investors to review strategies and adjust investment philosophies to optimize their future results. Financial experts agree that investment success is highly dependent upon the following activities.
Any investment plan should be based upon a level of savings that you can consistently sustain over an extended period. Every investor should plan to reach a projected balance at a certain point in time by calculating the annual net return needed to achieve it.
For example, If you save $5,000 per year and want to have a portfolio of $500,000 in 30 years, your annual net return must average approximately 7%. If you would be content with $250,000 at the end of that same period, your required annual average net return would be considerably lower at 3.1%.
An investment approach should balance risk and return parameters consistent with your personality, knowledge, aptitude, and interest. Some people are more comfortable with risk of loss than others. Some enjoy the tasks of research and analysis, while others prefer to devote their time and energy to other pursuits. An ideal investment strategy considers your unique personality and takes advantage of your abilities and desires.
For example, young parents working 50 to 60 hours per week and trying to spend as much free time as possible with their children are unlikely to devote the time needed to identify and analyze a variety of investments on a consistent basis. An investment strategy that requires 5 to 10 hours per week of research is most likely to be abandoned, just as seeking highly volatile investments and chasing unrealistically high returns in the hopes of meeting an improbable future portfolio value is likely to fail. Investing in a professionally managed mutual fund or an index fund might be a better option.
3. Manage Risk
Benjamin Franklin wrote in 1789 to Jean-Baptiste Leroy, “In this world nothing can be said to be certain, except death and taxes.” Risk – the possibility of loss – is present in all human activities, especially investing.
Effective investment risk management requires understanding the elements (frequency and magnitude) of risk and compensating for them by doing one or more of the following:
- Avoiding Risk. You can avoid risk by electing not to make an investment, by selling securities, or by purchasing bonds rather than common stocks.
- Reducing Risk. One common way to reduce risk is to maintain a diversified portfolio of securities, which generally results in less loss than a single security.
- Transferring Risk. Some annuities can provide a measure of protection against market losses, such as an equity-indexed annuity. You could also purchase a fixed annuity with a guaranteed rate of return and no market exposure. Either choice transfers the risk of investment to the issuer, as well as any potential profits in excess of the guaranteed return.
- Accepting Risk. Electing to stay fully invested means accepting the risk that your assets may lose value. Because you feel that the possibility of gain is greater than the risk of loss, you may choose to assume that risk.
Your investment philosophy reflects your attitude about risk and means taking actions consistent with your comfort level.
4. Pay Attention
Having an achievable annual return target and a philosophy of investments that fits your personality and situation is not enough. The investment environment constantly changes as the economy reflects the actions of governments, technological advancements, and international events. Successful investing requires regularly monitoring news, assessing likely impacts, and adjusting to changing circumstances.
Knowing why you purchased a particular investment when you did – and taking corrective action when conditions change – is essential to reaching your long-term targets. If you’re unable to regularly monitor the impact of current events on your investments, consider investing in a mutual fund whereby you pay a small percentage for one or more professional managers to do just that.
5. Choose Your Approach
There are two common approaches – value investing or speculation – to investment choice, each of which has its vocal proponents. In recent years with advances in technology, a third approach, trading – buying and selling assets based upon their price action, rather than their underlying value – has become popular as well. Understanding the philosophy behind each approach, the applicable tools and techniques, and the potential shortcomings can help you select the right route.
Value Investing Approach (Buy and Hold)
Warren Buffett, considered by many the most successful investor of the 20th century, said, “Only buy something that you would be perfectly happy to hold if the market shut down for 10 years.” According to another proponent of value investing, Margaret Franklin, president of Marret Private Wealth, says, “Investing is predicated on thoughtful, comprehensive, reasonable analysis of the securities you are purchasing and the portfolio being created against the return you expect to receive – which can come in myriad forms: interest, dividends, capital appreciation.”
Investing is based upon a belief that stocks and other assets have an underlying intrinsic value based upon their respective earning power, products, management, and competitive advantage. These are all factors which can be identified, analyzed, and measured in a process called fundamental analysis. The goal of an investor is to identify those companies whose intrinsic, or “real,” value is greater than their current market value, as well as companies with superior attributes which are expected to grow in the future.
Investors who believe that market prices are eventually going to reflect real values of particular companies generally anticipate holding periods of several years. This same approach would require selling companies whose intrinsic worth is lower than market value. Investors who buy and hold intend to be long-term owners of the securities they purchase and actively follow a company’s progress through regular review of financial statements, public filings, and press releases.
Value investing also requires active portfolio management to optimize total returns within the preferred risk spectrum. Portfolio management is the process of analyzing each individual investment in a group of investments in the hopes of reducing non-systematic, or diversifiable, risk.
- Systematic Risk. Systematic risk affects an entire market or a specific industry. For example, the market as a whole dropped during the 2008 mortgage security debacle, reflecting a massive loss of confidence.
