The Way of the Calm Investor Follow these five steps and you'll make better investment decisions--and agonize less over them
(MONEY Magazine) – If getting rich is supposed to make you feel good, why are so many investors so agitated so much of the time--even when the market goes up? It's not only that guy on CNBC who looks (and sounds) as if he just got his belt buckle stuck in an electrical socket. It's how you kick yourself for buying stock in eToys or Pets.com or WorldCom. It's how you kick yourself for not buying stock in Warren Buffett's Berkshire Hathaway. It's the way your favorite financial website bristles with red and green arrows that change color and direction every few seconds. It's daily headlines stocked with scary animals like bulls, bears and even dead cats that bounce.
Investing doesn't have to be like this. In fact, it's not supposed to be like this. Despite everything most market pundits say, investing is not a struggle, a battle, a game or a contest; it is a continuous process that lasts a lifetime. Whether you are winning or losing at any given moment is beside the point. The only thing that matters is whether you prevail in the end--and the factors that determine long-term victory are the exact opposite of the ones that tend to create short-term success. In the short run, the investors who can't let go--who track and trade on every market move--tend to come out on top. But the longer they keep at it, the more likely these same people are to become losers. That's because obsessing over the market leads you to think you can foretell the financial future. Then you will make increasingly aggressive bets, which sooner or later are all but certain to end up giving you either heartburn or heartache.
Fortunately, you can break this destructive pattern. The secret weapon is self-control, and you can put it to work simply by understanding yourself a little better. Best of all, by taking the anxiety out of investing, you will end up not just a lot calmer, but a lot richer. It's the ultimate twofer.
1 Know what you don't know
Let's start with the most important rule: Figure out--and constantly test--what you don't know. Decades of research by the world's leading psychologists has shown that overconfidence--thinking that you know more than you really do, or that you are more skillful than you actually are--is one of the most fundamental aspects of human nature. (Try our pop quiz at right.) Back in 1999, when you could dump all of your money into a dotcom stock and watch it triple in two days, one of the single most common phrases in online trading chat rooms was "I am a genius." In fact, anyone who made money trading stocks without first studying the underlying businesses had a lot of dumb luck, but not one iota of genius.
And if you were sure that Mexico is the first foreign country south of Detroit and that homicide takes more lives than suicide, you've got a normal human supply of overconfidence. When you think you're right about wrong answers like those, how can you ever hope to figure out something as complex as which stocks will go up or down, or what the market will do over the next month, the next year or the next decade?
The beauty of it is that you don't need to. Intelligent investors accept not just the possibility but the certainty that they will be wrong much of the time. Benjamin Graham, the father of investment analysis, urged people to focus less on "projection" (guessing how much you can gain if you're right) and more on "protection" (making sure you don't lose too much if you're wrong).
You need to protect yourself against being wrong in two dimensions: space (picking the wrong investments) and time (buying when you should sell, or vice versa). Overconfident investors are convinced they're right in both dimensions--just when they are most likely to be wrong. Fortunately, powerful protection is available. Putting all these protective tools to work at once will provide you with the closest thing to real peace of mind an investor can get.
--Diversify in space by always keeping some of your money in the U.S. and some abroad, in stocks, bonds and cash. Pick basic percentages of your assets to put in each--say, 60% in stocks, 30% in bonds, 10% in cash. Don't just look at the hole in the doughnut ("Oh, my God, I've lost 40% on Krispy Kreme stock!") but be sure to look at the whole doughnut. Remembering that the gain or loss on any one individual investment is just a small piece of how your portfolio fares will help you keep your cool in good and bad markets alike.
--If you're really sure some stock or fund or industry sector is a good bet, put only a small piece of your total assets there--10%, tops--and never add more, no matter what.
--Diversify the risk of time by investing the same amount every month through a dollar-cost-averaging program. That way, you'll never put all your money into the market at once right before a crash, or have nothing in the market right before it soars.
--Finally, once or twice a year, adjust your assets so they match the target percentages you picked earlier. That will force you to sell a bit of whatever has gone up and buy a bit of whatever has gone down--reversing the tragic buy-high, sell-low pattern that plagues most investors.
2 Look outside to see inside
It's easy--in fact, it's normal--to think that your analysis is right and that you are invincible. In the lecture he gave when he won the Nobel Prize in economics (available at nobel.se), psychologist Daniel Kahneman explained that we all have two mental systems for understanding the world around us: the intuitive and the analytical. Intuition provides fast and simple answers; analysis takes time and produces more subtle solutions.
