Last week, I discussed how beating the market is hard to do.
I wrote the commentary to provoke an awareness of the challenge that
faces anyone pursuing an active strategy. Bluntly put, if you try to
handpick investments without a disciplined, rational, well-thought-out
plan for doing so, (barring really good luck) you will underperform.
Rule
1: The optimal strategy is not one that maximizes return, but rather
one that helps you stick to your long-term investing plan and achieve
your goals. Big returns always sound enticing. Pitched by
someone with a charismatic personality, a high-return strategy sounds
even better. But if you can’t stick to the strategy because of its
complexity, the volatility it incurs, the time commitment it requires,
the number of transactions associated with it, your interest level or
any other reason, then it’s not an optimal strategy for you. If you are
unwilling to or can’t stick with a strategy, don’t use it.
Rule 2: Set up procedures to keep your emotions in check.
The biggest threat to most people’s portfolios is not the economy, the
Federal Reserve, valuations, or high-frequency traders, it’s their
brain. The human mind evolved to cope with very different hazards than
Mr. Market’s ever-changing moods. So be cognizant of what your emotional
tendencies are and set up procedures to keep them in check. These can
include pre-written sell rules, limiting how often you check your
portfolio, triggers to periodically adjust your portfolio or consulting
with a financial adviser.
Rule 3: Think and invest different.
Your biggest advantage as an individual investor is that you are not
tied to an investment objective. Rather, you are allowed to invest in
anything your wealth, your financial goals and the tax code allow you
to. So why focus on the 300 largest U.S. stocks when there are nearly
5,000 listed on the U.S. exchanges and a large choice of funds that
invest in international securities? Better yet, why use the same
strategy everyone else is or focus on the stocks currently making
headlines? If you want to beat the market, you have to invest in a
different manner than most people.
Rule 4: Use the wisdom of the crowds to your advantage.
While market efficiency is a big hurdle for active strategies to
overcome, there are benefits to be gained from paying attention to the
collective thoughts of market participants. We (AAII) use relative
valuation rules for managing our portfolios, letting the market help
guide our views about what is cheap and what isn’t. The trend in
earnings estimate revisions can tell you if a company’s outlook is
brightening or worsening. Momentum indicators such as the 26-week
relative price strength rank pair well with low-valuation strategies.
Rule 5: Higher Valuations = Greater Expectations = More Room for Disappointment.
The more favorably people view a company, the smaller its margin for
error. Far more money is made from buying stocks that are undervalued
than from buying stocks that are overvalued. Even if you are a growth
investor, make sure the stock is undervalued relative to its prospects
(after ensuring those prospects don’t assume an overly optimistic
outlook).
Rule 6: Lower your costs.
Every dollar you pay in investment expenses and transaction costs is a
dollar you will never see again. In addition to trading with less
frequency, take advantage of the tax law. Put your most tax-efficient
investments in your traditional brokerage accounts, and use your
tax-sheltered accounts (e.g., IRAs) for your least tax-efficient
investments and strategies. Your goal should be to maximize the benefit
from what you spend.
Rule 7: Develop a consistent, well-defined approach to investing and stick to it regardless of what the market is doing. Being a successful active investor requires having a plan based on factors and strategies proven to work over the long term.
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