With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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According to a recent article in CNN Money, only if you attempt to sort out the handful of winners from the rest of the market.

As the article points out, the majority of indi­vidual securities tend to post negative returns over the long run.

In fact, research by Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were respon­sible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database.

As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses of around 2% over the past 29 years.

So what can you do?

According to the article, diversify as broadly as you can. With a small list of stocks, it’s easy to miss out entirely on the top 10% performers. Doing so would have cut your annual returns to 6.6% from 10.4% over the past 29 years.

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“Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.” –Jesse Livermore

Jesse Livermore is a famous early 20^th century trader and speculator who was immortalized in the 1923 book, Reminiscences of a Stock Operator by Edwin Lefevre.

Many consider Livermore one of the greatest traders and speculators who ever lived.

Now, we’re not mentioning Livermore because we think aggressively trading and speculating in your account is the way to go. Instead, we want to highlight the above quote from Livermore and discuss its relevance to today.

“Wall Street never changes.”

From the standpoint that Wall Street is all about making money, that statement is true. It was as true in “The Roaring 20s” during Livermore’s lifetime as it was during the internet bubble of the late 1990s.

“The pockets change, the suckers change, the stocks change.”

Wow, that statement is spot on.

Wall Street continues to come out with new products that they think the public will buy even if they make little economic sense. Do you remember all those shaky limited partnerships from the 1980s? How about the dot-com IPOs of companies that had little revenue and no profits? And more recently, we had newfangled mortgages that let you buy a house with no money down or skip payments or just pay the interest only, among other options.

“But Wall Street never changes, because human nature never changes.”

This is the key quote.

In particular, as humans, our emotions have a tendency to get the best of us. In good times, we tend to get greedy and make decisions that under normal circumstances would be too risky for us.

In scary times, we tend to panic and “get out at all costs.” We like to keep up with our neighbors so we behave in a herd-like fashion. We extrapolate the most recent trends and expect that they will continue indefinitely. All these tendencies have the ability to work against us and preclude us from reaching financial security.

The “smart” people on Wall Street understand our human frailties and, unfortunately, some of them use it to their advantage. Don’t allow this to happen to you. Work with an advisor you trust.

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In a battle of the sexes, finance professors Brad Barber and Terrance Odean crunched the trading data on over 35,000 households from a large discount brokerage firm.

They built upon psychological research, which indicates that in the area of finance, men tend to be more overconfident than women. Additional research shows that overconfident investors tend to trade more often than less confident investors.

Armed with this data, Barber and Odean went to work.

They hypothesized that men traded more frequently than women and that this excessive trading hurt their performance more than it hurt the performance of women.

Here’s what they found in a 2001 study published in The Quarterly Journal of Economics:

1. Men overall traded stocks 45% more frequently than women.
2. Single men traded stocks 67% more frequently than single women.
3. Women overall earned annual risk-adjusted returns that were 1.0% greater than men.
4. Single women earned annual risk-adjusted returns that were 1.4% greater than single men.

So yes, based on this study, women are more successful investors than men because they earn a higher annual return.

An interesting sub-point from the study is the out-performance by women was solely due to their lower trading frequency. Women were no better than men at security selection; instead, their advantage came from making fewer trades.

Let the bragging begin!

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Would you agree that the stock market has been volatile in the last six months?

As you may have guessed, that’s a bit of a trick question. Most people would say that, yes, the stock market has been very volatile since early November 2008.

For example, just from November 7, 2008 to November 20, 2008, the S&P 500 index dropped 19%. It then rallied 24% by January 6, 2009.

But, that was just a tease. Between January 6 and March 9, the S&P 500 index dropped a frightful 28%.

And, just when people thought the financial system was coming to an end, the index turned around and proceeded to rise a whopping 37% from the March 9 low to last Friday.

It’s enough to make your head spin.

But, let’s assume for a moment that you went into hibernation for the past six months and slept right through this volatility. Would you wake up happy or sad about your portfolio?

Well, if your portfolio performed similar to the S&P 500 index, then you’d wake up essentially the same as you went to bed, meaning, there was no net change in your portfolio. Surprisingly, from November 7, 2008 to May 8, 2009, the S&P 500 index moved less than 1%.

That’s right, after netting the 19% drop, the 24% gain, the 28% drop, and the 37% gain, the index is essentially flat.

One of the keys to being a successful investor is to get neither too depressed when the market is down nor too euphoric when the market is up. Checking your portfolio on a daily basis can lead to a daily dizzy spell while checking it on a less frequent basis may help keep you on an even keel.

