There are a lot of myths about investing. They all share these common traits:
On the surface, they make sense.
They’re fairly easy to implement.
They give you a sense you are doing something positive.
They provide a false sense of empowerment.
They require closely monitoring the financial news.
The most insidious of these myths is that researching individual stocks is the key to investing success. Unfortunately, many believe this fairy tale to be true. CNBC’s Jim Cramer, for example, recently established it as his “golden rule for long-term market prosperity.” Like many other “gurus” in the financial media, Cramer counsels investors to obtain “a solid understanding of a company’s fundamentals by looking at earnings reports, reading news stories and parsing through Wall Street analysis.” He believes doing this “homework” is the key to profitable investing.
It’s an appealing theory, and it resonates with investors. In most areas of life, hard work and careful research do pay off. But when it comes to investing, all that “homework” is actually counterproductive.
Is Ignorance Bliss in Investing?
I consider myself a sophisticated investor. I’ve written six books on investing, two of which made the New York Times bestseller list. I am a registered investment adviser representative and have been a wealth adviser for many years. I have written thousands of financial blogs and have read hundreds of peer-reviewed articles on investing.
I have never done any research on any of the stocks in my own portfolio.
I am familiar with many portfolios that consist solely of mutual funds. The stock portion of these portfolios often own more than 10,000 equities. They frequently include most publicly listed domestic and international stocks.
I have never done any research on any of the stocks in my own portfolio. I have no interest in the fundamentals of these companies. I have even less interest in the views of Wall Street analysts or pundits who appear on TV.
I am content to capture the returns of the global marketplace. According to New York Times blogger Carl Richards, the average U.S. stock mutual fund had a 10-year average return of 8.18 percent at the end of 2013. The average investor, however, earned only 6.52 percent on his or her investment. The gap is caused by investors who attempt to time the market, often in response to the views of “investment pros” who believe they have the ability to accurately tell you when to buy and when to sell.
There is similar evidence that investors in individual stocks earn lower returns than investors using a buy-and-hold strategy because they also typically buy and sell their stock holdings (often at the wrong times) rather than holding on to them.
Investors (in both mutual funds and individual stocks) who pursue a buy-and-hold strategy should rebalance periodically to keep their risk profiles intact. They should have no interest in how the markets are performing today, next week or even next year.
Doing Research on Stocks Makes No Sense
The concept of doing research on particular stocks makes absolutely no sense to me. As an individual with limited resources, what are the chances my “homework” will uncover something that has been missed by hedge fund managers, mutual fund managers, Wall Street analysts and others with far greater resources than I could imagine? Vanishingly small.
Meanwhile, even with all the resources they have available, the track record of these institutional investors demonstrates that their research often does not permit them to beat a simple index. For the 12-month period ending June 30, 60 percent of large-cap active mutual fund managers underperformed their benchmarks. Over the prior 36 months, 85 percent underperformed.
Think about that data for a moment. The most sophisticated fund managers in the world struggle to select stocks from among the S&P 500 that will beat the returns of the index itself. This dismal performance is not an aberration. Over the past five years, more than 70 percent of all actively managed funds failed to deliver returns higher than their benchmarks.
Information Is Immediately Incorporated Into Stock Prices
It’s not difficult to understand the reason for this underperformance. We live in a world where information is disseminated almost instantaneously. All the news that could possibly affect the price of publicly traded securities is already known to the millions of traders engaged in buying and selling stocks. And it is immediately incorporated into the price of stocks. The possibility of an individual uncovering something these traders have missed is infinitesimally small.
Even if you concluded, based on your research, that a stock is underpriced, there must be someone on the other side of the trade willing to sell that stock to you. That person or institution has reached the opposite conclusion. Why would you assume you are right and they are wrong?
Here’s the request I encourage you to make of anyone who is telling you to research stocks in an effort to “beat the market”: Show me your data.
You are unlikely to receive anything meaningful in response to this demand. Conversely, the weight of evidence against trying to pick stock “winners” is overwhelming. Consider this sampling of studies.
The Takeaway on Doing Research to Pick Stocks
Instead of engaging in the high-risk exercise of stock picking, you would be better off buying index funds with low management fees in a globally diversified portfolio. Your focus should be on your asset allocation and not on doing “homework” in an effort to “beat the market.”
You will be in good company. Some people who agree with this approach to investing include:
Eugene Fama (Nobel laureate)
Merton Miller (Nobel laureate)
Harry Markowitz (Nobel laureate)
Daniel Kahneman (Nobel laureate)
William Sharpe (Nobel laureate)
Warren Buffett
Peter Lynch
In future blog posts, I will deal with some other pervasive investing myths. Next up: The myth that great companies make great investments.
