Investing Tips

Those seeking to win financial freedom early in life aim to keep their heads about them when their fellow investors are losing theirs. Those following realistic long-term buy-and-hold strategies tune out the most extreme claims of both the bulls and the bears. We think of ourselves as dolphins, creatures known for applying a measure of intelligence to the task of living life in an emotionally healthy way.

Investing Tips Item #1 -- Distinguish “Market Guessing” from Long-Term Timing

Scott Burns is my favorite personal finance columnist. That said, he dropped the ball big time in the advice that he gave in this recent column to an investor asking about the effect of stock market valuations on indexing strategies.

One of Burns' readers, P.R. from Dallas, observes: "I don't think any index strategy can work if one continuously ignores market valuation." Precisely so. That's just plain common sense, is it not? Unfortunately, common sense was abandoned in many investing circles during the '80s and '90s, as the U.S. market experienced the strongest and longest bull market in its history.

The fact that we are now beginning to see questions of the sort posed by P.R. from Dallas appear in mainstream publications (Burns writes for the Dallas Morning News) and not just in the small circulation/high influence publications where the writings of the best-informed investing analysts (people like Rob Arnott and Peter Bernstein) appear is a good sign. Burns' response shows that we have not yet reached a point where common sense observations are always given reasoned consideration. However, his decision to run the letter indicates that perhaps we have taken a number of steps in that direction in recent years. The optimist inside me tells me that we will reach the desired destination at some future day if we just make it a practice to put one foot in front of the other over and over and over again.

Burns knows how critical consideration of valuation levels is to the formation of a reasonable expectation of what sort of return long-term buy-and-hold investors can expect from their stock investments. He has on several occasions reported on Financial Analysts Journal Editor Rob Arnott's findings on this question. The question posed in his recent column provided him a great opportunity to do so once more, this time making it clear to his readers with large stock allocations that the historical stock-return data shows that it would be a good idea for the long-term investor to lighten up a bit before the inevitable downturn in prices kicks in (thereby insuring that he will have more assets available for investment in stocks when the long-term returns being offered by stocks are more appealing).

Instead, Burns put forward a non-sequitur about the costs associated with short-term timing strategies. The investor asking the question didn't express any desire to engage in short-term timing. How is a discussion of the costs that apply to those engaging in short-term timing relevant to the questioner's concerns re today's high valuations and their effect on indexing strategies?

Say that you were looking to buy a new car. You are about to sign a piece of paper agreeing to pay $40,000 for the model that you like. Just before you do, your wife calls you to let you know that she has found a dealer willing to sell the same model for $35,000. You say: "No way am I going to make that drive to the dealer offering the better price, honey. If I were to drive over to the other dealer, I would incur an expense in buying the gasoline needed to make the trip. I'm just going to pay the extra $5,000 and thereby spare myself that $5 of unnecessary gasoline expense."

That response does not make sense. Nor does it make sense to worry about the tiny amount of expenses that would be incurred in lightening up on your stock allocation at a time of high valuations and thereby opening up for yourself the opportunity to realize long-term gains of far greater significance. Fees are an important consideration for those engaging in short-term timing because there are so many fees involved and because the chances of profiting from short-term timing strategies are so slight. Fees are not a big deal for those engaging in long-term timing strategies, which are as different from the short-term variety as is day from night.

I share Burns' concerns re what he refers to as market guessing. But there is no need to engage in guessing in coming up with a long-term investing strategy that makes sense. We have many years of stock-return data to look at in determining what sorts of stock allocations make sense at any of the various stock valuation levels. We don't need to guess as to how to invest. We can use analytically valid safe withdrawal rate (SWR) analyses to guide us as to how stocks are likely to perform in the future, presuming that they perform in the future much as they always have in the past.

That's the essence of the new investing approach we will be exploring in depth at the "Invest Different!" section of this web site, the approach that I call "Valuation-Informed Indexing." Perhaps in days to come we will be able to bring Scott Burns (and a good number of others too) on board and spread the word far and wide about this exciting new approach for using historical stock-return data to help us all win financial freedom many years sooner than would otherwise be possible.

