Dare to be Average and You'll Come Out on Top
Investors – particularly young, inexperienced investors – tend to believe that they can “beat the stock market." At one point, I, too, held that belief. Experience taught me otherwise leading me to develop a taste for the average. Let's discuss the concept of "Daring to Be Average."
In my The Amazing Power Of Compounding blog, I mentioned a growing concern about individual investors’ increasing proclivity to trade stock in today’s volatile stock market. Investors – particularly young, inexperienced investors – tend to believe that they can “beat the stock market." At one point, I, too, held that belief. Experience taught me otherwise leading me to develop a taste for the average. Let's discuss the concept of "Daring to Be Average."
I once felt that diversification – a form of loss mitigation – would limit my rewards. And it’s true. Bad picks will limit the reward of good picks. For example, by selecting an index fund, you are acquiring an ownership in its low-performing companies as well as its average and high-performing companies. My original thinking was that although I happened to be a “part-time” investor, I could also be an above-average investor… that I could successfully compete against the pros (Wazoos, I call ‘em). Well, like most amateur and/or part-time investors, I couldn’t. Coming to that realization steered me in the direction of building a portfolio around index funds and accepting the humbling experience of daring to be average. My ego was soon soothed by an increasing number of studies showing that unmanaged index funds routinely outperformed Wazoo-managed funds. And, yes, diversification helps manage risk.
Do Rewards Require Risk?
Risk and reward are most certainly connected. High risk can be rewarded with high returns. But that same measure of risk can also be rewarded with low or no returns. An undiversified portfolio combined with good luck can achieve amazing returns… but with bad luck (and luck is part of the investment game) it can be a devastating experience. On the other hand, a diversified portfolio combined with good luck can achieve those same amazing results… but with bad luck, a devastating result can be somewhat mitigated through diversification. In short, not all risk is rewarded, but a stretch of bad luck can be mitigated by proper diversification.
The Amazing Power of Compounding is a function of time and yield. But the time factor deserves some amplification. There’s a common perception that the risk of stock ownership declines as the investment horizon increases. I don’t agree. Holding a stock for a long time doesn’t reduce or eliminate its risk. Nor does holding a diversified portfolio for a long period eliminate the risk factor. In the latter case, the risk is simply mitigated because of diversification… not eliminated.
I utilize dollar-cost averaging in investing because it offers the risk-reduction benefit of investing over time. It involves investing the same amount of money on the same day each week or date each month… in for example, a Total Stock Market Index or S&P 500 Index Fund. Dollar-cost averaging over a period of time theoretically lowers the risk associated with lump-sum investing.
But note that I said, “over a period of time”. Once a period of time ends, normal investment risk reappears. To genuinely enjoy the fruitful “risk-reduction” of dollar-cost averaging, it must continue long-term. The only real benefit of “short-term” dollar-cost averaging is avoiding disappointment… an emotion decision-makers feel when they realize, after the fact, that another choice would have been more profitable (i.e., taking a big loss on a lump-sum investment versus a smaller loss by dollar-cost averaging over time).
Rolls Royce v. Chevy
When I (often) speak of my PDQ Principles, I am obviously inferring that, along with Patience and Diversification, it is important to invest in high Quality companies. That’s common advice, but is it necessarily good advice? It depends on a couple of questions we must ask ourselves when making important buying decisions. Without question, at fixed points in time, some companies are of higher quality than others. But are those “really good” companies worth the difference in price over "less good" companies? A Rolls Royce is a better car than a Chevy, but is it that much better? Is the investment in stocks of great companies better than in companies that are not so great? This is when valuation becomes important.
Value is Relative
During the buying process, it is especially important to consider the price of stocks relative to their value. Seven years ago, Exxon Mobil was the world’s most valuable company. Last Friday, Tesla, a company struggling for profitability, was valued by investors at $390 billion, twice a very profitable Exxon’s current market value of $165 billion. And Apple computer lost $180 billion in value that same day… more than Exxon’s total current valuation. By the way, if you’re lamenting last Friday’s losses in the stock market, the Omaha Sage, Warren Buffett, lost $19 billion on his position in Apple alone. That’s why I stick with mutual funds – in large part, index funds – and dare to be average.
Ditch Day Trading
Each investor has his or her own agenda and risk tolerance. Some become speculative day traders, where today’s gains can be quickly eroded by tomorrow’s losses. That was my experience, finally prompting me to ask, “Why gain 25-30% this month and lose most if not all of it next month?” More conservative, long-term investment practices might not deliver those occasional sensational results, but a highly diversified, buy and hold approach is a powerful form of risk mitigation that appeals to the dare to be average crowd. Yes, there are those with the proper tools and skills to be extraordinarily successful at day trading, but it’s a stressful approach with little appeal to me.