Don't try to invest like the pros
The way some finance wizards manage their money offers valuable lessons - in what not to do.
(Money Magazine) -- Investing has a few simple rules that everyone knows are true yet most people find amazingly hard to live by. Diversify; don't chase hot returns; don't think you can outsmart the market. If you did nothing more and nothing less, your success would be all but ensured.
Turns out regular folks like you and me aren't the only ones who struggle to live by these precepts. A new survey shows that finance professors - the experts who analyze markets and teach future mutual fund managers how to build portfolios - have the same willpower problems as the rest of us. We can learn something about how to address our own shortcomings if we study theirs.
Colby Wright, a young scholar at Central Michigan University, surveyed more than 600 finance professors at major U.S. universities to find out how they invest their own money. It turns out that most keep things simple and smart: They do little or no stock picking, and they avoid investing in options, futures contracts or other more esoteric securities.
About two-thirds of the professors, in fact, have the bulk of their assets in index funds, the low-cost baskets that essentially own the entire market. These academics more or less practice the basic lesson of modern portfolio theory: Diversification is the key to holding down your risk and maximizing your returns. That leaves a third who have gone astray, however.
So much for theory
In their classrooms, these professors lecture on complex theories of how markets balance risk and return. In their portfolios, the profs who trade ignore that mumbo jumbo. How do they decide when a stock is a buy? By doing a discounted cash flow analysis? Or consulting the capital asset pricing model? Nope. Like any CNBC junkie, they zero in on how much the price has risen lately. To heck with theory - that sucker's going up!
Worse still, among the 44 percent of professors who believe that the market is efficient - meaning that whatever is knowable is already priced into stocks - nearly a quarter nevertheless agree with the statement "When I invest my own money, my goal is to beat the market." In other words, having spent their careers studying the stock market, these experts have concluded that it can't be beaten by anyone - except them.
"Professors' perceptions of market efficiency have little, if any, influence on how they invest," says Wright. "What really drives their investing behavior is their confidence in their own abilities."
In this, the professors are just like the rest of us. Although everybody knows how hard it is to beat the market, nobody stops trying. Let me rephrase that: Everybody knows how hard it is for everybody else to beat the market. So you and I are always honest about each other's chances of success but never about our own.
The real lessons
There are two important bits of learning embedded in Wright's survey data.
First, whenever anyone tells you that research "proves" a novel method of investing is a market beater, bear in mind that the professor behind the paper is most likely an indexer who has never road-tested his theory in the real world of trading costs, taxes and other expenses.
Second, remember that even many of the people who know best can't resist chasing hot stocks, so you have to control your behavior in advance. Put 90 percent of your money in low-cost index funds and lock yourself in by adding a fixed amount every month through an electronic transfer from your bank.
Speculate - if you must - with just the remaining 10 percent, and use a checklist of buying criteria to make sure you never buy a stock purely because it has been going up. You can buy a stock only from someone who doesn't want it anymore. You don't have to be a finance professor - in fact, maybe you shouldn't be one - to realize that the seller may know something you don't. The less you fool with your portfolio, the less often you'll play the fool.
Are you on track for an early retirement? Tell us why at firstname.lastname@example.org. Include your financial details and your family could be profiled in a future column of our Millionaire in the Making series.Send feedback to Money Magazine