Investing Tips Item #2 -- Understand Why the “Somewhat Psychopathic and Antisocial" Don’t Possess an Edge

“The best investors are somewhat psychopathic and anti-social.”

So says William Bernstein, author of The Four Pillars of Investing, in this thread at the Vanguard Diehards forum. He explains that: "Anything that blocks the emotional response to investment results--positive or negative--is a good thing; there is nothing so destructive to returns as "human nature." In Bernstein's view, "a belief that everyone else is wrong but you is an excellent antidote to herd behavior."

Could that be right?

I say no. I do understand where Bernstein is coming from. He is very much aware of the historical reality that investors have hurt themselves terribly through herd-like behavior. Middle-class investors tend to up their stock allocations when prices are high and then lower them when prices are low, the precise opposite of what logic says you should be doing. If herd-like behavior is so damaging, it should be a good thing for an investor to have a contrary nature and the anti-social have extremely contrary natures. It follows then that those with anti-social natures make good investors. No?

No. It defies common sense that that those with anti-social natures, or even psychopathic natures, would make the best investors. When a logical conclusion defies common sense, I think it is a good idea to check out the logic chain that led you to that conclusion. I have the greatest respect for William Bernstein. But I think he is using a seriously flawed logic chain on this one.

The greatest investor of all time is Warren Buffett. Does this guy strike you as being psychopathic? Or anti-social? He doesn't strike me that way. Warren Buffett is not a head case. His ability not to become a head case despite his great wealth and success is what has made him such a long-thriving investing genius, in my view. You don't have to go nuts to invest well.

Now, Warren Buffett does have a somewhat unusual psychological make-up, in my assessment. He's an independent thinker. That helps a lot in investing, I believe. The key to Buffett's success is that he takes the independent thinking far enough to obtain great benefits from it but not so far as to justify calling him anti-social or psychopathic. He demonstrates to us how we might go about aiming to get the goodies that follow from standing apart from the crowd without taking things to the point that you ruin your life (which generally translates into ruining your investing hopes too) in the process.

I remember reading about this guy who ran a huge hedge fund. He was extremely wealthy and extremely smart. Too smart. He couldn't resist getting involved in some complicated play that put his fund into bankruptcy. That's the sort of thing that Warren Buffett never does. There are different kinds of smarts, I think. There's I.Q.-smart and there's real-world smart.

There was a time when there was a group of investors who posted in our discussion-board community that they knew better than all the rest of us how best to invest. They were "MasterMind Investors," they used to assure us. They told us their secret was that they had developed complete control of their emotions and thus did not make the mistakes that might trip up most others.

What was funny (and also sad) was that, if ever someone suggested that perhaps they did experience some emotions about investing after all and perhaps it was even an emotional insecurity about the strategies they were following that prompted them to refer to themselves as "MasterMinds," one of them would respond by saying something to the effect of: "I am NOT emotional. Not even a tiny bit. I have NO emotions. I will KILL anyone who says I do!" And the guy would turn all red in the face and begin banging on the table.

Somehow this argument never impressed me too much. I have emotions. You have emotions. The MasterMinds have emotions. Buffett has emotions. Bernstein has emotions. We all have emotions. I think that the road to investing success is in learning to manage your emotions, not in denying them or even arguing that developing negative emotions leads to investing success.

I ask Bernstein in the thread linked above if he would be willing to take an hour of his time to discuss his views on safe withdrawal rates (SWRs) at the Early Retirement Forum. I think that would be great. I don't agree with Bernstein re the comments quoted above, but I do agree with him on SWRs. I think that if we are able together to tease out the implications of his SWR findings a bit, he might be a big help to us in spreading the word re the new approach to investing developed in our community in recent years--Valuation-Informed Indexing (or Emotion-Informed Investing, if you prefer to call it that).

