I was recently notified that I was ranked #7 on Investopedia's list of Most Influential Financial Advisors. I am very grateful to receive this honor. It was somewhat unexpected. I have spent so much time trying to help investors that I have not stopped long enough to reflect on the impact I have made in the lives of my clients and social media connections. This award supports that all my efforts to educate investors and help them navigate the uncertain financial markets has not been in vain.
It means a lot to me to be recognized with such a notable group of financial advisors. Investing has always been a passion of mine. This passion started at a young age with small ventures such as a lemonade stand and lawn mowing services. In college, it continued with investing in the stock market. When I graduated, I got my first job at Paine Webber. Almost 10 years ago I co-founded Innovative Advisory Group. Investing and providing financial advice is in my blood.
As my knowledge of investing has grown, so has my desire to help others understand the mysteries of the financial markets. I hope to impart some of that wisdom to you in this post as well as other articles on this site.
Once again, I would like to thank Investopedia for this acknowledgement of my efforts. I also want to thank my clients and social media connections. I would not be where I am today without you.
Top 10 pieces of financial wisdom that can help you invest better
Investing is challenging, but it doesn't have to be. It requires some extensive knowledge to become a highly successful investor in the stock market, but there are many ways to invest successfully. I will discuss some different ways to figure out how you can invest successfully below, however you will need to understand these simple concepts if you want to be successful long term.
1) Understand your investor psychology
Every investor is different because the psychology of every person is different. If you are trying to be like Warren Buffett you may ultimately fail because your ability to invest may not be the same as the Oracle of Omaha. He is obviously a very wise investor, but he also has a certain style that works for him that may not work for you or me. He has a great deal of patience that most people don't have. He also has a great deal of insight that does not come from financial media. Most importantly he spends all day reading through annual statements. My guess is that you don't have that kind of time to do that.
If you look at all the investing legends, you will find that most of them are very different in how they invest and what they invest in. Some invest in value stocks, others in distressed debt, others in currencies or commodities, and still others in real estate.
Within each of these asset types many investors have different strategies. Some investors are buy and hold investors, others are day traders or swing traders, and others arbitrage. You need to know your strengths and play to those strengths.
Let me give you a good example of playing to your strengths. I know an investor who has a problem with stop losses. If he places the stop loss in the market, frequently other investors will sell off the stock to hit his stop loss order then allow the stock to rise again (this is a common problem). So he has to keep the stop loss to himself and execute the trade when the stock hits that price. The problem is that when the time comes to sell, he frequently second guesses his original thesis. Then the stock continues to drop, so he loses more money. He knows this about himself, so he has used options to cover this deficiency.
If used properly a stop loss may not be necessary. But rather than fight his own psychology, he has devised an easier way to win. The point is that he realized his psychological flaw and found a way to compensate for that flaw.
We all have psychological flaws, it is ingrained in our primal nature. Thousands of years ago, fear kept us from getting eaten by tigers. Now it keeps us from making rational decisions with investments. If you cannot handle your fear, then you need to find ways to compensate. Computers are one way investors handle this problem. Using a financial advisor is another way to do it. Investors have to find their own way to handle their emotions. If you cannot, then you raise the probability of failure.
Everyone has emotions. Your ability to navigate investments in spite of these emotions is what separates good investors from bad investors. Get to know your investor psychology and master your investing strategy.
2) Keep it simple
Many investors have come up with complex systems of how they invest as a way to beat the market. However, I have found that simpler is better. Let me give you an example.
You can invest in a stock. It doesn't get much simpler than that. You can also use options with that stock, or create a hedging strategy with that stock, or a multitude of other things that complicate that investment. Your strategy may great, but implementing it may be challenging, or its complexity may make it challenging to manage, or exiting the trade might be tough. All of these things are important to consider.
The other part of using a complex strategy is how much time does it take to manage. If you have a simple system, it may take you 1 hour a month to monitor and manage,. If you have a complicated strategy, it may take you 30 hours a month. Does the 30 hour method produce a much better result?
Time is a much more valuable asset than money. You can always make more money, you cannot make more time.
3) Invest in what you know
This is the primary rule every investor must follow. Invest in what you know. Peter Lynch was very fond of this saying.
