I have been investing, speculating, and day trading in the stock market since the year 2000. Over the years I have made so many mistakes and repeated them over and over until I learned not to do them anymore. Finally this year, 2015, I have decided to become a buy-and-hold investor. My new philosophy is: set it and forget it. Well, actually I don’t forget, I just continue adding stocks with the objective of holding them over long periods of time.
What are some of the lessons I have learned?
Every investor has a risk tolerance and an investment objective. I have mine and everybody else have theirs.
A friend of mine wanted some exposure to the stock market and she asked me for my opinion to invest $1,000. I suggested to buy a Canadian index fund which represents the 60 biggest companies in Canada. Not too long after her purchase, the index went down a few percentage points. She felt uncomfortable with the volatility of the market and she sold. Obviously she had low risk tolerance and my suggestion was not well suited for her.
- Diversification is a free lunch
- Index funds are better than actively managed funds
- Stocks are better than bonds
- Small stocks are better than large stocks.
- Diversification is a free lunch. As an individual investor I only had the resources to buy a handful of stock, I felt that I was diversified but I was not and my returns were erratic. In contrast, when I started purchasing ETFs composed of thousand of stocks my returns were more stable. If my cost is the same, whether I buy one stock or an ETF composed of thousand of stocks, I am getting a free lunch by diversifying. I get stable returns without paying anything extra for it.
- Index funds are better than actively managed funds. Here is a sobering reality: 86% of actively managed funds do not beat the index. If your goal is to maximize returns, you will do better by investing in index funds than by investing in actively managed funds. How’s that? Well, running an actively managed fund is expensive: there are marketing fees, research fees, compliance fees, tax expenses, and salary expenses. All those expenses can add up to about 2% of the assets. On the other hand index funds’ strategy is to buy-and-hold. The funds are run by computers. There are no marketing fees, no research fees and there are minimal salary and tax expenses. The total cost of running an index fund is about 0.1%. It is this remarkable difference in cost which gives the upper hand to index funds.
- Stocks are better than bonds. Historically, stocks have always outperformed bonds. As an example, the average return for the past 10 years for the stock market has been about 8.1% while the average return for bonds has been about 4.6%. Here is my question: If a person’s objective is to maximize returns, why would they bother with bonds? Yes, bonds reduce short term volatility, but if our investment horizon is longer than 5 years, the benefits of decreased volatility are minimal and the opportunity cost of not being in stocks is significant.
- Small stocks are better than large stocks. Since 1926, the average return for small stocks has been about 2% higher than for large stocks. The drawback is that small stocks are more volatile. That means that your losses would be higher in those years in which the stock market is negative. If you can stomach the increased volatility an extra 2% of gains could represent the difference between accumulating a nest egg or a really big nest egg.
Investment is a statistics game. You want to stack the odds in your favor. Past performance is no guarantee of future returns, but if history serves us following these principles will increase your probabilities of winning.