Investing Tips Item #3 -- Aim to Get Rich Quick and Slow

Get rich quick? Or get rich slow? Which is best?

I say "neither." I prefer an approach to wealth accumulation that combines the benefits of both approaches--a Get-Rich-Quick-While-Also-Getting-Rich-Slow Approach.

The benefits of a Get Rich Quick approach are obvious. You get picked in the first draft by the Cowboys or you put out a hit record, and there you are. From that point forward, your accountant deals with all that icky money stuff.

The downside of this approach is equally obvious. It rarely works. Put all your chips on a Get Rich Quick scheme, and you are likely to end up busted.

That's why most smart money advisors favor the Get Rich Slow approach. There are several downsides to Get Rich Slow, however. One, it's not too exciting an approach. Two, there's a lot of leverage in the Get Rich Quick approach that you are passing up by going with a pure Get Rich Slow strategy--one Get Rich Quick idea that works can generate the wealth of ten Get Rich Slow ideas that work. Three, it can take a long time to Get Rich Slow. Will you still be young enough to enjoy the benefits when they come to you?

The root issue here is the question of what sort of risk profile makes the most sense. Get Rich Slow stuff is low-return or moderate-return stuff but steady stuff. Get Rich Quick stuff is high-return stuff but highly unreliable stuff. I like a middle-ground approach. I try to take on enough risk to keep things interesting, but provide for enough stability in my overall wealth-accumulation plan so that losing out on most of my long-odds bets doesn't cause me to experience any sense of panic.

There's a good bit of risk in my effort to generate some income from my writing work. But I don't need to worry if my writing business does not pay off quickly because my investments in TIPS and ibonds throw off enough income to cover my family's must-pay bills. Still, there is enough risk in the writing-business component of my plan that I am reluctant to invest heavily in stocks so long as valuations remain high.Taking calculated risks that you can afford to take on really can help you Get Rich Quick. But sometimes that happens only after a long time of waiting for those long-odds bets to pay off. It is the work you do building the Get Rich Slow parts of your overall plan that permits you to get through those long waiting periods and thereby see the long-odds bets bear fruit.

The idea of Getting Rich Slow is not in conflict with the idea of Getting Rich Quick. Getting Rich Slow helps with the project of Getting Rich Quick (and it works the other way around too).

Investing Tips Item #4 -- Be Wary of Misleading Risk-Tolerance Questionnaires

"I've been in this business almost 20 years and I find that most people have a risk tolerance that is lower than what they are willing to admit in public or in a risk-tolerance questionnaire." So says Richard A. Ferri, a chartered financial analyst and author of the book All About Asset Allocation, in a recent Humberto Cruz column. That's a line-drive observation. Much of what I have heard from those in our community with high stock allocations tells me that Ferri's comments are very much on point.

The column explains that many investors decide on their stock allocations by making reference to questionnaires that purport to reveal an investor's risk tolerance. But the questionnaires are slanted to encourage stock allocations higher than what are in many investors' best interests. "A lot of the questionnaires are designed to find an estimate of your maximum risk tolerance, which is really to the benefit of Wall Street sales people," according to Ferri.

One of the most important findings of The Great Safe Withdrawal Rate Debate was our finding that the one mistake you absolutely want to avoid is selling stocks when stock prices have headed dramatically downward. You should be buying stocks when prices are down, not selling them. However, if you had an 80 percent stock allocation before the price-drop, it's hard to see how you would be able to increase your allocation to take advantage of the lower prices. The time to position yourself for purchasing stocks at attractive prices is when prices are high, as they are today.

Cruz says: "My decision is to keep no more than 30 percent of my portfolio in stocks now (or 40 percent tops, counting real estate and commodities)." That's not the ideal stock allocation percentage for all. There is no ideal stock allocation for all. But it's good to hear a personal finance expert telling the side of the story rarely voiced at the tail-end of long bull markets. Cruz's allocation makes sense for Cruz, and it makes sense for a good number of others too.

