In a previous post, we looked at five critical investing facts that every investor should know. These included the “math” behind beating the market, an honest assessment of the returns delivered by index funds, and several others.
I would encourage you to read that post first before proceeding with this one.
Today we are going to look at five more investing facts that every investor should know.
Keep these in mind during both good markets and bad. I promise you’ll find yourself in much better shape than the typical investor.
Investing Fact #6
Investors who ignore taxes do so at their own peril
One of the most significant, but often overlooked, challenges associated with strategies that attempt to “beat the market” is the impact of taxes.
This is one of the reasons why performance and returns are typically stated on a pre-tax basis. Only recently have we seen any attention being paid to the tax costs associated with mutual funds, hedge funds, and other investment vehicles.
In a taxable account, however, you simply can’t afford to ignore taxes. Several studies have demonstrated that a typical actively managed strategy will incur 2% to 3% in annual tax costs above that of a simple index fund.
Keep in mind, that 2% to 3% number comes directly out of your annual return. In other words, if you earn 7% before taxes, your return would dip to 4% to 5% after taxes.
Simply put, this means a manager would need to generate alpha on the same order just to break-even on an after-tax basis. The unfortunate reality is that very few fund managers have shown a consistent ability to deliver after-fee alpha of any kind, let alone 2% to 3% per year.
For that reason, we need to be acutely aware of turnover, capital gains, and asset location when it comes to portfolio design. If not, we run the risk of lining Uncle Sam’s pockets at the expense of our own.
Investing Fact #7
Owning individual stocks is rarely necessary (or beneficial)
A lot of people assume that step one in developing an investment plan is knowing which stocks to buy and which to avoid.
Unfortunately, as many well-respected people have found, there is very little evidence that even the smartest fund managers can pick the right stocks to outperform their benchmark.
For individual investors, the situation typically worsens for two reasons:
- It is very difficult to properly diversify with individual stocks unless you have a very large portfolio
- The transaction costs of buying enough stocks to achieve proper diversification often eliminates any potential for market-beating returns
Although Jim Cramer and other talking heads would like you to believe you can build a diversified portfolio with as few as 10 to 15 stocks, that simply isn’t true.
Even in an asset class like large cap U.S. stocks (which is the easiest to diversify in), you need somewhere on the order of 60 to 100.
Once you move in to small cap stocks, for example, you need to own several hundred (at a minimum) to successfully diversify away unrewarded risks.
The primary instance when owning individual stocks would be helpful is in a large taxable account with low, negotiated transaction costs. Such a portfolio would allow the manager to custom-tailor the portfolio to the tax profile of the investor. This can be a sound, low-risk way to increase after-tax returns.
Ultimately, however, for most investors individual stocks does far more harm than good.
Investing Fact #8
There is no “right time” to be buying or selling
It’s very easy to play Monday morning quarterback in the world of investing.
“That was clearly a time of irrational investor behavior.”
“The writing was on the wall that stocks were overbought. How did you not see it?”
However, as the saying goes, “hindsight is always 20/20.” In reality, studies of professional forecasters have shown that following their recommendations leads to no better a chance at being right than the flip of a coin.
Even the most powerful statistical predictors of market valuation only explain about 40% future real stock returns.
In fact, rainfall (yes, the rain that comes out of the sky) does a better job predicting returns than some of the common metrics (such as consensus GDP growth or the trend of earnings) you hear spouted by the “gurus.”
In addition, in a world where literally millions of transactions are taking place every day (most of them between sophisticated institutional investors), investors need to ask themselves: What do I know that everyone else doesn’t?
Remember, all stocks are owned at all times by someone. Thus, if you sell, someone else must buy. If you buy, someone else must sell.
So at the end of the day, if your opinion about the market or a stock leads you to make a trade, someone must be willing to take the other side. Do you know something they don’t?
Investing Fact #9
Diversification is the only (yes, the only) free lunch
If the facts I’ve covered up until now haven’t made it clear, eliminating unnecessary risks and potential hindrances from your portfolio should be a top priority.
We’ve covered costs, taxes, active manager risk, and market timing risk, thus far. We’ve also briefly spent some time talking about diversification as it relates to owning individual stocks.
However, diversification is such a critical topic that it deserves a discussion of its own.
And, unfortunately, most investor portfolios are severely under-diversified.
They are typically concentrated in stocks of large. U.S. companies, meaning they lack appropriate diversification from both a geographic and asset class perspective. Specifically, almost every investor portfolio would benefit from a reallocation that also included:
- International stocks (both developed and emerging markets)
- Types of stocks and sources of return (market cap, value, profitability, etc.)
- Real estate (through low-cost REIT funds)
With the low cost mutual funds and ETFs available to investors today, insufficient diversification isn’t a problem that we should burden ourselves with. It really, truly is the only free lunch and it makes no sense whatsoever to fail to take advantage of it. Thus, my advice is as follows:
When in doubt, diversify. When you’re confident, diversify. I don’t care what your state of mind, diversify!
Investing Fact #10
Where you invest is just as important as what you invest in
When most people think about investing, the first thought that usually enters their mind is “what should I invest in?”
What you choose to invest in, however, isn’t even the first question you should be asking yourself.
Rather, you need to decide where you will invest your money. And I don’t mean where in terms of geography (i.e. U.S. stocks vs. international stocks).
I mean where like what type of account your money will go into. Before you do anything else, you need to devise a plan around your asset location.
Whether through your 401k, 403b, or an IRA, you almost certainly have access to a tax-advantaged account that deserves your money before a taxable brokerage or mutual fund account.
The reason being is that the tax advantages of retirement accounts really add up over time (potentially to the tune of 20% to 30% higher returns). In addition, if your employer matches your contribution to your 401k or 403b, you should be looking to capture the full match every year. Trust me, you won’d find a better return on your money anywhere.
Thus, before you start worrying about what to buy in your portfolio, decide where you should buy it first.