Blog #26 Quiz Time!

In my previous blog, I shared four basic rules of investing. I’m not done with this topic yet. But before pressing on, it’s good to pause and reflect on the rationale for these rules and the key takeaways. In that spirit, please take some time to answer true or false to the following questions (answers are provided below).

Questions (true or false)

Rule #1 Don’t lose money. Therefore, hold most of your money in cash instead of riskier assets.

Rule #2 Invest to beat the market index

Rule #3 Buy the right stocks at the right time.

Rule #4  Monitor your investment frequently (e.g., weekly)

 

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Answers

Rule #1 Don’t lose money. Therefore, hold most of your money in cash instead of riskier assets.

False. The idea that cash is a safe asset is an illusion. Over the long-term, cash can lose a big chunk of its purchasing power due to inflation. For example, if cash has a fixed return of 1% a year and inflation is a constant 2% a year, $100 buys less than $91 worth of things in 10 years. It buys even less ($82) in 20 years. To get ahead of inflation, you need to invest in higher return (higher risk) assets such as stocks and property.

Rule #1 is not about avoiding risk by hiding in cash. It’s about overcoming behavioral biases that leads you to lose money when investment should be something that is rewarding. As mentioned in my previous blog, these biases include being overconfident of beating the market, under-diversification, chasing trends, chasing overpriced volatile stocks and trading excessively.

Rule #2 Invest to beat the market index

False. The idea that one must invest to outperform an index is wrong at so many levels.
First, index investing isn’t not bad at all, so, it is unclear why there is a need to beat the index.

Second, it’s hard to consistently beat the index even if you want to. We know this from the investment record of mutual fund managers, most of whom are not beating the index. Rather, the index is beating them. Not convinced?  Check this website.

Third, isn’t the goal of investing to grow wealth? If so, you need an investment process.  That process begins by defining an investment goal that is clear and reasonable. Your goal should be clear in the sense that you know what you want the money for (e.g., to finance junior’s university education when he reaches 20 or to fund you and your spouse’s retirement). It should be reasonable in it allows sufficient time for your investment to realize your goal. For stocks, a rule of thumb is that your holding period should be at least 10 years to earn the equity premium, which is the average excess return that stocks provide over those of cash and bonds.

Rule #3 Buy the right stocks at the right time.

False. As said earlier, stock picking and market timing are easier said than done. That is why mutual fund managers struggle to show superior returns and also why there is increasing interest in passive investing through ETFs.

Once you have defined your investment goal, the next step is to develop a strategic asset allocation plan that emphasizes “time in the market” rather than efforts to “time the market”. The latter is futile and harzardous to your wealth. The former requires no attempt to actively pick stocks or divine the market. Instead, it emphasizes holding a diversified portfolio that comprises different asset types (cash, bonds and stocks for example), and a buy-hold-rebalance strategy with a long-term focus. An example is a glide path asset allocation plan illustrated in my previous blog and repeated below:

Image result for life cycle asset allocation

 

Rule #4  Monitor your investment frequently (e.g., weekly)

False. When you invest in something, the odds are in your favor. When you gamble, the odds are against you. Frequent checking of stock prices fosters a lottery mindset. There are two main reasons why this so. First, you want to have a shot at hitting the jackpot in the shortest possible time. That is why you are frequently checking prices. Second, you are loss-averse.

To a loss-averse person, a dollar lost feels more painful than the pleasure of a dollar gained. Behavioral finance research shows that most people are indeed loss averse. Loss aversion leads to myopic investment behavior and a lottery mindset. If you are loss-averse, you will be quick to take profits on winners (in case the profit turn into a loss) but you will hang on to losers, rationalizing that “if I don’t sell, its only paper loss”. Once your losers recover and turns in a profit, your profit-taking instinct will kick in again!.

You can see where this leads to. A loss averse person will view investment as a short-term gamble. Checking stock prices frequently reinforces this attitude because you will encounter more instances of gains and losses

Rule #4 doesn’t imply that you should not review your portfolio at all. In fact, my previous blog recommends a life-cycle investment approach where the asset allocation should change gradually over time as shown in the glide path above. Other valid reasons for changing the asset are (a) when you revise the return forecasts for the asset classes in your portfolio and (b) you revise your investment goals. For example, if you up-size your wealth target, you may need to save more or take more risk by the allocation to stocks. Clearly, these changes are of a different nature from the obsession to check stock prices daily or weekly!

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