Stocks are a wonderful asset class for those investing for the long term. Unfortunately, the risks of stocks at times of high valuation have been greatly underplayed in recent years. I hope that a good number of middle-class investors hear the wise words of Cruz and Ferri and make adjustments to their allocations to bring them more in tune with what their common sense tells them is right and less in tune with what the gravely flawed conventional wisdom of recent years has led them to believe is the "rational" and "optimal" way to go.

A lot of the tools used to reveal what stock allocation is "rational" and "optimal" appear to have been designed more to serve the interests of those who make a living selling stocks than the interests of the middle-class investors making use of them.

Investing Tips Item #5 -- Tune Out Patronizing Investing Advice

Here are some words that William Bernstein (author of The Four Pillars of Investing) recently posted to a thread at the Vanguard Diehards discussion board:

"I certainly do believe that asset classes frequently become undervalued or overvalued, and that the informed and disciplined investor can take advantage of this by varying policy allocation judiciously in a direction opposite large valuation changes. How many investors have the mental and emotional equipment to do this? Very few, in my opinion."

Do most investors really lack "the mental and emotional equipment" to do the right thing? I question whether this is so.

You don't need to be a genius to figure out how to invest reasonably well, in my view. It's fair to say that most of us are never going to rise to Warren Buffett's level of understanding of investing strategies. But the basics are not all that hard to understand. And, if you possess a firm grasp of the basics, you can earn a reasonable long-term return on your savings. I think that most of us are capable of understanding the stuff that we truly need to understand.

Gaining enough control over your emotions is harder. But I believe that that can be done too by investors who make a serious effort at doing it. The big problem for many investors is that they are not aware of the emotional traps that threaten their long-term investing hopes. I think that we are still very much in the early stages of learning what it takes to invest successfully. It is only when the information easily available to the typical investor addresses the critical emotional aspects of the investing experience that we will be able to assess whether most investors are capable of taking the realities into account.

It's the experts who have been dropping the ball by failing to put forward observations like the Bernstein observation quoted above. Investors may or may not be able to take advantage of what people like Bernstein know about how to invest. It's impossible to say until insights like the one cited above are broadcast widely enough to become common knowledge.

Investing Tips Item #6 -- Aim for True Diversification

Diversification has an almost magical power. As a general rule, you need to take on more risk with your investments to generate higher returns. Properly employed, diversification permits you to obtain higher returns with lower risk. That's a very good deal indeed.

The problem with diversification is that, while there is widespread agreement that investors should seek to be diversified, there is little consensus as to what constitutes effective diversification.Some would say that you are diversified if you put all of your assets in an S&P index fund. It's certainly true that by doing that you would come to own shares in a lot of different entities. While you would own shares in lots of companies, though, they would all be companies with a good bit in common. You would own shares in a diverse mix of large U.S. corporations.

Many would say that to achieve true diversification, you would need to own shares not only in the S&P index, but also in a mid-cap index and in a small-cap index and in a value-stock index. Even that wouldn't do it for some. Some would argue that you can't achieve true diversification by being invested solely in U.S. stocks, that you need to own a global index fund.

It's harder to know what you are really buying when you go global. Not all nations apply the same regulatory and accounting standards as the United States. So you might be setting yourself up for a fall by buying non-U.S. stocks, especially if you include emerging economies in your global mix. Achieving true diversification can get awfully complicated!

Even those who go global do not necessarily achieve true diversification. Some argue that true diversification means investing not only in stocks, but in non-stock asset classes too. It can be argued that true diversification requires a significant bond investment, or a significant gold investment, or a significant cash investment, or perhaps all of those.

Yikes!

The day may not be far off when we will be hearing the argument that the truly diversified investor must own a specified number of Beanie Babies and possess a baseball card collection including cards for players whose value is likely to go up when the value of stocks and bonds and gold are going down.

Diversification is a great thing in theory. It is a hard thing to pull off in the real world.

