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Investing Doesn’t Mean Playing the Markets

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

We’ve learned, aside from getting out of debt (yes, you need to get out of debt to win with your money; otherwise, bankers win with your money), how to play defense in our financial lives. Now, let’s learn how to play offense and make that money grow.

Up until now, we’ve focused on two main aspects of protecting your money:

  • Budgeting: You want to spend money in ways which are important to you and not fritter it away, leaving you wondering at the end of the month where it all went
  • Insurance: Instead of the drip, drip, drip of loss of money when you live without a budget, insurance protects you from losing an enormous chunk (or all of it) in one fell swoop if the unfortunate strikes in your life.

Now, we’re going to look at how you can put yourself in the best possible position to make your money grow. I can’t guarantee that you’ll make money. The stock market is a fickle entity, but I also think it’s one of the three best sources of increasing your net worth. We’ll also examine the other two (real estate and entrepreneurship) in later articles.

But, first, let’s look at how to invest in the stock market.

Notice that this article is titled “Investing Doesn’t Mean Playing the Markets.”

What does that mean?

Many people like to believe that they somehow have the upper hand when it comes to picking stocks. Monkey Brain likes to sit in the back seat telling them that they’re smarter, they’re quicker, and they have knowledge that nobody else has.

The facts state otherwise. There’s a reason that the term “dumb money” exists – it’s reserved for people who have Monkey Brain pushing the buy button in their brokerage accounts. I recently heard someone say that he was having a good year because he was actively trading stocks and was up 8% on the year. He quickly realized that he wasn’t doing particularly well when someone else pointed out that the market was up about 14% at that time.

How does Monkey Brain convince us that we’re going to beat the market?

  • He tells you to invest in companies you’ve heard of. This is called positional bias, which makes us think that companies which are familiar to us are the ones which are going to be successful. Almost all of the successful companies were once companies that nearly nobody had heard of before they became big. That was the time to invest in them. Few people knew Steve Jobs when he was a twentysomething, but they’ve all heard of Apple Computers now.
  • He falls for the “rookie fallacy”. The “rookie fallacy” is when we become enamored with someone or something for its potential and undervalue a more qualified or better performing comparable candidate. We see this happen a lot with IPOs. There’s a lot of hype around IPOs because people think that they can catch a stock at the ground floor and ride it all the way to the top. They also see the potential in these stocks and don’t look at the actual profit numbers. There are two classes of people who benefit greatly from IPOs.
  • The founders. They’re the ones who got the stocks for a penny, relatively speaking, and now they’re cashing out. This is a liquidity event for them, to pay them for all of the hard work.
  • The investment bankers. They get to buy shares at preferred prices before the IPO and then sell them to their favorite clients at a discount to the IPO price. They also get paid a LOT to bring these stocks to market.

Note that “you and me” aren’t in that lot. I used to, not particularly successfully, actively trade stocks. I never was able to buy an IPO at the opening at the actual IPO price. The average retail investor (finance speak for ordinary folks like you and me) will almost never get in to an IPO at the original price because of the flood of orders which hit the market the moment it opens.

  • He causes you to chase your losses and cut your gains. You should be doing the exact opposite – riding your winners and dumping your losers. Monkey Brain, though, lives in the land of prospect theory, where losing is approximately twice as painful as winning. Therefore, in order to keep from losing, he uses mental accounting to separate your trading into two different accounts: the winners and the losers. As long as you don’t sell a losing stock, you’re only a loser on paper, according to Monkey Brain. He doesn’t have to add that into the losing column. At the same time, he’d hate to have lost a winner, so as soon as a stock gains, he wants you to sell it so he can chalk that investment up in the winner column. He also doesn’t include magnitude of losses. You can have 3 small wins and a HUGE loss and be down overall, but Monkey Brain doesn’t care. 3 is bigger than 1.
  • He thinks nobody else watches CNBC or reads the news. When Monkey Brain hears the latest “guru” on CNBC or reads about it on a commonly read website like The Motley Fool, he takes ownership of that little stock tip. He thinks that he can get an inside edge on everyone else because he watched CNBC or opened up the Motley Fool article, and he’s going to get one over and get in on whatever stock purchase they recommended before anyone else does. It happens all the time when Jim Cramer makes buy recommendations on his television show Mad Money. There’s even a term for it: the Cramer Bounce. Stocks will jump at the open the next day because hundreds or thousands of Monkey Brains sat down at their computers the night before putting in buy orders for whatever he said “buy buy buy!” about that evening on the show. They’re all thinking “HEH HEH. NOBODY BUT ME MAKE THIS TRADE!” And, the stock has a temporary spike as the flood of purchase orders come in, only to immediately settle back down to where it was previously once the market recalibrates.
  • He wants excitement. Trading stocks sends adrenaline throughout the body, giving Monkey Brain a high. So, trading becomes like a game to him, giving him the same rush of hormones blasting into your body. He does it for the rush. You’re doing it to save for your retirement and other goals. If you want an adrenaline surge, try skydiving.