Managed to get that raise or promotion? Fantastic — now don’t go out there and spend it all immediately. In classic "keeping up with the Joneses" fashion, too many of us see an increase in salary or a sudden windfall (like an inheritance) as an excuse to take our lifestyle up a notch. We buy bigger houses than we need, get the latest gadgets even though ours work just fine,and spring for fancy steak dinners just because we can.
Instead, whenever your financial situation gets a boost, consider the best ways to put that money to work for you. The truly wealthy are those whose money continues to grow and earn them more, even when they’re not actively doing anything with it.
1. Lifestyle inflation
The average American household that carries credit card debt holds a balance of around $15,000. If you’re among those who have a credit card balance, you’ve probably seen the little chart on your monthly statement telling you how much you’ll pay in interest over the next several years if you make only the minimum payment. (If you haven’t, look at it.) The same chart will also compare that to a "suggested" payment that’s slightly higher.
Our recommendation? Throw everything you can at paying your balances off as fast as possible. And make sure not to take on any additional debt in the future; if you can’t pay for a consumer good out of pocket, don’t finance it.
2. Credit card debt
We don’t demonize student loan debt the way we do credit card debt because we see an education as an investment — and higher education often is the difference between one income bracket and another. Similarly, many people justify taking out a car loan by stating that they need a car to get to work.
That said, debt is still debt, and the longer you take to pay it off, the more interest you’ll pay. Once you’ve freed yourself of credit card debt, paying down your car and student loan balances should be next on your list.
3. Car loan and student loan debt
Whether it’s to handle an unexpected car repair, a sudden illness or a major plumbing problem, you should always have some money set aside to cover unforeseen expenses. Set up a regular monthly transfer from your checking to your savings account to earmark this money before you’re tempted to touch it. If necessary, cut back in another budget category (like eating out or entertainment) to free up the funds to save more.
Putting aside a little each month could prevent you from getting socked with a hefty bill you can’t afford and then need to finance.
4. No emergency savings
No matter your age, you should be adding to your retirement funds — such as your 401(k) or individual retirement account — each month. Just setting aside money sporadically won’t cut it; you need to identify how much you’ll need to live on once you stop working and monitor whether you’re on track to reach that amount.
Here’s a quick-and-dirty rule of thumb: multiply your annual spending by 25. This is the amount you’ll need in your retirement portfolio, if you assume that you’ll withdraw 4 percent per year to live on during your retirement. In other words, you’d need $1 million in your portfolio to live on $40,000 annually. Creating a plan will help you make sure you’re able to retire the way you envision.
5. No official retirement plan
A home is a big investment, and sometimes that investment doesn’t wind up netting you the return you thought it would.
The biggest culprit is having too large a balance on your mortgage, which detracts from your own personal stake in the current market value for your home. The sooner you pay this amount down, the better your home equity will be.
You also want to be careful when purchasing a new home. Buying in a neighborhood that’s on the downward spiral or buying the most expensive home on the block, likely won’t net you a good return when it’s time to sell. Also take care to stay away from custom renovations (like turning the garage into a recreation room), which could negatively affect your resale value.
6. Poor home equity
Paying high investment fees eats away at your gains. And since your gains compound over time, this creates a domino effect that can really chip away at your wealth. Take a close look at your investment companies’ fees and shop around to make sure they’re not taking more of your money than they need to be.
7. High investment fees
If you don’t have a long-term investment vision and are simply playing the market, you could seriously undermine your wealth-building potential. Stop paying attention to market fluctuations, media pundits and the stories of your friends and family. Instead, create your own long-term investment strategy that will maximize your overall returns. Resist the urge it play it ultra-conservative (or fall for get-rich-quick schemes) and educate yourself on the best way to make your dollars work for you.
If you’re having trouble making sense of your options or want a second opinion, seek the help of a trusted financial adviser.
8. Risky investments
Based on your experience and seniority level, education and industry, you should have a fairly good idea how much you ought to be making at your job. If you don’t, check out a site like PayScale to get a ballpark figure.
If you’re not making what you’re worth, you’re doing more than leaving money on the table; you’re also losing all the compound growth and investment returns that money could be generating for you. Invest in yourself with professional development and continuing education, make the case for that raise or promotion, or seek out a company who will value you higher.
9. Making less than you're worth
If you don’t have proper insurance coverage, you’re taking a very big risk that could come back to bite you. Too many people think the worst can’t happen to them, but the hard truth is you can’t predict the future, and scrimping on sufficient insurance is never a good idea.
Of all the things we’re hesitate to part with our money for, adequate insurance coverage should not be one of them. No matter your age, everyone should be properly covered with:
Health insurance.
Disability insurance.
Homeowner’s or renter’s insurance.
Flood insurance (if you live in a flood-prone area).
Umbrella liability insurance (especially if you own a small business).
If a spouse or children relies on you for support, make sure you have a decent term life insurance policy, as well.
10. Insufficient insurance coverage
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