To be an intelligent investor, you have to use both systems. For example, instead of buying into Google's initial public offering (IPO) just because your gut tells you that it's the next Microsoft, use your analytical side to check your intuition. Thousands of investors, over many years, have gotten hosed in IPOs. Why should you fare any better? ("Because I know what I'm doing and they didn't" is not a valid answer.) The wealth of data at University of Florida finance professor Jay Ritter's website (http://bear.cba.ufl.edu/ritter/) shows that over the long run, initial public offerings have underperformed existing stocks of similar size by 4.2 percentage points a year. That's a good reminder that you should never engage in any investing strategy without reviewing the real-world results of other people who've tried it. You'll also minimize the odds of future panic by asking this question: "If I'm buying, someone else is selling; how likely am I to know something he doesn't?" In the case of an IPO, the sellers happen to be the people who founded the company. Do you really think you know more about the stock's future--and the right time to buy in--than they do?
3 Remember all the roads not taken
When it comes to investing, you can always see exactly what would have happened if you had made a different choice: Market prices and returns are available both on what you own and on what you don't. A glance at the newspaper and you exclaim, "I knew I should have sold my bond funds last year!" A click on a website and you sigh, "Why didn't I buy eBay stock before it was too late?"
There are a few simple cures for this Monday-morning quarterbacking of yourself: First, be well diversified, so no single mistake, no matter how serious, can ever wipe you out. Second, keep track of your hunches. Sure, you might have been right about bonds and eBay. But chances are, you also "knew" you should have sold all your stocks in September 2001 and that you should have bought Internet Capital Group in March 2000. Instead of kicking yourself, you should be patting yourself on the back for not taking your own advice in those cases. Tracking all your predictions--good and bad alike--will help you see that there's no point in bemoaning what might have been. It's where you're going that counts.
4 Keep your eyes in front of you
As Patrick Henry said, "I have but one lamp by which my feet are guided, and that is the lamp of experience. I know of no way of judging the future but by the past." In the financial markets, however, the past is not always a perfect prologue; in fact, the future is often the opposite of what the past would suggest. And using many years of data won't always solve that problem: At the end of 1981, the average annual return on long-term Treasury bonds over the previous 50 years was 3%, nearly eight percentage points worse than the annual return on stocks. And yet the current yield on those bonds--the actual income they would deliver to investors--was 14%. Anyone who relied blindly on the past instead of paying attention to the present missed out on the future. From 1982 through 2003, long-term bonds returned a fat 11.8% annually, just two percentage points less than stocks with only a fraction of their turbulence. History is worthless if you forget to filter it through the sieve of common sense.
Watch, also, for the two most common pitfalls in market statistics. The first is "time dependency," in which a minor change in measurement period can make a major difference in returns. Sure, Firsthand Technology Value fund outperformed Standard & Poor's 500-stock index by 45.9 percentage points last year. But in 2002, the fund underperformed the index by 34.1 points. So you should never judge past returns by a single measurement period; instead, look at as many periods as possible. The second pitfall is "survivor bias," in which the losers are left out of the data. Prof. Jeremy Siegel's famous Stocks for the Long Run numbers, for example, are based on returns from as few as seven (yes, seven!) stocks at the dawn of the U.S. market, when hundreds of others were going bankrupt. Remember that the next time someone tries to tell you that two centuries of market data "prove" that stocks will always beat bonds in the long run.
Finally, get yourself a copy of Darrell Huff's classic, How to Lie with Statistics, perhaps the best book not officially about investing that an investor could ever read. Short, funny and unforgettable, it will show you how to talk back to numbers and the people who try to use them to pick your pockets.
5 Less is more
Often, the more you trade, the less you make (see the chart at right). A big reason: costs. Dozens of finance professors and other researchers have studied the performance of mutual funds and stock pickers, and there's only one thing they all agree on: Over time, investors who keep their costs down will outperform those who don't. Warren Buffett has estimated that the investing public pays about $130 billion a year in brokerage costs, fund management fees and other expenses. Considering that the companies in the S&P 500 generated total operating income of $137.6 billion last year, Buffett's math has an astounding implication: that we investors are turning most of our rightful share in corporate America's profits over to the intermediaries who handle our money for us.
If you set your expectations realistically, the need to keep your investing costs at rock bottom becomes even clearer. Assume conservatively that stocks are likely to return about 6% annually and that inflation will run at 2% to 3%. That leaves a net return (before taxes!) of 3% to 4%. Between management fees, sales charges and trading costs, the typical mutual fund costs between 2% and 3% annually. Even if you buy stocks directly, your brokerage expenses will probably run between 1% and 2%. Thus, the people who handle your money will keep between one-third and three-quarters of your return for themselves. If that's not stressful, what is?
Luckily, how much you pay to invest is almost entirely within your control. Buy no mutual fund that charges over 1% in annual fees. (Using an index fund like Vanguard Total Stock Market, you can own every stock worth having for as little as 0.2% of assets--just $2 a year on every $1,000 you invest.) Get your own trading costs down close to zero by thinking like an owner, not a renter of stocks. Harvest your losses once a year to minimize your tax bills. As Benjamin Franklin wrote more than 200 years ago, "Human Felicity is produc'd not so much by great Pieces of good Fortune that seldom happen, as by little Advantages that occur every day." By taking control of your costs, you can pile your savings higher with each passing day. Little things mean a lot!