If you haven’t guessed by now, I don’t like investing in individual stocks. We have far too little information to accurately assess which stocks are best positioned to rise, and even the stocks which seem best positioned to rise could be beset by all sorts of other mishaps, like CEO deaths, sudden FDA disapprovals, or Jim Cramer saying “sell sell sell!” one night on Mad Money.

How do you avoid these risks and biases?

In its simplest terms, think about owning stocks in this way. If you own one stock and all of your investable money is plowed into that one stock, your success goes the way of that one stock. If it flies, whoo hoo! Umbrella drinks on the beach for the rest of your life! If it goes into the toilet, you’ll be in the doldrums.

Now, imagine you’ve split your money and purchased two stocks. If one flies, then you might not be able to buy umbrella drinks for the rest of your life while living on the beach, but you could afford nice vacations every year. If one stock crumbles, then, while it’s a punch to the gut, you’re still in the game with the other stock.

Each time you split up your money to purchase different investments, you’re splitting the risk as well. While you’re going to limit the upside (the reason the term risk-reward exists is that you have to take risk to get reward when you invest), you’re also going to limit the amount of damage that one individual failure can do to your investments.

So, then, the answer is to split up your money and make tons of micro-investments, right?

Not necessarily.

First, academic research shows that once you get to about 25 different stock investments, you’ve done about all of the diversification that you can do. You won’t get incrementally more benefits from buying a different stock when you buy the 26th stock than you did in buying the 25th stock.

Just buy 25 stocks, then, right?

It’s not that easy. There are two primary problems in that approach:

  1. The commissions would take a significant bite out of your purchases. Let’s say that you had $10,000 to invest and you decided to buy 25 different stocks. Even at most low cost brokers (granted, places like USAA and Schwab now offer $0 commission trades), you’re going to pay $8 to buy each stock and $8 to sell it. That’s $16 X 25, or $400. So, right away, you’ve taken a 4% hit on your investments just by paying brokerage commissions.
  2. Which 25 are you going to pick? The more you try to analyze individual stocks to determine which 25 make it onto the island, the more susceptible you are to the psychological biases which I discussed above. What advantage will you have in researching stocks in your spare time compared to the people who do this for a living, can go walk floors, understand markets, and the like? None.

We know that we need a basket of stocks to diversify our investment risks, but we don’t want to kneecap our kitty by paying all sorts of brokerage commissions. The answer is buying mutual funds. A mutual fund is a pooled investment where lots of people put in money and then the mutual fund manager buys stocks on their behalf, ostensibly doing so more efficiently and cheaply than the individuals could do on their own.

There are two primary types of mutual funds which we want to concern ourselves with.

  • Actively managed mutual funds: these are mutual funds where the fund manager picks which stocks to invest in, and trades stocks based on what he or she thinks the market is going to do.
  • Passively managed mutual funds: these are mutual funds which seek to replicate indices of existing stocks, like the S&P 500 or the Russell 2000 index.

Active fund managers all have Monkey Brains too. They usually don’t realize it. The numbers bear this out. To wit:

 

After 10 years, 85 percent of large cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.

Furthermore, most academics agree that it takes between 20 and 25 years to determine if investors get their gains as a result of skill or as a result of luck. If you pick a fund which has outperformed the market index over the past five years, you have a 1.1% chance of picking a manager who has actual skill enough to pick the winners rather than being lucky. 98.9% of the time, you’ll be picking a manager who was lucky over the past 5 years.

You’ve got to ask yourself one question: Do I feel lucky? Well, do ya, punk?

If you haven’t figured out by now, I’m a fan of investing in passively managed index funds.

How to find an index fund that’s right for you

I got my start in investing when I was in college. I had no idea what I was doing. I picked four USAA mutual funds pretty much at random and stuck an equal amount of money in each. I remember I picked a world fund because I was a German major, but beyond that, there was no process behind my picks.

Much to my surprise, a few days later, I received four prospectuses from USAA. They were enormous documents that were about the size of a Vogue magazine (not that I read Vogue, mind you), and, to me, equally incomprehensible.

Nowadays, the prospectuses are generally digitized, but they can still be daunting, particularly for a novice investor who doesn’t know what to look for.

