I wrote a few weeks ago Investing Is Simple.
“You come up with an asset allocation, open some accounts, pick a few index funds, and you are done. Once in a while you see if anything is out of whack and you redirect your new money to wherever is lagging. It’s not complicated at all.”
If investing is that simple, then why in the world are there so many talks about investing? There are many books, professional journals, newspapers, magazines, TV shows, radio programs, and now blogs about investing. The Bogleheads investing forum I participate in (user name “tfb”) has more than 3 million posts. If investing is simple, what can’t possibly be exhausted in 3 million posts?
What makes investing so hard?
1. The best strategy requires knowing the future. I think that is the root problem. At the bottom of every investing question, except ones that relate to facts (for example What’s the IRA contribution limit this year?), people are really asking about the future. Because nobody knows the future, it’s impossible to come up with a definitive answer.
Should I invest a lump sum now or dollar cost average over a period of time? If the market goes up and never comes down over the period you are considering, you should invest the entire lump sum now. If the market goes down, and it goes down sharply, you are better off with dollar cost averaging.
I’m 40. How much should I invest in stocks? If stocks will do better than bonds over your investment timeframe, and more stocks don’t make you sell out in a bear market, you should invest more in stocks. If stocks will do worse or you will sell out at the bottom, you should invest less in stocks.
How much should I invest in international markets (value/growth, small cap stocks, emerging markets, real estate, …)? If they will do better, you should invest more. If they will do worse, you should invest less.
Should I invest in this actively managed fund X or an index fund? If fund X will do better than the index fund, you should invest in fund X.
Should I invest in a short-, intermediate-, or long-term bond fund? If interest rate goes up, you should stay short until it reaches a peak. If it stays the same or goes down, you should invest in an intermediate- or long-term bond fund until the rate reaches a bottom.
I have these stocks …, should I dump them and buy mutual funds? If your stocks will do better than the mutual funds you pick, you should stay with your stocks. Otherwise buy mutual funds.
We have an inverted yield curve (current price crossed moving average, high unemployment number, Fed or China doing this or that, a new President, …). Will there be troubles ahead? Maybe, maybe not.
Nobody knows the future. Everybody wants to know the future. Knowing the future will answer all the investing questions. You can analyze the historical numbers however you want. It still will not tell you what lies ahead.
2. High stake with replay. Uncertainty isn’t new in life. We face uncertainties in other ways. We must make decisions on which job to take and whom to have an intimate relationship with. Both of those decisions can have a big impact on our lives. However, I can’t think of another decision that has both a high stake and an accurate replay.
If you choose to marry person A, you don’t know whether you would be happier with person B. You take your chance and you move on. If you take job A over job B, you don’t know where job B would’ve led you. When you are investing, you know exactly how your alternatives would’ve played out after the fact.
If you had a high percentage of your portfolio in stocks and the market tanked, you can calculate exactly how much more you lost than if you had a low percentage in stocks. If you didn’t invest much in emerging markets and emerging market soared, you can calculate exactly how much gains you missed.
At the height of 2008’s stock market volatility, the value of my portfolio dropped more in one day than my pre-tax salary in one month. To earn my salary, I had to get up every day, commute to work, work more than 8 hours a day, for an entire month. A simple failure to act (sell stocks the previous day) negated all that. If you think like that, it drives you crazy.
If the stake isn’t as high, a sub-optimal decision isn’t too bad. If there isn’t instant replay, you wouldn’t second guess yourself as much. The high stake and replay make investing hard.
3. The disconnect between strategy and outcome. This one relates to #1 about knowing the future. A good strategy does not necessarily lead to a good outcome. A good outcome does not necessarily prove that the strategy is good. Luck plays a big role in the outcome.
The two most favorite phrases my econ professor used to say were ex ante and ex post. Ex ante means before the fact. Ex post means after the fact. You can analyze everything and come up with a best strategy ex ante. You see it has worked beautifully in the past. You do Monte Carlo simulations and you see a 90% success rate. But when you invest, you don’t have the luxury of doing repeated experiments and taking the average result. You only have one shot. If your particular investing timeframe happens to be an outlier, you don’t have a time machine to go back and roll the dice again.
When you see a strategy producing good ex post results, does it mean it will work well for you in the future? Remember you only have one shot. However sound a strategy looks now, the outcome may be poor. However great results were in the past, it does not prove it was a good strategy to begin with. How do you know you are not fooled by randomness?
Let me give an example. You read that you should diversify and not buy individual stocks. Warren Buffett invested $5 billion in Goldman Sachs in September 2008. If you followed Warren Buffett and bought Goldman Sachs’ stock the next day after the news came out, you would beat both the S&P 500 and the SPDR Financial Sector ETF (XLF) by a long mile a year later. Goldman Sachs up 40%. S&P 500 down nearly 20%. XLF down 30%. Next time you hear Warren Buffett invested in another public company, should you follow?
Let me give another example. After I sold PIMCO foreign bond fund, it went up 1.7% in two weeks. For a bond fund in this low yield environment, 1.7% equals interest for almost a full year. Was it a mistake to sell?
The lack of proof for anything in investing makes investing hard.
So, is investing simple or hard? No matter what you do, it’s guaranteed that you will not have the best possible outcome ex post. In other words, there is this thing called risk. You can take your chances and make it complicated, or follow a simple, conservative, and sensible strategy. It’s impossible to tell which way will win in the end. Remember you have only one shot. For me, I settle for good enough.
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TFB, I really liked this post. Thanks. I agree with the notion that sound strategy does not equal sound outcome in investing because of risk. That does not mean one should have a casino mentality. For the fiscal year 2009 (1 Oct 2008 – 30 Sept 2009), I made my disciplined DCA retirement contributions and came up with a 20% gain for the year. Not bad at all but it isn’t great either considering the market movement from March 2009 to Sept 2009. But I didn’t have to worry the whole year about when to invest and if I had invested at the right time. So a sound strategy removed my notional second guessing and in investing that is invaluable.
Harry Sit says
KD – You can probably tell that I agree with you. Dollar cost average into a sensible asset allocation looks like a simple, sound, ex ante strategy that will lead to a good outcome. The problem is that other people have different ideas: magic formula, Rule #1, Elliott wave, simple moving average, you name it. They all point to historical records. We also have testimonies from current followers for how the method worked for them, as you will see in the comments to Rule #1.
You made some really good points in this post. IMO people get caught up in the hottest stocks, trends, etc. and eventually get “off course” of their investment goals. A disciplined investment strategy is essential to meeting your objectives. You need to make sure your investment portfolio is being compared to independent benchmarks, whether you manage it yourself or hire an adviser. In addition, an objective third party should evaluate your long-term performance and portfolio to ensure you’re still “on the course.” Remember that realistic expectations go a long way when developing investment objectives.