I expect that, as we develop the Valuation-Informed Indexing approach, we will need to be looking into ways to better define, apply and profit from the diversification concept.

Investing Tips Item #7 -- Are Investing Newsletters Worth the Money?

Are investing newsletters worth the money?

Sometimes yes, sometimes no.

Compare the price you pay per word for information imparted in an investing newsletter to the price you pay per word for information imparted in a book, and investing newsletters come off looking awfully expensive.

Compare the price you pay per hour spent drinking down the wisdom of an expert by reading an investing newsletter to the price you pay per hour spent drinking down the wisdom of an expert by visiting him in his office under a consulting arrangement, and investing newsletters come off looking like a steal.

The question is--Are investing newsletters properly compared to books (because they have words printed on pages, like books) or to consultations with experts (because they put forward specialized insights of the type often imparted through consultations)?There are thousands of investing newsletters available for sale. Most would not be worth $10 to you, much less $100 or $200. Most offer a negative value proposition because they impose one more demand on your time without offering actionable insights likely to guide you to a higher level of financial freedom.

But when you find a newsletter that offers insights of a specialized nature on a topic which you understand well enough to permit you to take advantage of the insights but not well enough to mine them all on your own, a newsletter can be worth its weight in gold.I have given serious consideration to subscribing to Outstanding Investor Digest. It is given rave reviews at the Motley Fool's Berkshire-Hathaway Discussion Board, and it is a savvy group of investors who meet there. Another one I have on my list is Jim Grant's Interest Rate Observer. I enjoy Grant's writing, and he says things you don't often hear in the general media. A third newsletter I would consider buying is the Dow Theory Letter published by Richard Russell. Russell is smart enough and has been around long enough to have developed a sound long-term perspective.

Investing Tips Item #8 -- Are Stock Brokers Bad People?

Are stock brokers bad people?

I say "not really."

Some people are harsh in their assessments of stock brokers, arguing that they make lots of money for giving advice that is often poor. Stock brokers are really salespeople, they point out. They often earn a commission on sales of the investment products they recommend. Thus, they face big pressures not to tell it entirely straight.

I agree that stock brokers who work on commission are essentially salespeople. I personally don't think that most investors should be using brokers who work on commission. But I also think that some of the criticisms you often hear of brokers ignore an important aspect of the question.

Real estate salespeople work on commission too. So do car salespeople. Lots of people want to be able to talk to a human being before turning over the amounts of money they are turning over when they buy a car or a house or a stock fund. People are worried about making mistakes and they are willing to pay significant amounts of money for the assurances they get from salespeople.

The reality is that salespeople often do protect people from making mistakes. Brokers can't afford to make too many recommendations that cause them to lose commissions. But there are lots of cases in which they are able to impart advice that does not cause the loss of a commission, and in those cases brokers can provide their clients a genuine service. My father used a broker and his broker once offered good advice on setting up a will. Good salespeople want to win the loyalty of their customers, and, when they can, they naturally try to help.

I don't think that it's generally a good idea to buy investments from commissioned brokers, however. The best way is to inform yourself of the pros and cons of the purchases you are considering to a point where you possess enough confidence in your judgment not to need the hand-holding supplied by a salesperson.

The root problem is that many people don't feel confident making investment decisions. Brokers are able to make lots of money doing what they do because they are addressing a deeply felt need.Most people who are smart enough to earn and save enough money to be concerned about how it is being invested are also smart enough to learn what it takes to invest successfully. So why are so many insecure about their decisions? It's because much of the conventional investing advice is unnecessarily complicated, at times self-contradictory, and often presented in less than compelling ways.Change that and people won't feel a need to pay brokers significant sums of money to hold their hands.

Investing Tips Item # 9 -- Avoid Becoming Emotionally Invested

There were no white Volvos on the road prior to May 2000. You see them all over the place nowadays.

Why the change? Did lots of people all of a sudden develop a craving for white volvos?

I suppose it could be that. Another possible explanation is that there were people riding in white Volvos all along. What happened in May 2000 is that I bought one. From that point forward, I began taking note of white Volvos. I never noticed them before then.

