Idea 4: Don't invest in drips and drops. Go all in.
There's something almost warm and fuzzy about the notion of dollar-cost averaging, or DCA. First, it's so simple: Some days the market is up; some days it's down. By investing in stocks in small amounts over time, instead of going all in on one specific day, you get to even out the good days and the bad, helping to tame some of the volatility of investing. Even better, you end up buying more shares at the cheaper prices, and fewer at the high prices. It seems like value investing on autopilot.
Too bad that, according to a stack of studies, it doesn't actually improve your prospects. As business professors John Ross Knight and Lewis Mandell put it in the title of a paper, "Nobody Gains From Dollar-Cost Averaging." Why is this? Assume that your ideal allocation, given your risk tolerance, is 50% in stocks. If you go in slow, that means that you are invested too conservatively until you hit 50%. In a market that's down, you might be glad you did this. But in a market that goes up, you are missing much of the gain. And buying at steadily higher prices.
If you think you can't predict when the market will go up or down -- and that's a smart call, there -- you should just figure out the optimal amount you want to hold in stocks (or any other asset) and buy in.
If you assume that stocks go up over time, chances are you'll come out ahead. A study published in the Journal of Economics and Finance simulated DCA and lump-sum investment strategies using nearly 75 years of stock market data; lump-sum was the easy winner.
HANG ON A SECOND ...This argument applies only to the decision of what to do with a lump sum you want to invest. But most people think of dollar-cost averaging as simply investing a little bit of their salary in the market every month. And that still makes perfect sense. In that case, you aren't purposely keeping any cash on the sidelines.
Although the math shows DCA doesn't really work, it can still be very useful for psychological reasons. If you find the thought of making a big investment so scary that you can't pull the trigger, DCA is a decent second-best strategy that will eventually get your portfolio where you want it to be. Mandell suggests doing it over the course of a few days or weeks, not months. That way it won't really hurt you, but will mitigate the risk of buying moments before a market crash. -- David Futrelle
THE LESSONS: Dollar-cost averaging appeals to the nervous Nellies in us all. But it's more of a psychological crutch than an investment strategy. Not that there's anything wrong with that.
If you feel uneasy about the prospects for a given investment, the answer isn't to stretch out the process of buying in. Instead, just allocate less of your portfolio to it. Diversification is still the best tonic for uncertainty.
Idea 5: Maybe you should chase performance.
Chasing hot investments is generally a sucker's game. You read about a popular stock, mutual fund, or asset class -- micro caps! emerging markets! -- and you're tempted to buy what's on a tear and enjoy the ride.
But as we've learned from bubbles in dotcoms and condos, people who invest in something just because the price is rising -- "momentum investors" is the standard label -- have a talent for jumping onto a winning horse just before it pulls up lame.
But here's the wrinkle. While you can get killed with emotion-driven momentum investing (where, say, you fall in love with Apple after you watch it go up 90%), there's evidence that it works if you can be systematic and consistent about it.
A landmark paper by Narasimhan Jegadeesh and Sheridan Titman found that top-performing stocks over three- to 12-month periods continued to outperform, on average, over the following three to 12 months (and that laggards over the same time period continued to underperform).
Cliff Asness, managing principal of AQR Capital Management, says that momentum may be the result of different investors reacting to the same news at different times (the way some see a blockbuster the weekend it opens, while others wait a month to visit the multiplex). Plus, it's human nature to jump on bandwagons, whether the market is going up or down.
Bear in mind that momentum works in general, not in every single case. That's what trips up many investors -- including many mutual fund managers -- who merely dabble in momentem to justify two or three bets.
"Anytime a statistician tells you about a strategy, it means they're doing it in 10,000 places and hoping it works out on average," says Asness. "This doesn't mean you can say, 'Yeah, IBM's going up.' "
Attempting a broad-brush approach, AQR last year launched AQR Momentum (AMOMX), which takes the 1,000 largest U.S. stocks, ranks them by performance over roughly the prior year, and invests in the top third of performers. The track record for the fund (expense ratio: 0.49%) is too short to judge its success.
HANG ON A SECOND ... Even Asness advises using momentum in conjunction with a more conservative value portfolio. Although momentum works in both bull and bear markets, when the market makes a U-turn, the results can be disastrous. --George Mannes
THE LESSONS: There's a simple way to take advantage of momentum's effect: Don't trade too much. Be slow on the trigger to rebalance your portfolio. Think along the lines of once a year, not once a quarter. A Vanguard study found this boosts returns in markets with momentum, and doesn't really hurt when momentum fades.
Understanding momentum can also prevent you from making costly mistakes. Don't be too eager to buy "on the dips." Stocks with falling prices can have downward momentum. If you are a stock picker hunting for bargains, look for beaten-down shares that have started to perk up. "If you consistently pursue value while fighting momentum, you've got a little bit of wind in your face," says Asness.
Idea 6: Diversification is swell, but you don't need commodities.
For decades, commodities futures have had the stigma of being little more than tools for gambling. But recently many advisers have been arguing that all savvy investors should own some commodities. Be skeptical.
The vogue for these investments is partly driven by worries about inflation, which commodities are thought to protect against. But it's also because, as stocks around the world move more and more in sync with one another, investors are trying to find profitable ways to diversify. And recent studies have shown that commodities have provided stocklike long-term returns, while also often zigging when global stock and bond markets zag.
When you buy a commodities future, you don't own the physical pork bellies or grain bushels, but instead a contract to pay a certain amount for them later on. If you look more closely at the way returns from these investments work, you may not be so eager to jump on the bandwagon.
For starters, unlike stocks, where bull and bear markets tend to last only a few years at a time, "commodities go through long ups and downs that could last decades," says Fran Kinniry, a principal with the Vanguard Group. "You have to be willing to hold them for 30 or even 40 years." For a lot of that time, they could feel less like a diversifier and more like dead weight.
What's more, with futures -- or the new funds and ETFs that track them -- part of your gain or loss comes from the "roll return." The details are messy, but here's what you need to know: When you buy a future, you're providing insurance for a producer who wants to lock in a price. In the past, producers' demand for this insurance outstripped the supply of investors willing to provide it, so you'd get a little extra premium that added to your return (or softened your loss).
But lately commodities futures are so popular that this roll return has gone negative. That could be a sign that futures are overpriced and that total returns will be lower than in the past. "If you want diversification and inflation protection, just buy TIPS," says Michele Gambera, head of quantitative analysis at UBS.
HANG ON A SECOND ... There may be legs in this market yet. Yale finance professor Gary Gorton says China and India are keeping their commodity inventories low. That could bring more producers into the market, pushing roll returns back up. "The truth is," he says, "we just don't know." --Paul J. Lim
THE LESSONS: You can probably do just fine with a standard stocks-and-bonds portfolio. Even if market forces shift back in favor of commodities, "the evidence is by no means so clear that they're a must," says Thomas Idzorek, chief investment officer and director of research at Ibbotson Associates.
Much of the current vogue for commodities is driven by the fact that they are still relatively complicated. Fund companies and brokers that can't charge much for boring old stock funds anymore would love to sell you a pricey commodities play.
If you do decide to own commodities, don't put much faith in the record of past returns. Remember that when everyone in America realized that stocks provided a high return in the long run, prices went up and returns eventually fell. The same thing could happen as commodities become more popular.
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