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“Whoever manages my money better beat the S&P 500! What’s your strategy? What’s your performance? Jim Cramer says buy Lehman Brothers. What do you think of Lehman Brothers? Should I buy gold? ”

A prospective client asked these questions during a meeting last year. When I attempted to discuss goals, he directly focused on investments and described the classic investors mistakes he made over the last decade including:

• Buying technology and growth stocks in 1999 and holding to the end of 2002 realizing a huge loss.
• Buying bonds in 2003, just in time for the bond market to decline. (Yes, bonds can and do decline.)
• Buying a property to fix up and flip in 2006. Still holds the property at a loss and cannot sell as the mortgage is higher than the home’s value.

He planned to retire in a few years and wanted advice but didn’t want to talk about goals. He only wanted to focus on investments and strategy.

After a decade of making mistakes, this investor is still looking for the secret to maximize investment returns. But the reality is this: The more you search for investing secrets, the worse your returns will be!

Now, suppose in 1999 he:

• Identified his goals
• Designed a plan with a real financial planner focused on these goals
• Understood the portfolio was a tool, a means to an end.

First, a financial planner would have helped avoid the classic investor mistakes he made.

Second, a financial planner would have designed a diversified portfolio based on his goals. A portfolio designed with an end in mind!

Last, a financial planner would continually monitor the plan, adjusting goals and/or the portfolio allocation based on the plan. In other words, benchmarking the portfolio against the plan, not an arbitrary index.

The time has come to stop searching for the next “hot” investment or guru who can provide market beating returns.

It’s time to define life goals and design a plan with a financial planner toward achieving these goals.

It’s time to meet with a financial planner on a regular basis to benchmark your portfolio against the plan and adjust as required.

It’s time to understand a portfolio is not the end. A portfolio is a means to an end.

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Risk and uncertainty are two different things and distinguishing between the two may help you be a better investor.

We can think of risk as a random outcome that has a known probability distribution while uncertainty has a random outcome with an unknowable probability distribution, according to economist Frank Knight.

For example, playing blackjack is risky because the outcome on any single hand is random, but it still has a known probability distribution. Conversely, dropping a bomb on North Korea would create uncertainty because we have no way of applying a probability distribution to the outcome of that action.

Investing appears to contain aspects of both risk and uncertainty.

From a risk standpoint, we have many decades of historical performance and statisticians can easily develop all kinds of probability distributions for expected returns and standard deviations.

From an uncertainty standpoint, we have days like October 19, 1987, when the Dow Jones Industrial Average dropped 22.6%. That record drop was effectively outside the practical bound of any probability distribution.

Okay, so what are you supposed to do with the knowledge that investing contains elements of risk and uncertainty?

Here are two thoughts.

• First, don’t be overconfident. While you may take some comfort that historical probability distributions can show you what to expect in the future, don’t get too confident in that idea. Past performance is no indicator of future results because we have the uncertainty of unexpected events like the October 1987 crash or even the current bear market.
• Second, like playing poker, use the odds to your advantage. The market is down about 50% from its all-time high. As long as you believe we’re not at the end of the world, then one could argue that the market is a lot cheaper today than it was in October 2007. So, your odds of making a profit from today’s market level may be greater than they were back then.

With the right understanding, we may be able to turn risk and uncertainty into allies instead of enemies.

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A recent article in The New York Times announced that sound investment strategies might have run their course.

It warned investors it could take as long as 20 years for stocks to regain their losses. As evidence to back up this rather large assertion, the article mentions from 1966 through 1982 — a full 16 years — stocks returned almost nothing.

And it’s true – that fact, without the key addition of any perspective or back story, is enough to scare anyone away from ever investing in stocks again.

Looking back over that 16-year period, we see the S&P 500 closed at 94.06 on February 9, 1966.

On August 12, 1982 – 16 years later — the S&P 500 closed at 102.42, barely above the February closing of 1966.

It’s easy to see, then, that stocks can do nothing over long periods of time. This leads many to believe the current market can, and probably will be as “bad” as this ’66 — ’82 period.

Of course, there is one major flaw in that assumption.

Why do dividends matter?

The article discloses the figures provided are a “price-basis” only. So what exactly does this mean? It’s simple: they don’t include dividends.

And dividends have a major impact on total return.

For instance, if you bought the S&P 500 in February 1966, and held for 16 years through to the end of August 1982 — and reinvested your dividends along the way — your annualized return would have been 5.80%.

Not as bad as the article makes it seem, right?

How important is diversification?

What if you, as a prudent investor…

• Diversified your portfolio* by putting 30% into Treasury Notes
• Divided the rest between large and small U.S. stocks
• Rebalanced the portfolio annually
• Reinvested all dividends and interest during the same period

The results? Your annualized return would have been 8.40%.

That’s certainly not what I’d call “doing nothing” over a 16-year period!

I’ll give the article some credit for encouraging investors to diversify, especially through the use of U.S. Treasury Bonds. While this is good advice, it is old news to prudent investors who always hold and rebalance a fully diversified portfolio.

