Many investors get a lot of anxiety chasing mutual fund returns, hoping that history repeats itself while they are in the fund. In fact, a fund which has already yielded large returns has less of a chance to do so again when compared with its peer group. A better idea, rather than stressing out over the vagaries of the financial markets, is to look for wisdom in time-tested, academic methods. Once your high-quality investment plan is set up, relax. Let your investment compound, understanding that the plan is rooted in knowledge, not hype.
SEE: The Fundamental Mechanics Of Investing
As with growing a garden, you want to invest in good soil (strategy). Accordingly, you can expect there to be some rainy days (bear market) with the sunny (bull market). Both are needed for overall growth. Once a garden (money) starts to grow, don't uproot it and replant, lest it wither and die. Set up your investment wisely and then let it grow.
Academic research creates good soil. The body of knowledge about the market goes through a rigorous review process where primary goal is truth or knowledge rather than profit. Thus, the information is disinterested - something you should always look for in life to make wise decisions.
Greatly distilling this body of knowledge, here are a few key points to remember when it comes to investing in the stock market.
Risk and Return
This concept is similar to the saying "there is no free lunch." In money terms, if you want more return, you are going to have to invest in funds that have a greater probability of going south (high risk). Thus, the law of large numbers really comes into play here, since investing in small, unproven companies may yield better potential returns, while larger companies which have already undergone substantial growth may not give you comparable results.
This concept says that everything you need to know about conventional investments is already priced into them. Market efficiency supports the concept of risk and return; thus, don't waste your time at the library with a "Value Line investment" unless it provides entertainment value. Essentially, when you look at whether or not to invest in a large corporation, it is unlikely that you are going to find any information different from what others have already found. Interestingly, this also gives insight into how you make abnormal returns by investing in unknown companies like "Bob's Tomato Shack," if you really have the time and business acumen to do the front-line research.
Modern Portfolio Theory
Modern portfolio theory (MPT) basically says that you want to diversify your investments as much as possible in order to get rid of company- or stock-specific risk, thus incurring only the lowest common denominator - market risk. Essentially, you are using the law of large numbers in order to maximize returns while minimizing risk for a given market exposure.
Now here is where things get really interesting! We just found the way to optimize your risk-return tradeoff for a given market level of risk by being well diversified in your investments. However, you can further adjust the investment risk downwards by lending money (investing some of it in risk-free assets) or upwards by borrowing it (margin investing).
Best Market Portfolio
Academics have created models of the market portfolio, consisting of a weighted sum of every asset in the market, with weights in the proportions that the assets exist in the market. Many think of this as being like the S&P 500, but that is an index of only the 500 largest companies in the United States. Instead, think total market and think globally. One limitation is that while you are investing in the world, you are spending your dollars in your own country, so at this point things get a little dicey.
Roughly, the world market cap is about one-third U.S. and two-thirds international. As mentioned earlier, if you live in the U.S., this is primarily where you spend your dollars, and thus you could either hedge the currency or beef up the U.S. exposure. To keep this simple and comfortable to the investor, a 50% U.S. / 50% international weighting will help you to get started.
Putting This into Practice
You can achieve this weighting by selecting exchange-traded funds (ETFs) to replicate the market portfolio. You can buy an extended U.S. ETF and an international ETF, put them together and you have your duck soup! Now, you need to assess your greed versus fear: e.g., how much of your investment do you want to put into the market portfolio versus T-bills. If you are more greedy than fearful, you could even do some margin investing.
A key item you'll want to consider when assessing your greed factor is the return potential. As a general rule, for the market portfolio estimate a 10% return on average with 20% annual swings up or down is not uncommon. Compare this to U.S. Treasuries at a 3-4% rate of return with little principal swings if kept in short duration. Does knowing the difference of return versus risk change your level of fear, greed or risk tolerance?
To uncover your personal risk status, you must assess your financial resilience first. This is how able you are to sustain a financial loss. How much portfolio value can you put at risk? Since the market generally goes up over time, this really becomes an issue of time horizon. If you have Junior's tuition due in a year, your time horizon is short on the section of your portfolio that must cover that expense. Conversely, if you are just starting your career, you can better ride out any storms from a longer time horizon.
Second, you must assess your psychological resilience. What would keep you up at night? If you are an anxious individual who checks the stock market every day, you probably should keep your market exposure low. However, if you are more comfortable with the market and are too busy to constantly review stock quotes, your psychology is better suited for a higher market portfolio weighting.
The Bottom Line
One of the best lines from a common cartoon to take with you each day is Lion King's "hakuna matata," which means "no worries!" If you enjoy stock picking, go nuts, but do so for entertainment. If investing your nest egg is likely to cause you some anxiety, seek the academic, time-tested good soil and then rest well at night knowing you have done the due diligence and nothing more than modest rebalancing as necessary. A healthy harvest should follow as you learn to grow your green investing thumb.