There are virtually an unlimited amount of investments you could invest in. There is a good chance you have an expertise in a certain area that allows you to take advantage of your specialized knowledge.
For example, if you are an expert in the area of real estate, you may be able to find better deals than most people. Or you may be able to add value to a property that could create a bigger return for you than investing in an area you don't understand like emerging bio tech stocks. Or conversely, you might work in the biotech field and have a good insight into emerging technologies that most people are not aware of. You should use this knowledge to your advantage.
There are really 2 points to consider here:
- Invest in what you know
- Don't invest in areas you don't know well
The second point tends to be more of a problem for investors. The stock market is like a casino. There are shiny lights, bells and salespeople telling you to "invest" your money and "let it ride". It is really easy to invest in almost any publicly traded security. A few keystrokes and you can bet it all on red.
This is not conducive to good investing. Warren Buffett has made some good comments about this. He said, "Only buy something that you would be perfectly happy to hold if the market shut down for 10 years." What kind of investing decision would you make if you could only buy a stock that you intended to hold for 10+ years?
His point is exactly right. This also applies to private company stock. When you invest in a private company, you are making the assumption that you cannot liquidate the stock for years until a liquidation event. You make the investment with the assumption that you earn cash flow each year or grow the company's valuation. This forces you to do your homework prior to investing because you may not see your money for quite some time.
4) Understand your true risk tolerance
If you have a brokerage account or work with a financial advisor, you will have filled out a risk tolerance questionnaire. This would provide you with a estimate of what you risk tolerance is for different types of investments. This is an industry standard that financial advisors and institutions rely on to measure an investors ability to withstand risk or volatility. While it is a measure of risk, it is more accurately a measure of volatility.
It is hard to measure your own risk unless you have experienced volatility before. If you did not experience the wide range of asset price volatility from 1995 to today, then you may not truly know what your risk tolerance is.
If you were invested in stocks in 2008 and lost 50% on your investments (similar to the performance of the S&P 500), and you did not sell your stocks (assuming you were paying attention), then you have a high risk tolerance. That is the worst period of volatility I have seen in my professional career of 18 years. I applaud you if you were able to withstand that period of time without selling everything.
If you sell out at the slightest drop of 2-3% on your investments, this generally means you have a very low risk tolerance. If this describes you, then probably should not be invested in stocks.
That being said, my experience shows me that most people are tolerant to risk when the stock market is rising and intolerant to risk when it is dropping. No one likes to lose money, but it is a reality of investing in any investment. Every investment has risks. Your ability to tolerate volatility or loss can only be truly known when you experience it.
While you may think you have a high tolerance to risk, in an asset selloff, you may find out that you can't take it. By then it is too late. Selling after an asset has sold off is too late. You need to know this about yourself before the volatility happens, not after. Otherwise you will have a very expensive education.
5) Paper gains are not real gains
This is a hard concept for most people to grasp. If you invest in a stock and it goes up, you feel good, if it goes down, you don't feel so good, but when is the actual money made or lost?
When you sell.
This is not to say that you should sell all of your investment to make gains, but you should realize that until you sell, the temporary gains and losses are not important. What is important is the cash you receive from your investments. If you get cash distributions (i.e. dividends or interest) from your investments, these are gains you can bank regardless of whether you make or lose money on your investment when you sell.
If you invest in real estate, you will get a few benefits, rental income, appreciation, and tax benefits. You cannot predict what the price of the property will be from one year to the next. You hope the value goes up, but there are no certainties. Frankly, it really doesn't matter until you sell. That is when the gain or loss matters. However, the rental income is somewhat predictable and it is cash in your pocket every month.
The same is true for interest and dividends distributed from companies. These are real returns. Unfortunately most investors don't look at cash flow as returns. It is more glamorous to look at the capital gains. The problem is that capital gains are not predictable. It is speculation. This speculation drives stock prices on Wall Street.
If Wall Street closed tomorrow and you could not sell your shares, what would you have? You would have the cash flow (i.e. dividends and interest). Historically, a large part of the returns from stocks have come from the dividends. Don't overlook this simple but important performance metric.