I’m going to do a comparison between two S&P 500 index funds, the Vanguard 500 Index Fund Investor Shares (VFINX) and the State Farm Mutual Fund Trust S&P 500 Index Fund (SNPAX) to walk you through what I look at when I evaluate index funds.

The very first thing to look at is what index the fund is attempting to mimic. In this instance, I’m evaluating two funds which use the S&P 500 index as their benchmark; however, there are plenty of other indices, such as the Russell 2000 Small Cap Index or the MSCI EAFE Index. You’re looking to achieve diversification – the reason you’re in a fund in the first place – as well as asset allocation, such as sectors, size of companies in the fund, and geographies.

Next, we look at the fees for a fund. Since we’re comparing two index funds tracking the same index, it’s a pretty simple task to compare fees directly. We’re also not looking for the managers of these funds to do active stock picking for us, so the management fees should be lower; the lower, the better.

 

  VFINX SNPAX
Load: this is the commission paid to a salesperson to get you to buy the fund; can be front, paid when you buy, or back, paid when you sell N/A 5%
Management fees: this is the fee paid to the fund to actually administer the fund itself 0.14% 0.18%
12b-1 distribution fee: this is generally a marketing fee for the fund N/A 0.25%
Other expenses: various expenses not accounted for in the other descriptions 0.03% 0.34%
Other costs: Sometimes funds have costs if you do not maintain a certain investment $20 annually if under $10,000 balance $10 quarterly if under $5,000 balance

Usually, the prospectus will provide you a table to show you how much fees and expenses would cost over given time periods, such as 1 year, 5 years, and 10 years.

Then, we look at turnover for the fund. Since we’re looking at an index fund, this should be low, as the components do not often change, but relative valuations do. This will affect short and long-term capital gains from the fund. For an index fund, lower turnover is better than higher turnover because of both trading costs and capital gains realization.

  VFINX SNPAX
Annual Turnover Percentage 4% 5%

 
Next, look at the fund strategy. The S&P 500 Index is a value weighted fund, meaning that the highest market cap stock in the index will have the highest amount of shares in the fund, and the lowest market cap member will have the smallest share. The Dow Jones Industrial Average, by comparison, is an equal weight index, so the largest member and the smallest member both would have an equal amount of weighting in the fund. Some funds may vary from this strategy, although in this case, neither does. Sometimes funds invest in derivatives to bring their performance closer to the actual index, as there will almost always be a lag in performance due to fees.

After that, look at how the funds deal with distributions. There are three main distributions to look at:

  • Capital Gains. This is the difference between the share purchase price and the share sale price.
  • Dividends. This is what a fund does with the dividends that each of the stocks in the index issues to its shareholders.
  • Interest. There will often be some uninvested money (VFINX aims to invest a minimum of 80% of its assets and SNPAX aims to invest a minimum of 90% of its assets) which earns interest.

The prospectus will usually provide a table comparing the index’s performance to the fund’s performance both before and after taxes. Let’s look at the 5 year performance of both funds.

 

  VFINX SNPAX
S&P 500 Index Performance -0.25% -0.25%
Fund return before taxes -0.33% -1.55%
Return after taxes on distributions -0.64% -1.78%
Return after taxes on distributions and sale of fund shares -0.31% -1.34%

You can also use the same chart to determine how closely the fund tracks against its index. The smaller the difference, the better for you, since you’re investing in the fund to try to get as close to mirroring performance as possible.

Finally, you want to look at investment minimums. Some funds have a higher minimum investment than others.

  VFINX SNPAX
To open an account $3,000 $250 without an automatic investment plan

$50 with an automatic investment plan

Minimum balance required to avoid service fee $10,000 $5,000

 
Armed with this information, you should be well-prepared to make decisions about what index funds to invest in and which ones you should avoid.

There are no guarantees in life

Even with a properly diversified portfolio, there are still some risks which you’re going to face when you pony up some of your hard earned money to invest in the market. Here are but a few.

  • Market risk. There’s a saying that a rising tide raises all ships. A sinking tide usually does the same thing. If there’s an event which spooks the market, then most stocks will go down, regardless of the fundamentals of the stocks which comprise the market. Hello investor psychology and herd behavior!
  • Interest rate risk. If interest rates go up, then bond prices go down. It’s also more expensive for companies to get capital which they sometimes need to grow, and it’s more expensive for consumers to borrow money (except for consumers like us who don’t borrow to fund consumption), which can be a drag on stock prices.
  • Country/economic risk. Similarly, if the economy is in a tailspin, then even the highest performing stocks will usually suffer, as there’s simply less money being cycled through the economy. If an event hits the country (think 9/11) which has a significant impact, then there’s not much that diversification is going to do to help. Sometimes you just have to take your lumps and hang in there.

