Become a Better Investor
Follow this guide for investing success. Define your goals and your risk tolerance, invest in great companies for the long term and don't try to outsmart the market.
By James K. Glassman, Contributing Editor
From Kiplinger's Personal Finance magazine, January 2007
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Warren Buffett noted in 1999 that "success in investing doesn't correlate with IQ, once you're above the level of 25." What you need, he went on to say, "is the temperamentto control the urges that get other people into trouble in investing." He's right, too. Investing isn't nearly as hard as most people think. And, yes, proper temperament is important. But to really succeed at investing, you also need good strategy and good tactics. So as another year begins, here's my simple guide to both.
Your strategic checklist
First, decide why you're investing. You can't achieve a goal unless you know what it is. For many investors, the prize is a comfortable retirement, perhaps 20 or 30 years away. Or you may have multiple goals -- to purchase a second home in the next five years and to retire in ten years. The more distant the goal, the higher the proportion of stocks you should own in your portfolio. Also, you have no business owning an individual stock (as opposed to a stock within a mutual fund) if you do not intend to hold it for five years or longer.
Second, know your pain threshold. Stocks are volatile. Standard & Poor's 500-stock index has declined in 23 of the past 80 years. The dips can be sharp, unexpected and disturbingly enduring. In one day in 1987, the Dow lost nearly one-fourth of its value. The S&P 500 fell every year from 2000 to 2002, skidding from 1469 to 880. These things happen. If you can't tolerate that kind of pain, then choose bonds over stocks, but realize that your returns will inevitably be about half as much, if history is any guide.
Third, develop a view about the economy and stick to it. My own (which I highly recommend) is that the future will be pretty much like the past. Since the end of World War II, the U.S. economy has grown at a little more than 3% annually, with intermittent but not prolonged recessions. If you are continually shifting your opinion of the economy, you will also be continually shifting your portfolio, and you can't be a good investor. Don't pay attention to the Fed or to the unemployment rate. If you buy for the long term, think long term.
Fourth, be a partaker, not an outsmarter. Markets are generally efficient, so do not expect to beat the historic averages by very much over time. The annualized return for the S&P 500 since 1926 is a little over 10% -- figure 9% with expenses. If you can beat that mark by one or two points a year, you are doing spectacularly well.
Your tactical checklist
Construct a portfolio and know what's in it. Most investors have stocks and bonds in several accounts. Consolidate the information on your holdings and establish clear, comprehensive allocations (for example, 70% in stocks and 30% in bonds) and sub-allocations (such as for stocks, 50% in large U.S. companies, 20% in large international companies, 20% in small U.S. companies and 10% in real estate investment trusts).
Stick with stocks and bonds. Don't buy commodities. In a recent report, AllianceBernstein noted that "over the last 50 years commodity prices have grown at an average of 2.5% a year, well below the rate of inflation." Commodities are also extremely risky. Low return and high risk don't make an attractive package.
Approach the investing process systematically. The exact proportions of stocks and bonds are determined by your goals, age and risk tolerance, all of which may change over time. But if, for example, you decide in your forties that your allocation will be 80% stocks and 20% bonds, don't change course over the decade. Having more bonds in a portfolio means lower returns but a smoother ride. For example, Ibbotson Associates found that a portfolio allocated 90% to stocks (S&P 500) and 10% to bonds (long-term U.S. Treasuries) returned an annualized 10.3% between 1926 and 2004. A 50-50 portfolio returned an annualized 9.5% but was one-fifth less risky.