There is no such thing as entirely objective stock research. Why? Because everyone who does research either owns stocks or does not own stocks, and being in either circumstance causes the person in it to want the data to show that stocks perform in certain ways.

All stockholders, and all non-stockholders too, are human.

Yikes!

It's not easy to buy stocks. Not when you don't own any. The easy thing to do when you don't own any stocks is just to continue not owning any stocks. Inertia is one of the most powerful forces influencing life choices here on Planet Earth.

Say that you work up the level of enthusiasm for stocks needed to overcome the inertia that works against your efforts to form a decision to buy them. Now you've really done it! Now you've put your neck on the line. Now you've developed an emotional need to justify exerting all that effort. Now you've become emotionally invested in arguments that buying stocks is a good thing to do.

Say that the thought of selling enters your mind. Now inertia works not to keep you out of stocks but to keep you in stocks. Now that powerful force is working in the other direction.

Say you never overcome your inertia against buying stocks and yet others around you do. The anti-stock inertia does not remain of the same intensity. It grows more powerful. Having seen others choose different paths, you are now more committed than before to your anti-stock position.

That's so until the emotional forces causing you to want to buy stocks become strong enough to overcome your anti-stock inertia. Jump that hurdle, and you build yourself an even taller hurdle against selling than the one that the early stock-buyer must overcome to sell.

What a mess this investing business is for us humans! It would all be so much easier to understand if it worked in the way in which they say it works in the conventional investing guides.What is it with humans anyway? Is it something core to their nature that causes them to be such troublemakers?

Investing Tips Item #10 -- Balance Fear and Greed with Hope and Love

You cannot reason your way beyond the influence of the negative emotions of fear and greed. Negative emotions will transform any effort to reason into an exercise in rationalization. So how the heck are you to go about escaping the influence of these portfolio killers?You counter a negative emotion with a positive emotion. Hope is a more powerful emotion than fear. Love is a more powerful emotion than greed.

I learned this by looking for the common traits of Financial Freedom Community members who follow realistic investing strategies. We're all human, so all of us are at risk of falling victim to the greed that has in recent years caused so many to believe things about stocks that cannot possibly be true. We learn how to deal with this investing reality by checking what those who invest effectively do different.Effective investors do not take comfort in silly "studies" proving that stocks are going to perform in ways in which they have never before performed. Effective savers root their asset allocation strategies in real things. They do look at data (in realistic ways). But effective investors do not make a fetish of their data explorations. Effective investors are focused on the stuff of real life. They don't deny their humanity. They embrace it.

Say that you are seeing people all around you getting caught up in the Bull Market and you feel a temptation to shift to an asset allocation larger than what is appropriate for someone in your circumstances. It's greed that is pushing you in that direction. What pulls you back? Love.

Perhaps you love your daughter, and you can't stand the thought of blowing the money that you could use to help her with her college expenses. Perhaps you love the idea of starting your own business, and you can't stand the thought of losing your chance due to an unhealthy impulse to compete with those caught up in the irrational exuberance of the day.

Love is an emotion that contains within it the emotion of greed. Greed is a desire to grab stuff to make your life better. There's nothing wrong with that desire so long as it does not get out of hand. The greed experienced by those rooted in love is a tempered greed. It is a greed countered by a concern about what can happen when the downside of greed is ignored. Love is smart greed.

Hope is smart fear. When you hope for something, you worry that you will not attain it, do you not? The thing that drives the hopeful person is concern that, if she does not take effective action, her dream will not be realized. Those who hope have not overcome fear. They have managed it. They have contained it. They have transformed it from something life-destroying into something life-affirming.

Your fear and your greed are parts of your human personality. You cannot escape them. Do not even try. Turn their power in a positive direction. You can beat the negative investing emotions with the positive investing emotions. Fear and greed become helpful motivators when their power is channeled in a good direction through the stronger forces of hope and love.