Investing for Dummies — The Six “Must Know” Rules

It would take you a long time to learn all there is to know about investing. Fortunately, there are six Investing for Dummies rules that tell you 80 percent of what you need to know.

The first Investing for Dummies rule is — Stocks Rock!

Investing for Dummies I’ve gained a reputation in the Financial Freedom Community as a “bear” because I was the one who developed the Valuation-Informed Indexing approach to investing, an approach that takes advantage of the fact that stocks provide a far stronger value proposition at times of moderate valuations than they do at times of high valuations. That doesn’t make me a bear. That just makes me a guy who likes to obtain the highest possible value from each dollar he earns, both when spending money and when investing it.

The reality is that I love stocks, and for good reason. Stocks have done more to help middle-class workers win financial freedom than any other asset class. The same historical stock-return data that taught me the importance of paying attention to valuations also taught me that stocks offer a mouth-watering 30-year return regardless of valuations.

We are today (this article was written in June 2006) at valuation levels nearly double the moderate level. Stock returns are not likely to be too exciting for the next 10 or 20 years. So I don’t think it would be wise to put too high a percentage of your portfolio in this asset class at this particular time. But the most likely 30-year annualized real return for a stock purchase made today is 5.3 percent. Show me another asset class that can match that without requiring a good bit more work than it takes to invest in a stock index fund.

There are all sorts of asset classes that offer strong value propositions in the right circumstances. The middle-class worker seeking Investing for Dummy advice, though, should be considering placing at least a portion of his assets in stocks even when valuations are high, and more than that when they drop to moderate or low levels, from which the long-term returns are juicier.

The second Investing for Dummies rule is — You Don’t Need to Beat the Market.

John Bogle started a revolution in investing when he put forward the idea of investing in index funds rather than individual stocks or non-index mutual funds. Invest in an index, and you won’t beat the market, but you will match it. Given the appealing returns available to those who keep valuations in mind when deciding what percentage of their assets to put into stocks, there’s no need to beat the market. Matching the market by investing in index funds is good enough for most middle-class workers to achieve their financial freedom goals.

I’m not an indexing purist. I believe that you could get better returns from picking individual stocks or non-index mutual funds than you likely will get from index investing. The risks would be greater, though. And it would take a lot more time and research to invest successfully that way. If you are seeking Investing for Dummy advice, index funds are probably the way to go.

The third Investing for Dummies rule is — Emotions Trump Numbers.

Most conventional investing advice is numbers-oriented. There’s great value to be obtained from studying the numbers. As I noted above, I learned what I needed to know to develop the Valuation-Informed Indexing approach by virtue of research done into what the historical stock-return data says about how stocks perform starting from various valuation levels. If you have lots of time to devote to the project, you can learn all sorts of things about how to invest successfully by looking at research papers and articles and the historical stock-return data itself.

Keep It Simple

If you are seeking Investing for Dummies advice, though, you don’t want to get yourself tied up spending too much time with the numbers. You need to focus on the fundamentals. The most important things you need to know about stock investing are the ways in which it affects your emotions. When people say that stocks are risky, what they mean is that their prices are volatile. The reason why price volatility translates into risk is that it causes people to lose the ability to think clearly about their investing strategies.

If you are new to stock investing, please start out slowly. Stocks really are risky. There really are dangers to investing in this asset class. If you find yourself getting too enthusiastic, pull back. The most important trick is keeping your emotions in check at all times. Successful stock investing doesn’t come from being smarter than the other guy (or gal). It comes from being more emotionally balanced than the other guy (or gal).

The fourth Investing for Dummies rule is — Buy-and-Hold is Harder Than It Looks.

Just about everyone who advocates stock investing today advocates long-term buy-and-hold investing. There is a magic to buy-and-hold as powerful as the magic of compounding returns tapped into by those who save when they are young. The magic is — the unpredictability of stock returns (and thus the risk of stock investing) diminishes as you hold your stocks for longer time-periods. Hold your stocks for only one year, and you may do very, very well or very, very poorly. Hold your stocks for 30 years, and you are almost certain to do at least reasonably well.

Word had gotten out that buy-and-hold investors are successful investors. So just about all stock investors today describe themselves as buy-and-hold investors. Don’t believe it. The buy-and-hold concept only became popular during the most recent bull market, which was the longest and strongest bull market in the history of the U.S. market. If things go in the next bear market as they have in earlier bear markets, many of those now talking the buy-and-hold talk will find themselves not able to manage the buy-and-hold walk.

How can you learn whether you are a true buy-and-hold investor or not? Again, proceed with caution with your stock investing project. Do learn about this exciting asset class. Do put some of your money into it. Not too much, though. Learn about the pitfalls of stock investing before you take a chance on the sorts of stock allocations that could cost you a significant percentage of your life savings. Move forward, but move forward slowly. And focus your efforts on discovering how successful investors practice buy-and-hold not just on paper but in the real world too.

The fifth Investing for Dummies rule is — Valuations Matter.

There are lots of investing advisors who will tell you what I told you above, that stocks offer a mouth-watering long-term return. There are not too many who will be entirely straight with you about the other side of the story, that those who purchase stocks at times of high valuations can suffer bone-crushing losses that can remain in place for long periods of time. There’s a good chance that stocks will provide a negative real return for the next 10 years. If experiencing a loss on your investment causes you to sell your stocks, forget about those juicy returns that go to those who stick with their stock purchases for 30 years.

How Investing Works

Valuations matter. At times of low valuations, the returns provided by stocks are nothing short of amazing. At times of moderate valuations, the returns provided by stocks are plenty exciting. At times of high valuations (like today), stocks are an iffy value proposition over 10-year and 20-year time-periods. Consider keeping a portion of your portfolio in a safer asset class, such as Treasury Inflation-Protected Securities (TIPS) or IBonds. Then, when valuations drop and the value proposition offered by stocks improves, you can up your stock allocation to take advantage of the “sale.”

The sixth Investing for Dummies rule is — Timing Works.

It’s conventional wisdom today that “timing doesn’t work.” That’s a half-truth. There is indeed a good bit of evidence showing that short-term timing — jumping in and out of stocks because you think you know how they are going to perform over the next year or so — is unlikely to provide a good return. Long-term timing is an entirely different animal, however.

Long-term timing is reducing your stock allocation when prices go to extremely high levels and increasing your stock allocation when prices go to extremely low levels. There is a good bit of evidence in the historical stock-return data that long-term timing does work. And common sense supports the idea. All other assets we purchase provide a better value proposition when we obtain them at low prices than they do when we obtain them at high prices. Why should stocks be so different?

Avoid short-term timing. That’s not a game for the typical middle-class investor. Do consider lowering your stock allocation a bit at times of high valuations, though, and increasing it a bit at times of low valuations. A recent article in the Financial Analysts Journal by Cliff Asness (“Rubble Logic: What Did We Learn from the Great Stock Market Bubble?”) explains why long-term timing makes so much sense — Link to article on Investing for Dummies Rule #6.