How to invest

We’re going to explore this in two separate areas. First, we’ll look at how to split up your investments, and secondly, we’ll look at how to fund your investments.

Splitting your investments – asset allocation

In general, when you invest in the market, there are two broad categories of investments you can make:

  • Stocks/equities: this is where you get a share of a company and get to participate in the dividend distributions (if any) and any growth of the company. Legally, you have rights to the assets of the company after bondholders and preferred shareholders are paid off.
  • Bonds: this is debt that a company has. They borrow money from investors and promise to pay back at a certain rate of payments. Bond prices rise and fall inversely to interest rates. Let’s see why this is true. If Company A issues a bond which originally costs $100 and pays $5 a year, then the interest rate on that bond is 5%. If overall interest rates rise to 7%, then you can get a new bond for $100 which pays $7 per year. That means Company A’s price will have to drop in order to meet the equivalent 7% interest rate.

Because, aside from when bonds default – a rare occurrence in government markets and a fairly rare occurrence in higher grade corporate markets – you’re getting a known payment stream, the ups and downs of bonds are pretty smooth.

In comparison, stocks have unknown payoffs. Aside from stocks which issue a dividend (which can change at any time), there’s no known payment timeline or amount for a stock. Therefore, stocks can go up and down pretty frequently, and while, historically, they’ve risen over time, there’s no real certainty for what the market is going to do from day to day or from year to year.

This fluctuation is called volatility. It’s also a reflection of the risk-reward notion that we discussed earlier. The more volatility there is, the more risk that’s involved, and the higher the potential reward can be.

Ideally, you want to minimize volatility while maximizing your return. Studies have shown that it is possible to reduce the volatility of your portfolio by incorporating bonds into your investment mix while still retaining reasonable returns. I won’t get into the math (it has lots of square roots) to save you from having your eyes glaze over, but the bottom line is that having some fixed income investments will reduce the fluctuations.

When you’re young, though, you have more time to accept risk. As you get older, you’ll start to look at protecting your investments and using them to provide income, since you won’t be working to create a salary to pay for your expenses.

Therefore, the rule of thumb I use to say how much someone should invest in equities versus fixed income is:

Percentage of portfolio in equities = 110 – your age

Percentage of portfolio in fixed income = 100 – percentage of portfolio in equities

I also use a broad rule of thumb for how to divvy up your equities:

Total U.S. Market (I personally like a large cap index, a mid cap index, and a small cap index) : 65%

Rest of World : 30%

Precious Metals : 5%

The reason for the latter two is for balance. Investing in the rest of the world will allow you to capture gains from emerging markets when the U.S. isn’t doing so well, and precious metals tend to perform countercyclically to the U.S. market.

I do have one rule for where to invest your funds. If you have IRAs (you do, don’t you?), then you want to invest your income generating investment in the IRAs and your equity investments in your other investment accounts. The reason you want to do this is because bonds will generate interest payments. If you hold bond funds in your taxable accounts, then you will have to pay taxes on the interest payments. If you hold the bond funds in your tax sheltered retirement accounts, then you won’t have to pay taxes on the interest as it accrues. You’ll only pay taxes on traditional IRA accounts when you withdraw the money.

Again, I cannot emphasize this enough, use low cost index funds to accomplish your investment goals in the markets.

Putting your money to work – value cost averaging

If you have money set aside for investing but haven’t put it to work, by going through this lesson, you should be able to identify where you want to invest.

One question remains – how, exactly, do you enter the market? One big cannonball splash into the pool, or drip by drip by drip?

The research that I have done suggests that the drip by drip method is the best one. However, what I suggest takes drip by drip and puts a little twist on it.

There are times when you might actually sell rather than buy.

Shocking! I know! Sell when you’re supposed to be investing in the market!

In this section, I’m going to teach you about value cost averaging, the smarter cousin to dollar cost averaging, and the method which increases the chances that you’ll buy low and sell high.

Let’s say (for the sake of easy math) that you decide to invest $12,000 in a year. The easiest way to do it would be to invest all $12,000 at once in one fell swoop and be done.

Another way would be to invest $12,000 in 12 $1,000 increments. This is called dollar cost averaging. You’d invest $1,000 on the first of every month until you’d invested all $12,000. This allows you to invest in times when the market is down and times when the market is up.

However, you don’t want to buy when prices are high. Just like when you’re buying a big ticket item, you want to wait to buy until it’s on sale, right?

That’s where value cost averaging comes into play.

In the initial investment, you put your $1,000 into the market making your purchases (of index mutual funds).

