Silver certificate

Education of an investor

I worked throughout high school and through much of college as I was paying my own way. So, I didn’t have any “real money” or experience investing (as an individual) until a few years after graduation when I received my first year-end bonus in the summer of 2007.

Markets are efficient, right? And they have positive expected returns, right? That’s what I learned as a finance major and while studying for the CFA exams. So, I went “all in” with my bonus in late 2007. And then I watched my life savings get cut in half over the next 18 months (the S&P declined 50%+ late 2007-March 2009). That was my first investing lesson.

Here are a few other lessons I’ve learned as an individual investor:

1) Markets may not be 100% efficient but they are still smarter than most.

Markets aren’t 100% efficient (see Japan in the late 1980’s, U.S. technology and telecom in the late 1990’s, housing in the early-to-mid 2000’s). But that doesn’t mean the market can be beaten by most people, especially net of fees and taxes. And securities – within an asset class – tend to be efficiently priced relative to each other. Differentiated insight is rare.

Beating the market is challenging for those that spend 100% of their time investing. I know a few that do and they are pretty talented. What chance does the casual investor have?

2) Markets spend little time at fair value (and even less time cheap the last ~25 years).

Asset prices move from expensive to cheap and back again and spend frustratingly little time at “fair value.” Bob Shiller (the Nobel laureate) did the seminal work on this, demonstrating that discounted dividends are fairly stable (clairvoyant fair value), but the market’s valuation of those future cash flows tends to fluctuate widely over time.

And, for reasons that are not well understood, the markets valuation of earnings has been higher, on average, since the late 1990’s vs. history. Is that permanent? Temporary?

3) Few active funds outperform and they take rare insight to identify in advance.

We all know the disclaimer “Past performance is no guarantee of future results.” That’s 100% true. Yes, some active funds will outperform for several years at a time (many by chance). But that historical outperformance rarely continues – in fact, since investors chase performance, those funds tend to accumulate assets right before they underperform.

Plus, active management is expensive – both the direct costs (management fees and taxes) and indirect costs. A fund must generate 1-2% of alpha just to match the market.

4) Investment management is a for-profit business. And “clients” are the profit center.

With one notable exception (Vanguard), investment management is in the business of making money for themselves. They want to sell us their high-margin products (more money for them, less money for us). And, if you have a lot of money, this is even more true.

A discount broker I use, for example, makes half its revenue from the interest spread on investors’ cash. Is it any surprise their model portfolios include large allocations to cash?

They also understand our foibles – the seduction of narratives, how we chase past performance – and they use it to their advantage. They showcase “hot” and “trendy” funds and they offer us esoteric and expensive products, knowing we won’t be able to resist.

5) Market timing is impossible (and also less important for the periodic investor).

I’ve been right on this once (we all get lucky once in a while). But I’ve still sworn off it. I’ve learned the hard way that doing this with any consistency is pretty close to impossible.

I may tilt to cheaper geographies and asset classes, but I plan to stay invested. I have 20+ years of investing ahead of me so will be able to average into the market over a long period.

6) We are all fallible humans and subject to biases (anchoring, hindsight bias, etc.).

For years, I mostly believed biases were things that applied to other people (but not me). I’ve focused on “getting back to even” and misremember the past (I “knew it all along”). Hindsight bias is particularly pernicious as it makes it harder to learn from past mistakes.

7) We should keep it simple and focus on getting the big decisions right.

We all suffer from these biases (even if we don’t know it). To paraphrase Nassim Taleb, there are two types of people: those that know they have biases and those that don’t know.

My first “policy portfolio” had 11 different funds. I’d carefully thought about my target allocation to the first decimal. All that complexity, though, made my portfolio harder to manage. And life got in the way (well, at least work did). Now I have a simpler portfolio and focus on getting a few big decisions roughly right and sticking with it year after year.

I didn’t figure all of this out right away. I’ve picked up some credentials along the way but have also learned from my own experiences, following a few thoughtful people, and reading on psychology, history, etc. My recommended reading list for individual investors.

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