Sound investment strategies will never run their course.

* Portfolio – 02/1966 to 08/1982. Rebalanced annually. Components: Dimensional US Adjusted Market 2 Index: 70% Five-Year US Treasury Notes: 30% The S&P Data are provided by Standard & Poor’s Index Services Group January 1926-December 1989: S&P 500 Index Ibbotson data courtesy of © Stocks, Bonds, Bills and Inflation Yearbook^TM, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex Sinquefield).

Investors can not invest directly into an index.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.

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In investing, it’s natural to seek out clues that we’ve made the right choices, right off the bat.

We check the prices of our investments every few minutes, though they’ve barely had time to move in any direction. And, if we find, by some chance, that the price has gone down, we start asking questions right away:

• Should I have bought that stock?
• Did I buy the right fund?
• Is this portfolio manager my best choice?

Unfortunately, these questions don’t address the most important aspects of effective investing. What we should be asking is if our portfolio is properly aligned toward our overall, long-term goals.

Granted, the financial services industry, along with the financial media, is happy to oblige your thirst for instant feedback.

With a few clicks of your mouse, you can learn how the value of your portfolio has changed over increments as tiny — and ultimately irrelevant — as ten minutes.

You could check out five different analysts’ opinions of what your stock will do this morning – and then get the word from six more telling you what the market will do next week. You can find seven different ratings on the mutual fund manager of your fund of choice.

And if you’re tech-savvy, you can set your BlackBerry to scroll price updates on all your portfolio positions all day long — so you’re always up to the minute on “how much you have.”

Is this flood of financial information really telling me anything?

The reality is that none of this intensive monitoring indicates to us whether or not we’ve made the right choices, in terms of our long-term investment goals. If anything, all the rapid input can be a distraction, and can lead to serious investing mistakes.

The temptation is natural: you know that you’re investing towards financial goals that span decades, but you find yourself seeking positive reinforcement five minutes after you’ve put your money in!

Still, if you’re doing anything beyond reviewing your quarterly statements, there’s a significant likelihood that that the feedback you’re receiving will lead to poor investment choices.

The proper way to decide if you’ve made solid decisions is to focus on portfolio analytics — not individual positions.

Ask yourself…

1. How do portfolio positions correlate with each other? In other words, when one positions “zigs”  – does another one “zag”?
2. What is the impact of each position on the volatility of the total portfolio? Will adding one increase the volatility of your portfolio, while keeping the same return? Or can you increase your returns while reducing the volatility?
3. How tax-efficient is the portfolio? What are the total expenses?
4. Is the portfolio thoroughly optimized to harness the most risk-adjusted return?

Of course, the answers to these questions are much less readily available than the kind of noise the financial outlets provide us with – and that’s where problems start.

The current (and temporary) bear market encourages buzz from “doom and gloom” sellers, and creates a focus on loss of wealth. The irony is — even with all the debate about market dilemmas – wealth loss occurs mostly as the result of investor behavior.

This might seem like an oversimplification. However, given a long-term perspective, the markets have historically risen. So if markets are rising, how else could people be losing wealth?

That’s right – they’re making bad decisions based on insufficient data.

Your success as a resilient investor depends mainly on your behavior and the structure of your portfolio, not on moves based on short-term feedback — or worse yet, what shows up on the cover of Money Magazine!

photo credit: epicharmus

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“History does not repeat itself exactly, but behavior does,” according to legendary Wall Street veteran Bob Farrell

The economy is going through a recession, as it does periodically — but this recession is different from the last few our nation has experienced. Some economists have likened it to The Great Depression — not so much in terms of magnitude, but rather its structural characteristics.

It’s nothing short of dangerous to use the excuse that “this time is different,” to justify an investment stance that makes a dramatic break from established historical perspectives (e.g., buying tech stocks in late 1999).

Does history repeat itself?

But it’s often quite true: usually something is different every time we see an unusual market event.

And it’s that ability to discern a truly unique market phenomenon from an excuse for bad decision-making that separates good investors from great investors.

While we can’t count on history repeating itself exactly, as Farrell says, we can at least count on investor behavior remaining the same. We’re only human, after all.

This is why we see investors make the same emotion-based mistakes during this bear market as they did in bear markets previous.

How do I take the emotion out of my investment choices?

Resilient investors overcome the tendency to plan investments emotionally, rather than logically.

The key is to be aware that your emotions will, at times, block your ability to make reasoned, rational decisions. With this new awareness, you can slow down your decision-making processes until you separate the “good” investing information from the “bad.”

With a little extra time and thought – and less “emotion” — you will create a solid investment portfolio that stands the test of time.
photo credit: milena mihaylova

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