- Non-Systematic Risk. On the other hand, non-systematic risk affects a particular company. A recall of a company’s products followed by a decline of that company’s securities, while the overall market remains bullish is an example of non-systematic risk. Diversifying your investments among different companies reduces the applicability of non-systematic risk to your portfolio, since only an individual company is affected.
Fortunately, Wall Street firms employ hundreds of capable analysts constantly producing report after report covering projections of future earnings, ratios, and possible consequences of environmental events upon a single company, industry, or the market as a whole. In other words, these firms do most of the heavy lifting required to implement this approach.
A common complaint about value investing is that its proponents are in the market all the time. When a decline such as the one in 2008 occurs, investors can suffer major losses which may take years to reverse.
Opponents of the buy-and-hold approach point out that being in the market consistently violates the conventional wisdom of “buying low and selling high.” However, the underlying assumption there is that anyone can accurately and consistently predict market trends, which is not valid. Many market analysts feel there is a greater risk of being out of the market than being subject to occasional bear markets when the investment horizon is five years or more.
A speculative approach, unlike value investing, ignores the idea that any asset has a real or intrinsic value. In other words, an asset is only worth what someone is willing to pay for it at the current point in time – no more, no less. As a consequence, speculators focus on individual and group attitudes about a company, an industry, or the market as a whole. If the buy-and-hold approach is cerebral and logical – akin to a chess game with the players contemplating hundreds of possible moves and sequences – a speculative approach is more psychological and emotional – similar to a poker game where participants are looking for physical “tells” to discern whether a player is bluffing.
Speculators do not care about the underlying value of assets, only the likelihood that a later buyer pays a higher price. There is no question that emotion is a powerful driver of stock market prices. General optimism can turn quickly into unrestrained buying frenzies followed by market crashes; or, negative news can send the prices of individual securities plummeting to depths out of proportion to the actual impact.
Speculators look for information or events that are not commonly known or reflected in the stock price. A rumor of a new drug discovery, the accumulation or sale of shares by company insiders, and likely regulatory changes that may affect company operations are examples of circumstances which can change a stock price overnight. Speculators also use technical analysis of stock prices, such as the relative strength index, momentum, and moving averages, to identify price patterns and market trends.
George Soros, manager of an international hedge fund with more than $27 billion in assets, is perhaps the best known self-professed speculator. He has said, “I rely a great deal on animal instincts.” Soros believes that prices of securities depend upon the human beings who buy and sell them – and human beings more often act on emotion than logical considerations.
Speculators are guerrilla investors, buying quickly in large lots, watching their investments intently, and quickly selling if the price doesn’t respond as anticipated. They believe that nimbleness and attention compensate for diversification.
Opponents of the speculative approach frequently refer to it as the “greater fool theory of investing.” In plain language, you buy an asset solely because you believe a greater fool is going to come along and pay more for it. Margaret Franklin claims that speculation is based upon conjecture rather than fact-based analysis and, as a consequence, requires the assumption of more risk.
Speculators must be willing to spend long periods on the sidelines, waiting for the perfect opportunity to appear. In addition, they must be supremely confident since the decision to invest is often contrary to general wisdom.
Speculation is not for everyone. Its results are impossible to predict, and it is not a viable approach for managing retirement funds or assets that are going to be used well into the future.
The proliferation of personal computers, the availability of super-fast Internet connections, and the reduction in transaction expenses has enticed many investors into “day trading.” While a few traders may be successful for limited periods, the odds of consistent market profits are less than those of a weekend card player winning the World Series of Poker in Las Vegas. The combination of consistent small expenses – quote services, commissions, margin interest, and taxes – combined with the need for a constant presence at the computer, and an inability to make unemotional, rational decisions continuously cause most want-to-be traders to quit after a few unprofitable months.
It is easy to be seduced into day trading with promises of quick profits, particularly if you seek unreasonably high returns. Consider the thoughts of Damien Hoffman, editor-in-chief of The Wall St. Cheat Sheet: “For the home-based retail day trader, I would consider the occupation as dead… The number of people whose screenplays make it to the big screen is probably the same as those who day trade successfully.”
If you are determined to attempt day trading, limit your loss exposure to a small fraction of your portfolio – 5% or less.
Many investors, due to lack of knowledge, time, or interest, have turned to professionals to manage their equity assets. Mutual funds are available as are unmanaged portfolios (ETFs) designed to mimic the performance of a stock market index such as the S&P 500 or Dow Jones Industrial Average.
These alternative equity investments are a way of having your cake and eating it too: You get the benefits of ownership in the world’s best run companies without having to expend significant time and energy keeping up with your investments.
Beginning to save early, securing a return consistent with your risk profile, and letting your portfolio appreciate over time are essential elements to successful investing. Unfortunately, many Americans have yet to implement realistic plans to build their savings since, according to the 2013 Retirement Confidence Survey, the 57% of Americans currently saving for retirement report that they have less than $25,000 in total investments. With discipline and thought, you can achieve better results and set yourself up for the future you deserve.
Do you have an investment approach? How is it working?