Quote of the Day: January 30, 2012
Thinking Aloud About Fiscal Policy in a Depressed Economy...

Carl Richards and Henry Blodget Offer Investment Advice That Is Good

Carl Richards:

Carl Richards On The Psychology Of Buying High And Selling Low: Successful investing is hard. Not complicated, just hard. It’s hard because for the most part, we are wired to make the same mistake over and over again. We buy high and sell low because that’s what everyone else is doing. But like any problem that needs to be fixed, the first step is recognizing the problem and then coming up with a plan to prevent it.

Buying High and Selling Low: We don’t have to look too far to find ample evidence of poor investor behavior on a wide scale. In 1999 when the dot-com bubble got bigger and bigger, the NASDAQ was up over 85 percent… FOR THE YEAR. That was crazy enough, but what happened in the first quarter of 2000 was insane. We went on a buying binge, all of us. Up until January 2000, the record for net inflows (money going in, minus money going out) into stock mutual funds was $29 billion. Now here we are in January 2000, right after an 86 percent run up. Look at these numbers.

  • In January we poured $44.5 billion into stock mutual funds.

  • In February, the shortest month of the year, inflows hit $55.6 billion. That’s almost $2 billion a day!

  • And March was nothing to sneeze at either with an investment of another $39.9 billion.

Think about it. Over three months, $140 billion dollars entered the market—AFTER it already had gained over 80 percent. At a time when we should have shown some caution, we allowed ourselves to get swept along with the crowd, and we paid for it. March 24, 2000, was the peak of the dot-com bubble, and by October 2002 the market had lost 50 percent of its value. So we poured money in, just in time to get our heads taken off!

If the behavior at the top was wild, clearly we still hadn’t learned the lesson on the way down. With the S&P 500 down over 50 percent from its highs, we couldn’t sell fast enough. October marked the fifth month in a row that investors pulled more money out of stock mutual funds than they invested. That had never happened. I repeat, never. October turned out to the market low. So at the market low, instead of buying equities at the best “sale” prices in five years, investors moved their money into bond funds, making the classic mistake of having bought high and sold low. Bond funds experienced a record inflow of $140 billion in 2002, at a time when bonds where at 46 year highs.

How many of us became a real estate investor in 2006? Are we buying gold now? See the pattern.

Breaking the Cycle: Once we recognize the problem we can fix it. The first step is to have a thought-out investment process that we can stick to when things get tough. Investing involves risk so no matter our investment process so there will be times that we are tested. There will be times we are tempted to go to cash, “just until things clear up” like some did in 2002. But the only real hope of sticking with an investment strategy is to understand it at least enough to have the confidence to stay disciplined when times get tough.

Step One: Buy a S&P 500 Index Fund…. Step 2: Building a Diversified Equity Portfolio…. Step 3: Reduce Risk By Adding Bonds…. Step 4: Automate Rebalancing….

Henry Blodget:

What Carl didn’t mention is that he has a new book, The Behavior Gap, coming out on January 3rd. I’ve read it and it’s an excellent deep-dive into the psychology of investing. One thing I love is his explanation of why we “know” the things we should do…yet we don’t do them. This is totally different than most “information” books, which try to convince us about things we already know. Wouldn’t you rather understand why you behave the way you do?

Henry Blodget:

FINALLY, SOME EXCELLENT INVESTMENT ADVICE: Don't Play The Losers' Game: If you're an individual with some money to invest, the first thing you need to know if you want to invest intelligently is that you shouldn't play the Losers' Game. What's the Losers' Game? The game that 99.9% of the people who talk about investing appear to be playing: Namely, following global economics and markets and investment advice and trying to make smart decisions along the way. If you play that investment game, you're almost certain to lose. And the sooner you understand that, the sooner you'll be on your way to investing intelligently…. That doesn't mean that the people in and on the financial media are stupid--they aren't. It just means that almost everything they talk about is irrelevant (or worse) if your goal is to invest intelligently…. So that's the first thing you should do if you want to invest intelligently: Recognize the financial media for what it is--financial media…. The second thing you need to understand if you want to invest intelligently is that if you choose to play this global sport, you will not be playing in a special Little League or low-stakes table with the folks like you who just aren't that good at it. You will play in the same league as the best professional players in the world. And you should expect to do as well against them as you would do against the PGA Tour players at the Masters or the Green Bay Packers in the Super Bowl or the Yankees in the World Series or grand masters in chess. Because the third thing you need to understand that only way for you to make money trading versus investing intelligently (owning low-cost index funds) is to out-play these top professionals….

To make it smart to play the trading game, therefore, you have to have a good reason for thinking that you are going to be one of the alpha "winners" instead of one of the losers….

So, then, how do you invest intelligently?… Invest in a diversified portfolio of low-cost index funds. Rebalance automatically when the allocations get out of whack. That's it. That's how you invest intelligently….

The reason you don't hear more about it in the financial media is that it's boring. The financial media need to make a living, too, and covering the 24/7 market game is exciting. And there are lots of people who like following the markets minute-to-minute 24 hours a day, and the financial media competes for their eyeballs and ears.

But that has nothing to do with intelligent investing.

And just because the "magic formula" of intelligent investing is simple doesn't mean it's easy to do. In fact, it's very hard.

The reason it's hard is that it's hard to understand and believe that this strategy will guarantee that you will outperform about 75% of all investors, including the professionals, over the long haul….

So if you are smart and disciplined enough to do it, hats off to you.  Enjoy the time and money you would have lost if you had spent your life playing the Losers' Game.