At the same time next month, you account for market values. Instead of putting in another $1,000, you invest enough to make the market value of your investments $2,000.

So, let’s say that the market had been kind in the first month and gone up 5%. Your investment portfolio would have $1,050 in mutual funds. In the second month, you’d only invest $950.

On the other hand, if the market had a tough month and dropped 5%, your portfolio would be worth $950. You’d invest $1,050.

You’re buying more when the market is on sale and less when it’s expensive.

Let’s look at one more example.

Imagine that the miraculous happened after the first month. Your portfolio is worth $2,500.

What would you do?

You guessed it. Sell $500 worth to get the market value back to $2,000. In this case, you’re selling high and buying low.

This method takes a little more work than simple dollar cost averaging, but not much more.

I’ve included a worksheet for you to manage your value cost averaging.

Instructions for value cost averaging worksheet

This worksheet is designed to be both an investment tracking tool as well as a tool for helping you value cost average.

This is where you enter in your initial portfolio holdings. Put in the ticker symbol in the A cells (A1, A2, etc.) and the name of the fund in the B cells. The lookup cell in B10 is one that you can copy and paste directly into a symbol lookup box, such as the one at http://www.cnbc.com.

Paste results from B10 here.

When you make purchases, you’ll want to enter them into the rows starting at row 13. There are two parts to entering in the purchases.

First, enter in the ticker symbol, tab right to name and enter in the name, just like above. Eventually, Excel will automatically fill in the name for you. Then enter in the number of shares that you purchased and the price at which you purchased them.

The spreadsheet will automatically calculate how much you paid in the Total column. Note, for sales, enter in a negative price. You can enter in what account the purchase came from (e.g. Bob Traditional IRA, Roberta Roth IRA, etc.) in the Where column.

You can also use this spreadsheet to calculate your returns. If you enter in capital gains and dividends, put a 0 in the Share Purchase? column. When you make actual buys of funds, enter a 1 in the Share Purchase? column. Share cost will automatically update to reflect your purchases versus your reinvestments (e.g. dividend or capital gain reinvestments).

Now, go back up to the top of the spreadsheet. You’ll need to do some editing in Column C.

Go to cell C2 and hit the F2 key. You should see the following:

Move the cursor over a2 in the formula and type in the ticker symbol from cell A2. Do the same for all of your rows where you have entered in ticker symbols. Once you have done so, the spreadsheet should automatically calculate the total number of shares you have.

Now, move to cell E2 and hit the F2 key. You should see the following:

Again, move the cursor over a2 in the formula and type in the ticker symbol from cell A2. Do the same for all of your rows where you have entered in ticker symbols. Once  you have done so, the spreadsheet should automatically calculate the total amount of cash you have used to purchase shares of that fund with.

When it’s time to do your next round of value cost averaging, you’ll go to column F.

For each row, enter in the current price of each fund. The spreadsheet will automatically calculate the market value for each fund that you own.

If you have not entered in your purchases, you will need to manually enter in the number of shares in column C. Just make sure that you update the number of shares before you conduct your next round of value cost averaging.

In column J, you can enter in the accounts where you hold each fund. Column K tells you the percentage that each fund represents in your entire portfolio, and column L tells you what percentage each fund’s holdings is relative to your largest holding. Column M calculates the gain or loss for each fund, and cell M10 tells you the overall gain or loss percentage of your portfolio’s holdings.

In this section, you input how much cash you have in each account. List the accounts in column O and the cash balance in column P. Column Q gives you the percentage of your overall portfolio that each account’s cash balance represents.

Finally, when it’s time to do your value cost averaging, you’ll use columns H and I.

Based on your target allocations and incremental value cost averaging, you will input how much each fund should have as the target for the next investment. Column I will then tell you how much you need to invest in each fund. If the number is positive, you are buying. If the number is negative, you are selling.

It’s important to note that when you actually execute the trades, the numbers will end up being slightly different, as prices of mutual funds are quoted as of the market close on the previous trading day. However, once you enter in the trades, the numbers will be correct.

There is a sample worksheet so you can see how it works, showing what investments for April, 2013 would look like.

Related articles:

Do You Have to be Lucky to Beat the Market?

Why Does Monkey Brain Think Public Knowledge Gives Him an Inside Investing Edge?

Play the Market Like a Hedge Fund Manager

Why Past Performance Indicates Your Future Investing Actions

Do You Have Too Much Money in Fixed Income?

Stock Picking is No Better Than Sports Betting

If You Abandon Your Portfolio, Will It Abandon You?

The next article in this series is Retirement: Paying for Knee-High Socks and Hammocks.

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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