Tuesday, July 14, 2015

The Biggest Investing Sin Exposed

One of the biggest sins in investing, is investing money without a clear plan or strategy to accomplish specific goals. This investing sin causes investors to chase unrealistic returns, and to abandon one strategy for the next when things get tough. A common trait of successful investors is identifying their investment objectives, and then devising a plan to accomplish those. The important part after that is patiently sticking to your plan even when things get tough. It is unrealistic to assume that any real strategy can deliver results that are always better than everyone elses, and can also generate consistent profits all the time. Investors who fail to understand this, end up abandoning strategies at their temporarily weak point, and then wasting precious years that could have caused the capital to compound and accomplish their goals.

I believe that in order to be successful in investing, one needs to select a strategy, and stick to it for decades. This allows the power of compounding to do its magic. If you switch investing methods/styles every few years, because you chase what is hot, you are not going to let compounding do the heavy lifting for you. In addition, if you have high portfolio turnover, your compounding will be negatively affected, because you will be paying more in commissions, taxes and fees.

Recently, I have noticed that many investors have embraced one strategy which is sold as the best strategy out there. This strategy is supposed to provide better results than everyone else, and seems easy and cost effective to implement. The supporters of this strategy have real zeal in defending it, and can provide a lot of good arguments why it is perfect for all investors. They even go to recommend it to everyone, as a one size fits all approach, regardless of any understanding behind an individuals risk tolerance, experience, emotional ability to handle stock price fluctuations, knowledge, goals and objectives. The strategy I am referring to is index investing. Some of the arguments are very appealing, even I am sometimes considering whether maybe I am doing it all wrong. My other concern is that people are being told to buy index funds regardless of valuation. Buying securities at inflated prices is a recipe for disaster. Overvaluation in indexes between 1998 – 2000 was one of the reasons why stock markets delivered lackluster performance over the subsequent 15 – 17 years. As I have argued before, if you are a know nothing investor, who has an access to a 401 (k) plan, then over 90% of you should be in the funds in that plan. The important thing is to have a plan, and stick to it. This is one of the points I am arguing for in this article series anyways. I actually believe that long-term results on a diversified portfolio of dividend growth stocks will be close to results of a S&P 500 after 20 - 25 years. So indexing is nothing special - it is just a way for  ordinary know nothing investors to buy a portfolio of assets, and hold for the long run. You might say that dividend investors, who create dividend portfolios that throw off cash every quarter are similar to index investors. But hard-core index investors don't see it this way for whatever reason.

There is a massive influx of money that is chasing index funds. I am curious to see how this plays out. The contrarian in me is concerned any time I learn about a strategy that its participants believe is invincible and bulletproof and better than anything else. This could create poor returns for participants, despite their rosy expectations, particularly when they lack sophistication and experience dealing with the vagaries of Mr Market. When too much money starts chasing a strategy, it ceases to work for a while. When people see easy money, they chase the strategy that produced them in the past, usually to the detriment of that strategy. When expectations change, the long-term returns could still be good 20 – 25 years down the road. However, this is preceded by a long initial period of flat or negative returns. This was the case with the Nifty-Fifty in 1972, as well as Dot-Com stocks in 2000, and Emerging Markets in 2007 – 2008. As a case in point, I have a friend who has never invested in stocks, yet in 2014 he bought his first Vanguard funds. While a person who buys an index fund today and holds for 20 – 25 years would likely do fine, I am concerned about those who will abandon ship at the first time of trouble or at some earlier point in time. It is also possible however that we have a few decades before what I am fearing becomes true.

There are several individuals I have followed, which have become recent converts to index investing. Based on their documented history of chasing hot strategies, and chasing the best strategy, it is yet to be seen whether they will stick to their new strategy or not when things get tough. After all, investing feels safest when a strategy is on a hot streak. When stocks have been going up for 7 years in a row, indexing seems like a no-brainer – you get market returns without really doing any work. When I start getting feedback that I should just abandon all stock picking altogether, and just index, I start asking myself if we are seeing a bubble in indexing that could go terribly wrong. Relying mostly on total returns like indexing is very easy, after stock markets have only gone up for the past 7 years. It is yet to be seen whether, the investor who chases returns and jumps strategies will have the mental fortitude to stick to their plan during the next bear market.

Of course indexing is not a one size fits all approach that will guarantee riches for all of us. Different index investors will have starkly different expected returns, depending on their asset allocations. The index investor who owns 100% US stocks through an index fund will have a different return than the index investor who also has a sizeable allocation to international stocks. Each of those investors will have a starkly different expected return from that of an investor who holds US, International and Fixed Income funds. There is a plethora of index funds, and ETFs, for every sector, country or tilt to choose from. There are value or growth funds, equal weight or market weight, small cap, mid cap or large-cap. In addition, some international index funds have large variability as well, since you have developed, emerging and frontier markets. I would say that the past 7 – 8 years were relatively good for a dividend growth investor who focuses on US dividend growth multinationals. It was better to be a dividend growth investor than an index investor who had allocation to US index funds. It was even better to have a portfolio of dividend growth stocks than a portfolio of US stocks, International stocks and Fixed income over the past 7 – 8 years. However, as we all know, past performance is not an indicator of future returns. Of course, this is also the reason why I am skeptical about some investors who have recently switched to investing – I fear they switched because of recent good past performance of index funds.

My sample of three is not representative at all. These are individuals I have found through my browsing of the internet. If these individuals stick to their new found strategy for the next 20 - 30 years, I believe they will have high odds of succeeding. If they switch strategies however, I would be worried for them.....

Since this article is getting too long, I broke it down to two separate posts. Please stay tuned for part two.

Full Disclosure: None

Relevant Articles:

Why I am a dividend growth investor?
Is international exposure overrated?
The Four Percent Rule is Dependent on Dividend Yields
Dividend income is more stable than capital gains
How to generate income from your nest egg

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