6) Don't believe the hype
Wall Street is like a casino. New products are created as a way that the house can make money from the participants. Every few years Wall Street creates a new type of product to sell. Robo Advisors, smart beta, structured products, ETFs, separately managed accounts (SMA), hedge funds, private equity, managed futures, 529 plans, equity index annuities, the list is endless.
There is always something new for Wall Street banks and brokers to sell to investors. Some of the investments are good, others are not, and very few live up to the hype.
One way to protect yourself from potentially dangerous Wall Street trends is to not invest in new product types. Wait a few years to see how it works out before investing.
I'll give you a quick story about this with structured products. When I was working at one of the wirehouse broker dealers Structured products had just been created as a new product to sell. They made the terms really attractive to investors. I remember one of them was a 16% yield on a tech stock in 2001. It sounded great, but the reality was not so great. Actually, every structured product I saw during the early years lost money. I was not surprised. When you understood what they were doing, it was not hard to see how investors would lose on the deal.
Structured products still exist today, but they have been a bit more refined. Sure, there are still plenty of bad ones being created, but you can also occasionally find some good ones too. While I don't invest in any structured products, I get interviewed about 1-2 times a month for Structured Products Daily. I see what is being created and have a unique insight into the product, which I imagine is why I get frequently interviewed.
Structured products is only one of many new investment products. Don't invest in a new hype driven investment product or investment strategy. Wait a while till the product proves itself to be valid or not. If it is truly a innovation, then you can always invest later.
7) "Buy and Hold" is dead
While many investors have been conditioned for the past 30+ years that buy and hold is the best strategy, it is not necessarily true. Look at the last 18 years.
Since 2000, the stock market has had 2 recessions and 2 booms. Between 2000 and 2012 the S&P 500 had virtually no returns. As an investor you would have lost 13 years of compounding your returns. This also happened in the 1960s and 70s. There was a lot of volatility, but no growth. This happens during periods of time in the markets. There are times when buy and hold works well and there are times when a nimble trading strategy works well. If you want to be successful, you need to know when to hold em' and when to fold em'.
8) Don't Rely on Assumptions
The entire financial system is based on certain assumptions being true. This is dangerous. What if one of these assumptions turns out to be false at some point in the future?
Sure you can take the opinion that it will never happen... Like "real estate always goes up". How did that end up for real estate investors?
Lets take 2 common assumptions and look at what would happen if they were proven false at some point in time. This is an exercise in making sure you reconsider all your assumptions.
The common assumption is that we always have positive inflation and that cash will lose value over time. Virtually everyone in the US is making this assumption. Why? Because we have had constant positive inflation since the 1930s (with 3 small exceptions). Unless you are older than 80, there is a good chance you have never seen negative inflation.
This is the reason for the assumption that inflation is always positive... Unless you live in Japan.
Japan has had a strong streak of negative inflation since 1999. This is showing up in real estate prices, bond prices and more. The Japanese people are not making the assumption that inflation is always positive.
I wrote an article about Japan deflation as while ago. Deflation can be a big problem, but it is a bigger problem if you are making the assumption that inflation is always positive. Considering the global trends that exist today, do you think deflation is possible? It does exist in other countries and it is possible that it could affect the US at some point soon as well. Of course no one knows, but you should not make the assumption that inflation will always be positive.
If you want to think about what this would mean for the US, just read this article about how real estate mortgages affect your wealth with deflation. You cannot make assumptions about facts always being true because they were recently true. This recency bias will get you into trouble as an investor.
The risk-free rate
The other assumption to underpins the global financial system is the risk-free rate. As you can tell from the name, this is the rate of interest that you should get without taking risk... sort of.
Every investment has risks involved. The risks might be extremely small like in the risk-free rate. But they do exist. The problem is that when people make assumptions, they tend to forget that they are just assumptions, not facts.
The 3-month US Treasury Bill is typically used to determine the risk-free rate. I think that most people would agree that this is a good reference for this rate, but what if the US defaulted in its debt? Or what if the 3-month Treasury bill showed a negative return? How would that work with Wall Street's assumptions? My guess is that it would upend the entire financial system.
The point is not that these things will happen (although I do worry about deflation). The point is that if you rely on other people's assumptions without making your own assessment, you may get surprised. The global financial crisis in 2008 is a good example of this. Most people were convinced that real estate would always go up. This was true until it wasn't. That is when the trouble started.
