Be A Better Investor We can't control the financial markets--but we can control how we respond. Here are eight surefire strategies for boosting your returns.
(MONEY Magazine) – Amazing, isn't it, how quickly this investing gig can go from no-brainer to brainteaser? A little over a year ago, when the Nasdaq was an object of devotion rather than derision, the challenge wasn't finding stocks that would go up. It was finding the ones that would go up fastest. Lately, it's been a struggle finding stocks going anywhere but down. Even the Mighty Greenspan seems to have lost his touch. Witness the fact that after two interest-rate cuts in January, both the Nasdaq and Standard & Poor's 500-stock index were mired in bear market territory, leaving investors to wonder if his third rate cut in March will turn the market around.
Things had been going so well...When did we lose control?
The truth, of course, is that we never had control, not of the markets anyway. The outsize gains we reaped in the '90s may have created the illusion that we were in the driver's seat, but in reality we were just along for the ride. If we've learned anything from the downturn of the past year, it's that what the market giveth, the market can taketh away, without warning. And nobody--not you, not me, not Span the Man--can change that basic fact.
That doesn't mean we're powerless though. While we can't control the markets, we have absolute control over something much more important: our own actions. We're in charge when it comes to the things that really determine investing success: which investments we choose to own, the proportions in which we decide to hold them, when to buy, when to sell and--perhaps most important--how we respond to the euphoria that prevails when the market soars, as well as the pessimism that descends when stock prices fall.
In this special report, we outline a variety of ways for you to become a smarter, more successful investor. We begin below with eight strategies that can help you boost your portfolio's long-term performance. We've also revisited several individual investors who have appeared in previous issues of MONEY to see how they're coping with this uncertain market. And we've put together an Investing IQ quiz on page 65. There's no million-dollar prize or shot at TV glory at stake, but taking it can give you a sense of how much you know about the things that really count when it comes to investing success.
On page 70, we turn our attention to taxes--one of the critical areas over which you do have some control (even though President Bush's tax plan doesn't contain a "choose your own tax rate" option). As staff writer Laura Lallos points out in "Taming Fund Taxes," you can dramatically reduce the portion of your gains that goes to the Internal Revenue Service by taking advantage of the expanding menu of tax-efficient funds and new fund alternatives.
We round out this package with senior writer Jason Zweig's fascinating look at behavioral-finance pioneer Daniel Kahneman on page 74. We're sure that after reading this profile you'll agree that the single biggest thing standing between your portfolio and better returns isn't volatile stock prices--it's you, or more precisely, the psychological quirks that prevent so many of us from making rational investing decisions.
Of course, we also address the market's current state, in "What's Next" on page 82. But before you drill down into the details, take a step back from the daily hurly-burly and read on to learn how you can wring the most out of whatever opportunities the market has to offer.
1. INVESTING IS NO STROLL ON THE BEACH
Remember how as a kid you'd walk along the beach, filling your plastic pail with every shell you'd see so that at the end of the day you could proudly show Mom and Dad your wonderful seashell collection? Your parents' oohs and ahs notwithstanding, what you really had was just a random assortment of shells that you happened to come across that day. It was no more a collection than a used-car lot is a display of vintage autos.
Unfortunately, many of us go about accumulating our investment portfolios the same way. We pick up a stock we heard about on CNBC's Power Lunch one day, a mutual fund at the top of some newspaper's performance list the next day--and pretty soon we've got a portfolio that resembles our old seashell collection: a hodgepodge of investments chosen with no coherent strategy and little regard to whether the individual parts work together as a whole.
"The problem with this approach," says William Bernstein, author of The Intelligent Asset Allocator, "is that you end up with a nondiversified portfolio that can be very risky." Anyone who invested this way in the past few years likely became overweighted in tech stocks and funds, which got slammed with enormous losses last year.
There's a better way: Think portfolio first and specific investments second. By that I mean you should settle on a blend of different asset classes that don't move completely in sync with each other. Then you can go out and find the shells--that is, the specific investments for those asset classes. By diversifying this way, while one part is getting clobbered, other parts may be holding their own or even chugging along to gains.
