PART I
STYLE FOR SUCCESS:
CRAFTING YOUR INDIVIDUAL INVESTING STYLE
Some very talented and intuitive people can pick up a golf club and tee off without a hitch. Or they stand behind a podium and get their speech right the first time, right off the bat (pardon the mixed sports analogy). Donât you hate them? For the rest of us, it takes some preparation to start and to feel good about doing something. We want to learn and think about it, and know the ropes (oops, there I go again) before we try. Eventually we all seek a reliable, repeatable style. Over time, we âget the feel,â and expect our style to improve. The same applies to golf, public speakingâand investing.
Part I provides six habits covering important techniques and thoughts to help you initiateâand refineâyour own personal investing style.
HABIT 1
Know Yourselfâand Know What to Expect
Itâs a warm Friday evening, and youâve settled in to watch Sleepless in Seattle or some other classic favorite movie on your DVD machine. Just as you hit the âPlayâ button, your cell phone quacks at you. Itâs one of your old college buddies, Josh.
He asks you to go whitewater rafting tomorrow. âItâs going to be hot. Youâll love it. Câmon, give it a try.â
Uh, huh. Yeah, right.
You hate cold water. Really, you donât like water, period, and you especially donât like being in it. You donât like slippery rocks. Youâre not sure youâre up to the inevitable splash fights or free-fall (or so it seems) rapids or other chances you might take. And the mosquitoes and harsh sunânot to mention the potentially uncomfortable and silly chatter of old buddies of an era gone by.
But it does kinda sound like fun, doesnât it? Might be just the thing for a hot day, and to reconnect with your buds. You might not only get a kick out of it, but also find a new activity and pleasure and something new for the future.
You should do it.
What do you do? What do you tell Josh?
Like most great adventures in lifeâat least those not entirely within your profession, your personality, or your daily comfort zoneâyou might step back for a second to review who you are, what you like, and what you expect to gain (or lose) if you say âyes.â
Youâll have to decide if the pleasure is worth the effort, cost, or possible discomfort you might experience along the way. Is the gain worth the pain? That, of course, is the bottom line.
Perhaps itâs a bit of a stretch to compare investing with a summer weekend rafting trip, but in some ways theyâre similar. When youâre investing, you know that from time to time:
⢠Youâll get wet.
⢠Youâll get scared.
⢠Youâll be uncomfortable.
With both adventures, youâll want to think about the probable outcomes. Youâll want to keep the entire adventure within your comfort zone. Youâll want to imagine what you will get out of it, and how much and how often youâll get wet along the way.
Youâll want to think about whatâs reasonable to expect over the long term, what the realistic outcomes are, and decide whether the reward is worth the risk. As you would with any adventure, personal or professional, good investors habitually:
⢠Sense the outcomes.
⢠Sense the risks.
⢠Set reasonable expectations.
⢠Stay within themselves.
⢠Take what the markets give them.
Know What Youâre Trying to Accomplish
Why invest? Thatâs the first question any prudent investor must answer.
Investing isnât about bragging rights, nor do you invest âbecause everyone else is doing it.â A prudent investor invests to enhance the growth of personal income and wealth over a period of time. By buying a stock or fund or bond, you wisely deploy your personal capital into the capital markets to achieve a returnânothing less and nothing more.
In your profession, you earn income. Over time, if your finances are well managed, youâll save some of that income. Investing is (or should be) done to produce some return in the form of current income and/or growth, of that savings. Eventually, as you age, investment growth and income overtake your current earnings in size and importance, and if all goes well they should produce more than your then-current income after you retire.
In a nutshell: Make it, keep it, grow it.
These six simple words really are what personal finance and wealth management are all about. Investing essentially covers the âgrow itâ part. If you make it but canât keep it, youâll have nothing for the future. If you make it and keep it but canât grow it, youâre likely to consume whatever âseed cornâ you have and deplete your savings. Investing should guard against that outcome.
So a big part of Habit 1 is to deploy make it, keep it, grow it in your personal finances.
Know Whatâs Realistic
Do people make millions in the market? Sure. But not very many, at least not very many mortal individuals like you or me, right? People make millions on lottery tickets, too, but even fewerâtoo few to really matterâattain their wealth this way.
As an investor, you should develop the habit of having reasonable expectations. Baseball provides a good analogy: sure, you can swing for the fences to try to hit home runs, but youâll strike out a lot, and the home runs will likely be too few and far between to be of any consequence for the team.
If you have reasonable expectationsâand stay within those expectationsâyouâll likely come out ahead. As a baseball hitter, youâll get fewer home runs, perhaps, but a lot more singles, doubles, and the occasional triple. As a whitewater rafter, you wonât get wet as often, and youâll enjoy the raft trip more. You wonât have to deal with the pain and ambiguity of being dumped in the rapidsâin financial terms, of major failureâquite as often. Your investments, while always needing some attention and upkeep, wonât keep you up at night.
Investing Returnsâand Their Alternatives
So what is a reasonable return to expect from your investments?
Thatâs a tough question these days, especially as volatility has increased and markets can turn up or down seemingly on a dime. Beyond that, we all hear about the increased cost of things we save for long term, such as retirement or a college education, and we panic at the idea that our savings just wonât reach far enough. We start to feel as if anything less than a 20 percent annual return wonât do.
