The internet has changed the way we live our lives. Not long ago purchasing stock was not as easy as it is now. The order went through a complex network of brokers and specialists before the execution was completed. In 1983, that all changed with a dentist in Michigan who made the first online stock transaction using a system developed by what is now E*TRADE Financial.
Online brokers and easy access to financial data make investing your money as simple as starting a savings account. But in an internet-driven, do-it-yourself world, is investing also a do-it-yourself activity? If so, why not just fire your financial advisor, pay fewer fees to your mutual funds, and set up a portfolio of your own? We look at some of the basics of managing your own money before you actually become your own financial manager.
- The wealth of information available online may offer inexperienced investors with a false sense of security.
- It's important to understand modern portfolio theory and risk.
- Watch the market first in order to learn how it works and how it reacts to daily events.
- Set up a virtual paper trading account so you don't lose more money than you should.
Should You Manage Your Own Money?
That first trade, made by William Porter, changed the way investment products are researched, discussed, bought, and sold. Computerized trading has resulted in highly liquid markets, making it easy to buy and sell most securities quickly. The do-it-yourselfer now has access to the same free financial data professionals use. Websites like StockTwits set up entire communities of investors and traders who exchange information in real time.
But just because it's possible, does that mean managing your own money is a good idea? Professional investors have a saying: "The stock market is an expensive place to learn how to invest." They understand that it's easier to lose money than it is to make money, and because of that, some argue that the wealth of information available to people with an inexperienced financial background may offer a false sense of security.
Tools are only as good as the knowledge and experience of the person using them. Does a high-priced software package used by the world's best composers result in beautiful music? Does the newest innovation in surgical technology make a person with no prior training in the field a top-performing surgeon?
There's no doubt that the internet has given the retail investor the tools that they need to effectively manage their own money, but what about the knowledge and experience to use the tools effectively? For an investor who wants to manage their own money, what types of fundamental knowledge should they have before firing their financial adviser?
Modern Portfolio Theory
It's important to get a grasp of the modern portfolio theory (MPT) and gain an understanding of how asset allocation is determined for an individual based on their individual factors. In order to gain a true understanding of these principles, you'll have to dig deeper than the top-level internet articles that tell you that MPT is simply understanding allocation. MPT is not just about the allocation, but also its efficiency. The best money managers understand how to position your money for maximum return with the least amount of risk. They also understand that efficiency is highly dynamic as the person ages and their financial picture changes.
Along with efficiency comes the dynamic nature of risk tolerance. At certain points in our lives, our risk tolerance may change. Along with retirement, we might have intermediate financial goals like saving for college or starting a new business, the portfolio has to be adjusted to meet those goals. Financial advisors often use proprietary software that produces detailed reports not available to the retail investor.
In the plethora of free resources available, risk is treated too benignly. The term risk tolerance has been so overused that retail investors may believe that they understand risk if they understand that investing may involve losing money from time to time. But it's not really that simple. In fact, it's much more than that.
Risk is a behavior that is hard to understand rationally because investors often act against their best interests. A study conducted by Dalbar showed that inexperienced investors tend to buy high and sell low, which often leads to losses in short-term trades.
Risk is hard to understand rationally because investors often act against their best interests.
Since risk is a behavior, it's extremely difficult for an individual to have an accurate, unbiased picture of their true attitude towards risk. Day traders, often seen as having a high-risk tolerance, may actually have an extremely low tolerance because they're unwilling to hold an investment for longer periods. Great investors understand that success comes with fending off emotion and making decisions based on facts. That's hard to do when you're working with your own money.
Can You Beat the Market?
Do you know how likely you are to outperform the overall market? What is the likelihood of any one football player being better than most of the other NFL players, and if they are better for a season what is the likelihood that they will be the best of the best for decades?
Efficient market hypothesis (EMH) might contain the answer. EMH states that everything known about an investment product is immediately factored into the price. If Intel releases information that sales will be light this quarter, the market will instantly react and adjust the value of the stock. According to EMH, there is no way to beat the market for sustained periods because all prices reflect true or fair value.
For the retail investor who tries to pick individual stock names in the hopes of achieving gains that are larger than the market as a whole, this may work in the short term, just as gambling can sometimes produce short-term profits. But over a sustained period of decades, this strategy breaks down, at least, according to the proponents of EMH.
Even the brightest investment minds employing teams of researchers all over the world haven't been able to beat the market over a sustained period, according to famed investor Charles Ellis in his book, "Winning The Loser's Game: Timeless Strategies For Successful Investing." Critics of this theory cite investors like Warren Buffett who consistently beat the market, but what does EMH mean for the individual investor? Before deciding on your investing strategy, you need the knowledge and statistics to back it up.
If you're going to pick individual stocks in the hopes that they'll appreciate in value faster than the overall market, what evidence leads you to the idea that this strategy will work? If you're planning to invest in stocks for dividends, is there any evidence that proves that an income strategy works? Would investing in an index fund be the best way? Where can you find the data needed to make these decisions?
Learning to Invest
What do you do for a living? If you have a college degree, you might be one of the people who say that you didn't become highly skilled as a result of your degree, but instead because of the experience you amassed. When you first started your job were you highly effective from the very beginning?
Before managing your own money, you need experience. Gaining experience for investors often means losing money, and losing money in your retirement savings isn't an option.
Experience comes from watching the market and learning first-hand how it reacts to daily events. Professional investors know that the market has a personality that is constantly changing. Sometimes it's hypersensitive to news events and other times it brushes them off. Some stocks are highly volatile while others have muted reactions.
The best way for the retail investor to gain experience is by setting up a virtual or paper trading account. These accounts are perfect for learning to invest while also gaining experience before committing real money to the markets.
The Bottom Line
Many people have found success in managing their own money, but before putting your money at risk, become a student in the art of investing. If somebody wanted to do your job based on what they read on the internet, would you advise it? If you were looking for a financial advisor, would you hire yourself based on your current level of knowledge?
You may answer in the affirmative, but until you have the knowledge and experience as a money manager, managing a brokerage account with money that you could stand to lose might be okay, but leave your retirement money to the professionals.