Durable Principles for Investment Success
(1) Diversify: Investment returns can be much like the economy: cyclical. Whether it be on a country level, size level, or industry level, market leadership frequently changes. Certain regions or styles can outperform for sustained periods of time (see U.S. stocks over the last decade), but market returns tend to mean-revert over time. Strong returns can bid up stock prices and lower the probability of strong future returns. Being well-diversified and having exposure to stocks across geographies, sectors, and industries can help to smooth the cyclicality of returns within your portfolio.
(2) Keep costs low: This not only means to avoid investment funds with hefty management fees, but to also be conscious of trading costs. Trading too frequently tends to lower your returns over the long run as general trading costs (such as the spread earned by the market maker) and tax costs (especially on short term capital gains) eat into your net returns. Short-term capital gains can especially eat into returns as they are taxed at your marginal federal income tax rate and can also carry high state taxes (i.e. 12% in Massachusetts). Additionally, frequent trading may be a sign of behavioral reactions to moves in the market. Investing on emotion often leads to errors.
(3) Align your portfolio with your goals and needs: Everyone invests with a purpose. This may be to save for a down payment on a house, to save for retirement, to save for a child's education, or to simply earn more money on your savings than you can in the bank. Analyzing these goals and answering questions such as "When will I need this money?", "How much do I need it to grow?", and "What type of loss can I emotionally handle?" can help you to build a portfolio with a high probability of reaching your goals. Looking at the return variabilities of asset classes over different time horizons can help you to assess how to allocate your portfolio. For example, below are 1 and 5 year rolling return statistics for world stocks and U.S. bonds over the last 20 years.
(4) Find a strategy that works for you and stick with it: Not every investor handles the ebbs and flows of the market in the same manner. Understanding your behavioral tendencies and understanding how your portfolio is likely to act in various scenarios can help you to deal with periods of time in which your investments may be out of favor. Famous investor Joel Greenblatt says it well: "The big secret is patience. Find a strategy that makes sense to you and have the discipline to stick with it". Sticking with a strategy when it is out of favor is one of the hardest parts of investing. This is the reason why investors often sell recently underperforming funds and buy recently outperforming funds that go on to subsequently underperform. Following the herd into the latest hot stock or fund only to exit quickly when performance is not what you hoped for is an easy way to limit your long-term returns. For example, one of last year's hottest funds was the ARK Innovation Fund, returning 153% in 2020. However, $11.4 billion of the $17.5 billion that people have put into the fund over the last 3 years has come in the last 6 months. During this 6 month period, the fund has returned 1.73% vs. a return of 16.62% for the overall U.S. stock market (Russell 3000 Index). Investors have begun to take their money out, with almost $800 million leaving the fund in a 6 day period in late April/early May (Bloomberg). While we don't know which investors are leaving the fund, history would hint that it is those who came late to the party. Knowing what you own can keep you from making mistakes caused by rash, short-sighted decisions.
(5) Avoid making drastic decisions and market timing: Market timing generally does not work. If you are lucky and it does work, then you also need to be right a second time in when to get back into the market. If you have been waiting for the right time to enter the market, try taking the emotions out of it and systematically entering the market at regular intervals. If you are worried about the market and want to get out, try making incremental adjustments to your asset allocation. Instead of selling a huge portion of your stocks, try trimming back your allocation at the margin. Making systematic moves and marginal decisions when faced with emotional inertia can help you to overcome behavioral barriers and minimize unforced errors.
(6) Be mindful of the relationship between risk and return: Having a good sense of the downside and upside risks in any investment is crucial, especially when dabbling in new technologies and asset classes. The potential upside and downside are two sides of the same coin and you can't have the chance at huge returns without taking on a heightened chance of losing money. Investment risk lives in the future and in the unknown and there is no such thing as big upside with little downside. This should be taken into account when investing in assets with "huge potential" and bets should be sized accordingly.
(7) Save, save, save, invest, invest, invest: As discussed in a previous blog (Savings Rates vs. Investment Returns), increasing your savings rate is the best way to set yourself up for future financial success. Pay yourself first, invest what you can, and let compounding returns work for you.