Knowing what you can expect is critical, not only for planning your long-term finances but also for understanding alternatives. What do I mean by âalternatives?â
Any investor should know the alternatives, and should invest only when investing is the best and most prudent alternative. If the stock market indicates a 5 percent return but you can earn 6 percent with a virtually free bank CD or 7 percent (implied) by paying off all or part of your mortgage, these alternatives must be taken seriously for at least part of your investible capital. Similarly, within the world of investing, an investment that can deliver, say, 10 or 20 percent returns with greater risk must be compared with alternatives earning 2 or 3 percent with relatively lower risk.
Good investors get in the habit of constantly evaluating alternatives. (See Habit 24: Sell When Thereâs Something Better to Buy.) Good investors are also in the habit of using a moderate, achievable investment return as an assumption for the future growth of their wealth.
Reasonable ReturnsâOver the Years
Back to the current question: What should you expect from your investments? What is âachievable?â
For years, the rule of thumb offered by the financial community for stock market returns was 10 percent. Data collected from the 1920s until about 2000 bore this outâmarket performance plus dividend payouts came pretty close to 10 percent.
Now, how can a stock market, which really is a sum of the values of all corporations traded in that market, return 10 percent per year when the total economy, measured by Gross Domestic Product (GDP) is growing say, between 2 and 4 percent a year? Does this make sense? Can corporations, taken as a whole, grow faster than the economy as a whole? And, if so, is this sustainable?
These are great questions, and all investors should wrap their heads around the answers. In fact, stock market investing returns have outperformed the economy as a whole over the long haul, but not by as much as the numbers might suggest. Furthermore, it appears that the rule-of-thumb 10 percent return has moderated. Today itâs closer to 7 to 8 percent.
Where did the 10 percent come from? There were three components:
⢠GDP growthâreal economic growthâaveraging 3 percent
⢠Inflationâaveraging perhaps 3â4 percent over the long haul
⢠Dividends and payoutsâcash earned and paid out by companies and not retained as part of the companyâs value. The average payout, at least for S&P 500 stocks is just over 2 percent.
Today, however, economic growth as measured by GDP has waned somewhat, and that market share growth has probably also waned. Many companies are seeing renewed competition from smaller, more nimble firms, especially as larger firms downsize and outsource more of their business. A rather dramatic case in point (pardon the pun) is offered by the beer industry, where big is no longer best and market share enjoyed by the larger brewers is reverting back to small brewers, microbrewers, and so forth.
So what is âreasonableâ to expect today?
Hereâs a number: from 1929 through 2011, as measured by the S&P 500 index as a broad indicator of all stock market performance, the stock markets have gained 5.1 percent per year, compounded, over that 83-year term. As a real number, it implicitly includes inflation effects, market share gains, etc. Add to that the 2.2 percent or so in dividends, and you get to a 7.3 percent annualized return for stocks.
Thatâs niceâ7.3 percent, versus something less than 1 percent these days for most savings accounts, and even a paltry 1.5 percent for government bondsâwho wouldnât want to be in stocks? Well, the answer is simpleâthat 7.3 percent comes with considerable variation, or as market pros call it, volatility, from one year to the next.
In fact, in only 14 of the 83 years, the S&P 500 did grow in single digits. That means that in 69 of the 83 years, the change was something larger or smaller! How could any investor sleep at night?
While this sounds awful, there is some good news. First, some 55 of the 83 years are positive. Second, 46 of the 83 years are within a relatively benign 0 to 30 percent rangeâif you think of it as rolling dice, most of the outcomes are positive, and most are better than the 5.1 percent long term average. Still, in the really bad years, in the 1930s and more recently 2008, things can get really bad, and those assaults and corrections can really âdingâ the averages.
Good investors are aware of these figures, and should be quite happy with 5 percent growth with some current payout, in the 2 percent range. Itâs reasonable to expect a little bit moreâbut 20 percent a year ongoing is simply not realistic.
Know Yourself
Back to that rafting analogy presented at the beginning of the chapter. Assuming you find any of the pleasures of rafting worthwhile at all, what are you willing to risk to entertain those pleasures? If youâre a risk taker, you probably donât mind finding yourself in the river once in a while in exchange for a chance to enjoy the thrills of speed and action. Spills for thrills, right?
Most rafters, on the other hand, wouldnât mind getting wet occasionally to enjoy the adventure, the camaraderie, and the cooling refreshment on a hot dayâbut donât want to be pitched headfirst into an ice-cold, swirling, rock-infested rapids. In the investing space, most investors are willing to put up with a down day here and there as part of the process of reaping decent gains and finding a winner here or there, but arenât comfortable risking large amounts or enduring painful declines for a chance to double, triple, or quadruple their cash overnight.
ITâS INVESTING, NOT TRADING
Investing isnât (or shouldnât be) gambling. It is taking calculated, prudent risks to achieve decent returns over time. Overnight or short-term windfalls are nice, but they arenât the goal. Similarly, investors donât buy and sell, buy and sell, hoping to capture a short-term gain. Thatâs trading. Trading isnât necessarily gambling, but it is typically playing in the market as a professional securities dealer would, buying and selling, buying and selling, trying to capture small opportunities in the market over and over. Trading isnât necessarily a bad thingâif you have the time, energy, and expertise to pull it off. But it isnât the mainstream activity of those who read this book. This book is about the habits of the investor, not the trader.
So who are you, as an investor? What kinds of risks are you willing to take? Would you rather have $5 in hand or a 10 percent chance at winning $50? Itâs important to know what makes you feel good and particularly, what makes you feel bad as an investor. ...