For example, while tech funds were getting their clocks cleaned with average losses of 59.2% for the 12 months that ended March 15, real estate, natural resources and financials generated impressive returns of 26.7%, 24.3% and 31.4%, respectively. Even bonds, the pariahs of the investing world in recent years, were looking good, showing gains of 12%, compared with a loss of just under 15% for the S&P 500. With money spread among various asset classes that don't all move in lockstep, your portfolio can cruise to competitive long-term returns while minimizing steep setbacks along the way.
2. DON'T GIVE IN TO "GET-EVEN-ITIS"
If you owned two stocks--one that was up, say, 25%, and another that was down by the same amount--which do you think you'd be more likely to sell? If you're like most investors, you'd unload the winner. Indeed, when University of California-Davis finance professor Terry Odean studied trading patterns between 1987 and 1993 in 10,000 retail discount brokerage accounts, he found that investors were about 50% more likely to sell investments in which they had a gain.
Does this make sense? From a tax standpoint, the answer is almost certainly no. When you sell a stock in which you have a gain, a piece of your profit goes to the IRS, leaving you less to plow into your next investment. Now, if you were sure the winner was about to head south and the loser was on the verge of a comeback, dumping winners and clinging to losers would be the right thing to do. But when Odean examined the performance of the winners that investors sold and the losers they kept, he found that the winners outperformed the losers by an average of almost four percentage points over the subsequent two years.
Why are we so hesitant to dump losing stocks and so eager to jettison the winners? Odean says that the answer lies in something called "prospect theory," a tenet of behavioral finance that says we tend to avoid loss and regret whenever possible. Selling a stock in which we have a loss forces us to admit that we've blown it. We don't have to face that uncomfortable admission if we just hold on to the stock and don't realize the loss.
I've got a simpler theory: We hold on to losers because we suffer from a malady that I call get-even-itis. Simply put, once we're underwater in a stock, we'd do anything--undergo root canal without anesthesia, attend an Adam Sandler film festival--rather than sell that baby until it gets back to even. This makes no sense, of course, because the Amazon.com stock you paid $70 a share for at the beginning of last year and that recently traded at around $11 has no idea how desperate you are to see it claw its way back to 70 bucks.
As for our penchant for cutting loose our winners, I consider that a case of the "take the money and run" syndrome. Once we've got a decent gain in a stock, that paper profit starts burning a hole in our pockets; we can't wait to cash in at a profit and then crow about what terrific investors we are.
This I know to be true from personal experience. Not long after another market meltdown--the one back in October 1987, when stocks lost 20% of their value in a single day--I bought two shares of Warren Buffett's Berkshire Hathaway company, which was then trading at $3,050 a share, down from more than $6,000 before the crash. Within seven months, the stock shot to $4,100. Suddenly, a little voice in my head began urging me to sell. I knew that going for the quick profit was particularly taboo in this case, since Buffett is the patron saint of long-term investing. But I succumbed.
At first I considered myself a genius. After all, I'd earned a $2,100 profit on a $6,100 investment in just seven months. Could Buffett himself have done better? But my delusions of grandeur began to fade as I watched Berkshire shares climb and climb and climb. As of this March, Berkshire was selling for $70,000 a share. If I'd just held on, I would have earned an annualized return of 28% before taxes, far better even than the phenomenal 15.5% a year that the S&P 500 gained over the same period.
The lesson, of course, is that the decision to sell a stock should be based on your estimate of its future prospects, not whether you're ahead or behind in it. If you own tech stocks that are down 50% from their highs but that your analysis leads you to believe still have excellent long-term growth potential, then by all means hold on to them. (If you have a loss in these shares, you might consider selling and buying them back 31 days later to book a loss for tax purposes.) On the other hand, if you're sitting on a 90% loss in shares of a dotcom whose entire business plan was spending all its cash on a 30-second Super Bowl commercial in hopes of generating some buzz...well, the game's probably over, and it's time to sell and move on.