Risk management is not about worrying about every risk. It is about understanding every risk, no matter how improbable, trying to mitigate as many as possible and being comfortable with what is remaining. Don't rely on other people's assumptions or you might miss a risk that could turn into a problem in the future.
9) You don't need to invest in the stock market
This is similar to my earlier point of investing in what you know. There is no rule that says you need to invest in the stock market. It is one source of investments to choose from, but there are many investments to consider which are not located in the stock market. Your local broker won't make any money if you don't invest in the stock market, which is why you won't hear this from him or her. Most likely they will even tell you it is a bad idea without actually knowing anything about the investment. This reminds me of the story of the person who walks into the butcher and asks for advice on healthy foods to eat. Of course the butcher recommends the person buy meat. Are you surprised?
When you are considering investments, you have to be asset agnostic. Consider all investments on their merits and risks. Don't limit yourself to just stocks, bonds and mutual funds.
You could consider physical real estate, tax liens, horses, private company stock, franchises, farmland, domain names, and more. There are virtually an unlimited amount of investments available to you. Invest in what you know inside or outside the stock market.
As a side note, This also applies to your self directed IRA (learn more here)
10) Diversification only works when you are diversified
Diversification is an important part of every investor's portfolio. Many financial advisors rely on this as a staple in their investing strategy. Unfortunately, the traditional method of diversification may not work as intended.
If you think you are diversified, you may be wrong. When was the last time you looked at your holdings. Even if you are diversified across different mutual funds or ETFs, there is a strong likelihood that you are still not diversified.
If you look at 2008 as an example, most assets lost a similar percentage amount. A diversified portfolio should not do this. A diversified portfolio should mitigate this. The intent of a diversified portfolio is that you give up some performance on the upside to mitigate the downside loss when it inevitable occurs. Unfortunately, what actually happened was that when the market was rising investors didn't make as much money due to diversification and when the market dropped they lost the same amount as many other investments because everything became correlated. Here is an article I wrote about it at the time.
Most people found out the hard way that their portfolio is not as diversified as they originally thought. The problem is that our financial system has become so interconnected, that many assets will tend to correlate with each other.
The true culprit is the institutional flow of funds. These large pools of funds push enormous amounts of capital into certain assets. Some of these assets are not large enough to support this amount of money, so the prices rise accordingly. When they pull out the same thing happens to the detriment of the investments.
Take for example timberland. In 2001, I read an article about how it had a correlation to the S&P 500 of -0.01. This is as close to no correlation as I have seen in an asset. Many years later if you looked at the correlation it was much more closely correlated to the S&P 500. So what was an uncorrelated asset became correlated and effectively useless as a portfolio diversification tool.
This is true for many other assets such as managed futures and real estate. As soon as the institutional investors flow into the asset, it tends to correlate the asset much closer to other institutionally held assets.
ETFs have the same problem. If you look at ETFs, they need to provide a strong liquidity. Because of this they tend to invest in the most liquid assets, ignoring less liquid assets that may be more deserving of inclusion to the index. These liquid assets tend to be large cap companies with a big float of shares outstanding.
The GDXJ (small mining stocks) ETF just announced they were receiving too many new assets so they needed to find larger mining stocks to invest in in order to meet the need of investors. So instead of having a small cap mining stock index, it is not becoming a mid-cap mining index. So instead of the underlying assets driving the ETF, the ETF is driving the asset prices. This is a recipe for disaster.
The point of all this is to tell you that you may not be diversified. If you want to make sure you are diversified properly, you may need to look outside the stock market. Whatever your strategy, make sure you understand your investments and how they work together in your portfolio.
I started this piece about my recent award form Investopedia and I unintentionally turned it into an education piece for you. I hope you enjoyed it and learned a little something about investing.
I provide financial planning and investment management services, but what I enjoy most is the ability to make a significant positive impact on the lives of my clients. This is not limited to just financial markets, but also to areas of your life that are meaningful to you. If you are looking to find out more about how you can work with me, contact me here.
About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with alternative investments held in self-directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.
For more information you can visit: Innovative Advisory Group
About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and alternative investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.
Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exculsively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.