3. YOU CAN'T BUY PAST PERFORMANCE
Past returns are no guarantee of future returns--is there an investor on earth who doesn't know this line by heart? But when it comes to buying stocks and funds, we act as if we've never heard this warning. Instead, we scan some newspaper's top-performers chart, pore over Morningstar's list of five-star funds or the Schwab Select List--anything we can do to identify investments with the biggest gains.
Unfortunately, we can't buy yesterday's gains. And while there is some evidence in the case of funds, at least, that superior performance persists into the future, the effect is relatively small, doesn't last very long and is difficult to capitalize on after transaction costs and taxes.
The biggest danger, of course, is piling into stocks or funds that have generated humongous gains over a brief period. Short-term outsize gains are almost always unsustainable, which means investors who jump aboard such high fliers often end up strapping themselves in just in time to experience a white-knuckle ride down.
Tech and Internet stocks have taken the rap lately when it comes to chasing performance, but the truth is that investors will chase any investment that moves fast enough. Take Warburg Pincus Japan Small Company fund. In 1999, its position in Japanese tech and telecom stocks paid off big with a 100% gain in the first half of the year, followed by another 114% surge over the next six months. Not surprisingly, investors rushed into the fund, driving assets from a minuscule $50 million at the beginning of the year to more than $1 billion by year-end. Unfortunately, folks who chased 1999's stellar gains anticipating an encore got less than they planned for: The fund nosedived in 2000, losing a staggering 71.8%. Ouch!
Considering how quickly sizzle can turn to fizzle in the market, you're taking a big risk if you jump aboard a stock or fund that's recently skyrocketed to stupendous short-term gains. And even if rigorous analysis leads you to believe that such an investment still has plenty of upside potential, you should consider buying it only as part of a diversified portfolio that can help cushion the blow if your high flier flames out.
4. NEVER UNDERESTIMATE THE IMPACT OF COSTS
Obsessed as we are with returns, it's not surprising that we spend little time thinking about the cost side of investing. And even if we do manage to devote the occasional passing thought to expenses, they really don't seem like such a big deal. After all, you can buy and sell stocks online these days for $12 or less per trade. And if you pay an extra half a percentage point or so a year in operating expenses for a stock fund, what's the harm? That's nothing compared with annualized returns of 20% or more that many funds have earned in recent years.
But that kind of thinking betrays a misunderstanding of the true costs of investing and their long-term effect. Brokers' commissions are only one part of the cost of trading stocks. There's also the "spread," essentially a markup to compensate the broker for holding the stock in inventory or for buying and then reselling it to you. In large frequently traded stocks, the spread may be half a percentage point or less, but in small stocks it can easily swell to two, three percentage points or more. Then there are taxes, another cost that in some cases can slash upwards of 40% off your short-term gains (see page 70). "In the short term, those costs seem to matter very little," says John Bogle, the former chairman of the Vanguard fund group and a well-known zealot for low-cost investing. "But over the long run, they have a dramatic effect on your return."
To get an idea of the effect that high operating expenses can have on mutual fund returns, I conducted a little experiment. Using Morningstar's Principia program, I screened for all large-cap stock funds that have been around at least 10 years and then ranked them by their annual operating expenses. Next, I divided the funds into four groups, or quartiles, with the first quartile containing the funds with the lowest expenses and the fourth quartile containing those with the highest expenses. I then compared the performance of the lowest- and highest-cost groups over the three, five and 10 years to the beginning of this year. The results were amazing. The lowest-cost funds outperformed their expensive counterparts by 1.8 to 2.3 percentage points a year. If that margin doesn't seem like much, think of it this way: On a $50,000 investment, earning an annualized 10% instead of 8% for 10 years translates to an extra $21,741 going into your pocket before taxes.
Given how much high costs can erode returns, Bogle offers this advice: "Do your fishing in the low-cost pond." You can do just that by screening for low-cost funds at the Fund Selector on Morningstar's website (www.morningstar.com) or at our own site (www.money.com/money/fundcenter). The Securities and Exchange Commission would also like investors to give more thought to expenses, which is why the SEC recently issued a report suggesting that funds divulge to shareholders in semiannual and annual reports the dollar amount they pay in expenses. I wouldn't call the report scintillating reading, but it's worth perusing, if only to help you appreciate the importance of keeping investing costs down. You can find it on the commission's website at www.sec.gov/news/studies/feestudy.htm.
5. DETERMINE YOUR TRUE APPETITE FOR RISK
One of the ironic things about investing is that just when we should be getting wary about the risk we're taking on, we start to feel invulnerable. At the beginning of last year, for example, with the Nasdaq coming off an 85.6% annual return, investors were feeling positively bulletproof. But history tells us that the odds of a meltdown are highest after the market's had a huge run-up and companies are selling at bloated prices.
What accounts for this paradox? Why are we likely to invest more aggressively when alarm bells should be ringing in our heads? One reason, says Robert Shiller, a finance professor at Yale and author of Irrational Exuberance, is that we "just feel better about getting into the market when it's going up. Our self-confidence is enhanced." But there's another factor at work too. When we haven't experienced bear markets for a while--which was the case until recently--we tend to forget that they are a normal part of the investing cycle.
We got a reminder in March, when the S&P 500 fell more than 20% below its peak of a year earlier, thus slipping into bear territory. It remains to be seen whether this bear will linger as long as others have in the past. In the eight previous bear markets since 1961, it took almost three years on average for the S&P 500 to get back to its pre-bear peak.
Clearly, you want to factor in a healthy respect for the kinds of spills stocks can take. On other hand, you don't want to become so focused on avoiding short-term losses that you hunker down in bond and money-market funds, thereby limiting your ability to participate in the stock market's superior long-term gains. Such a strategy would be particularly foolish now, since stocks generate some of their biggest gains after they've suffered a severe setback. In the six years after the 1973-74 bear market, for example, the S&P 500 gained an annualized 17.3%. Since the bulk of that return came early in that six-year run, investors who deserted stocks for the security of cash likely missed much of those gains.
6. TUNE OUT THE NOISE
There's no doubt that the information revolution has vastly increased the amount of data, news and analysis available to us today. A few clicks of the mouse and we can review the latest earnings releases, the most recent economic barometers--even check out arcane (and in my opinion largely useless) technical indicators like Bollinger Bands and the Bolton-Tremlay Indicator. We can then tune in one of the ubiquitous cable-TV financial shows to watch a parade of pundits argue endlessly over what this cornucopia of information means for stock prices.
But does this tsunami of news necessarily make us better investors? The research of Paul Andreassen, a psychologist at Harvard in the late '80s, suggests not. Andreassen studied the relationship between the news media and investing. In one experiment, Andreassen separated people into two groups; one bought and sold stocks based solely on recent price data and the other traded after being given the price information plus headlines that explained the price changes. Andreassen found that when stock prices were volatile, the group that had access to the news earned less than half as much per share traded as the group that received no news.
Why would no news be good news? Andreassen theorized that we tend to take news reports almost as predictions. When a jump in a stock's price is accompanied by news that seems to make sense of the movement, we take that as a sign that the trend will continue. Conversely, when news reports make sense of a price decline, we tend to take that as an indication that the negative trajectory will prevail. As a result, we're likely to buy, buy, buy when the news is good and stock prices are rising, and sell, sell, sell when pessimism prevails and prices decline. With thousands of investors reacting this way, stocks can be driven to unrealistically high--or low--levels.
The solution isn't to ignore the news but to avoid reacting to every tidbit of financial information that comes your way. Your first reaction to virtually any new development in the economy should be, "Don't just do something, stand there!" That's right, do nothing--at least until you can sort out what's going on. If the fundamentals seem to have taken a turn for the worse, you may want to join the lemmings headed for the exit. But if the long-term case for the stock is intact, you may want to buy some of their shares.
7. GET BY WITH A LITTLE LESS HELP FROM YOUR FRIENDS
Would you buy a stock if it were recommended by Chandler, Ross or Monica on Friends? How about a fund touted by Phoebe, the ditsy member of the sitcom team? Okay, maybe not Pheebs. But if you're like most investors, you probably do look to your circle of acquaintances and co-workers for investing tips. When MONEY polled a statistically representative sample of its subscribers last year, almost half of those surveyed said that they regularly or occasionally use relatives, friends and colleagues as a source of financial information.
But just because someone you know is touting an investment that he just made in his retirement account, does that mean the same investment ought to work just as well for you? Of course not. For one thing, the two of you may have completely different tolerances for risk. An investment that's suitable for a colleague who rides out market declines of 30% or more without so much as breaking a sweat may be wildly inappropriate if you're the type who reaches for the Maalox every time the Dow drops 100 points. There's also the issue of the price you're paying. Any tip you get from a friend is not likely to be news. It's probably wended its way through hundreds, if not thousands of other investors. By the time you invest, the price may have been bid up so high that any future appreciation is limited. (Think Amazon.com at $110 a share in December 1999.)
Besides, even though we tend to bestow credibility in financial matters to friends and acquaintances who are successful in their careers, the truth is that expertise in one area of life doesn't automatically translate to expertise in investing. A little over a year ago, for example, Buffalo financial planner Anthony Ogorek was setting up a portfolio for a client who directed him to include a few stocks recommended by a relative, a biologist familiar with the latest trends in biotech. How have those stocks done so far? "One is down 87%, another is down 89%, and the third is off 92%," says Ogorek. "My sense is that my client's relative confused great companies with great stock picks. They're not the same thing." Finding terrific companies is only half the equation. The other, more important, half is finding them at reasonable prices.
However tempting a tip from a neighbor, friend or co-worker might sound, always do some research on your own or run it by a financial adviser. If you decide to buy the investment and it turns sour, at least you'll know you bought in on the basis of your own due diligence and judgment, not just the word of the guy who happens to live next door.
8. GIVE YOUR EXPECTATIONS A REALITY CHECK
From 1995 through 1999, the S&P 500 racked up an annualized gain of 28.6%, the highest by far of any five-year stretch in its history. With things going so well for so long, it wasn't hard to convince ourselves that this extraordinary run would go on and on. A survey of individual investors by UBS PaineWebber in December 1999 found that for the next 10 years investors were expecting annualized gains of 19%--19%! Nearly twice stocks' annualized return of 11.3% over the past 75 years.
While the past year's market decline has certainly shaken those assumptions, it may not have broken them. "I still don't believe expectations have been lowered enough yet," says Ogorek. "Until the markets really break people's hearts and dash their spirits, I think any sanity will be temporary."
The problem with overly optimistic expectations is that they can lead you to make lousy planning and investing decisions. Let's say you're trying to figure out how much you need to put away each month to have a $150,000 education fund for your Ivy League-bound toddler 15 years from now. If you believe that stocks can earn 20% year in and year out, you'd feel comfortable socking away about $160 a month. That's great if those 20%-a-year gains materialize. But if returns come in at their long-term average of roughly 11%, you'd fall about $80,000 short. Bye-bye, Harvard.
Plus, your efforts to get that unattainable 20% may lead you to some pretty dicey investments: risky IPOs, overpriced momentum stocks, dotcoms that are long on promise and short on performance. And given the propensity for such speculative vehicles to flame out, you might not only miss your 20% target, you could very easily wind up with less than the 11% average return, putting you even further behind.
You'll have a much better chance of reaching your goals if you set your sights on returns that are realistic--and build your portfolio from there. No one can foretell what that rate of return should be, of course. But the point isn't to predict the future. No one can do that. Rather, the idea is to base your decisions on expectations that are reasonable--returns that are achievable even if all the stars aren't aligned in your favor. That way, if results come in close to the levels you're expecting, you'll have no trouble sending junior to a top school.
And if returns come in much higher? Well, consider it a bonus that will allow you to retire in grand style--and perhaps spend more time on the beach, working on that seashell collection.