A Reader’s Question on Advice for a New Investor

Insantity Defense

A Reader’s Question:

Dear John: I have a friend who wants to know what to do with his money. I know Charlie Munger suggests investing in cheap index funds for a “no-nothing” investor. But aren’t there problems with indexes? What do you think?

Well, especially now when most bonds (especially government bonds) seem high risk for no-or-low return, the first question would be what should that person allocate towards equities.

I am working on my answer, but thought YOU have advice for this reader.

The links here:

all provide a case for equity investing.  However, when you hear that historically the stock market has returned 8.6% or 9% for the past 200 years, it is a little like saying the average height of the person in this room is five foot five inches tall. The room has a pro basketball player standing tall at 7.5 feet and a dwarf in the corner at 3.5 feet–the average is 5.5 feet.  People are still seared by this experience in 2007-2009.

I will post my response tomorrow.

 

13 responses to “A Reader’s Question on Advice for a New Investor

  1. Oh boy, an opportunity to give people advice I don’t do a good job of following myself!!

    Alright, I talk about this a lot with people of all shapes and sizes. Here’s what I always say:

    First of all, think about whether there is anything local and/or within your existing sphere of competence/expertise you could make a small, med or large investment in. A lot of people look at “investing” as being synonymous with the stock (and bond) market. But they can invest in rental properties, they can start a small business or side business or help finance a friend, relative or associate’s business as well. Too many people jump straight to the broad economy and miss potential opportunities to invest in their own communities, so to speak.

    Second, they should think about how committed they are to investing in the first place. A good litmus test is… are they willing to read a basic primer like The Intelligent Investor? If the answer is no, they really should consider whether even index investing is right for them, because a person who is so disinterested in taking it seriously that they don’t even read one book is probably a person who won’t have the emotional discipline to whether the volatility of the stock market once they put their money in.

    Third, once they read The Intelligent Investor or do some studying, then they still need to evaluate themselves. Maybe they’ll realize “I can’t handle this” in which case they shouldn’t invest!! That will save them A LOT of money in the long run. But maybe they’ll conclude, I can stomach it, but I don’t have time. Then they should start looking for a friend or relative, or competent professional, to help manage their money.

    Otherwise, if they decide they can handle it, they do have time and they do love learning, they can devote significant free time to managing their own small portfolio.

    • Thanks. I think for most of the public, you would be too ambitious in your advice. They have a full-time job and they don’t want to spend alot of time thinking or worrying about their investments. That is why an index fund may be the least bad choice for many.

  2. I’ve been getting this question quite a bit lately – I feel like people have had some time now to repair their finances, see their retirement accounts move back up, etc. and so things seem “good.” This position of confidence might be driving people to think that they’re in a position to invest. I would probably ask them what they did when the Dow shrunk to 66xx in May of 09. Were they investing then?

    If not, there are a few things I recommend:
    1. Setup a more than generous fund for anything unforeseen events. I suggest $20k as a general amount, however those with higher monthly expenses should maybe save even more.

    2. They should think about how they will feel if they invest now and the markets have trouble and shrink in price.

    The time to be investing is when times are tough. That $20k buffer will help keep most people at ease, because if they get laid off, between that buffer and unemployment insurance, they’ll probably be fine for a while. (Again, adjust for the situation… families may need to save more)

    The time to redeem your investments is going to be during good times, not bad. If they have any doubts about being able to withstand financial trouble, then don’t invest. And lean to the side of conservatism when in doubt. There is no proper calculator for “conservative.” Rather, they should take a look at how they did during the last crisis and/or their friends and family.

    I think that a part of the reason why firms with such durable moats like Coca Cola’s distribution are so attractive is that when prices fall, you can confidently buy if you’ve put yourself in a financial position to do so where you don’t need to sell off assets just to pay your electric bill. Because most people don’t have the time/interest/etc. to do this, the thing we can focus on is their mental confidence in the markets. The cheaper the index, the better – make them carry enough liquidity that they have cash to withstand market events and enough that they can actually invest when things are going crazy.

    In summary – there’s no hard rule or calculator I can point them to. It’s probably more about temperament than anything, because most of the mistakes will be made by emotion, pressure, short term troubles, etc. than a bad indexed investment in the broad overall economy.

  3. I think your advice is sound, but like all good advice it must be followed consistently. Thanks for posting.

  4. In my humble opinion, one of the basic questions to start with is ‘where is your panic button’. That will define part of your investment style.

    With regard to the public: I’m the last person to underestimate the crowd or people in general. But bear in mind that creating an edge in investing will take years…and can be as hard as becoming top 100 in a sport for example. To draw the comparison with sports – because of a background in sports I do know how hard top athletes work at both fun and less fun stuff. It requires tons of discipline to be in the gym for 3 hours each day and not doing your sport but just training your body (speed, prevention, balance, etc.). The same goes for investing.

    So without giving a complete answer I believe people should already start with asking some basic questions/remarks:
    – what is your panic button?
    – what are you goals?
    – do realize that 90% of the money management industry is marketing
    – do realize that you will double your money every 10 years by having 7% a year
    – …

    Don’t trying to give a definitive answer here…

  5. I would first talk with the person and establish goals, risk tolerance, and time horizon. That’s a long talk in and of itself, but well worth it to having them thinking realistically about those things to help frame what type of investment they should make, if any at all.

    In a general sense, someone with average risk tolerance and a time horizon of five or more years, I would suggest them to either open a managed account with Formula Trading (Joel Greenblatt’s Magic Formula operation) or invest in one of Greenblatt’s Value Indexes. In his book “the Big secret for the small Investor” Greenblatt examines the flaws in typical Indexes, ie, most heavily weighting most expensive stocks, or by market cap, and assembles his own index based on Magic Formula valuation principles. The Index then re-adjusts to allocate more to stocks that are cheaper by his Magic Formula metrics rather than just pile on to whomever’s market cap is increasing.

    His Value Index, according to back testing, would give superior returns, with reasonable (at least how I see it) volatility. I’d have the investor dollar cost average into it, using money that the investor could afford to have invested for at least 5 years, hopefully longer.

    This would achieve a couple of things:
    1. solid returns over a long period
    2. a nice blended cost basis
    3. investment access to one of the greatest contemporary value minds around.

    The key would being able to convince the investor to stick with the strategy. Investing inside of an IRA or other tax advantaged plan with penalties for early withdrawal would be helpful in achieving that.

    • Risk tolerance is a very interesting thing to think about – I think The Most Important Thing by Howard Marks is the best set of descriptions I’ve heard yet.

      Stocks and bonds have often been the 2 extremes that have been historically compared. Those with less risk tolerance should go to bonds, and those with more should go to stocks. The thing is though – this is something that changes over time and based on price. At too high of a price, even stocks in the best companies are very risky. At too low of a price, even Enron’s bonds after the fraudulent accounting came to light was the least risky investment around. (Buffett bought those bonds at 10 cents on the dollar and recovered @ 40 cents on the dollar) Oh, and the day we experience unexpected inflation, long duration bonds may no longer seem that attractive even though they were once angels in our portfolios.

      I think choosing an investment manager is a very tough thing to do, because it involves a lot of trust. You have to know that they’re managing these risks and reward situations for you. Your own definition of risk tolerance may not be adequate for the thing that happen once every 30 years, because you really have to spend your career focusing on it to handle those situations well.

      I know that 99% of Wall St will follow the approach I am not the biggest fan of, and the way I justify it is that it’s better than not saving at all. If these potentially flawed methods actually get people to save for retirement, that’s far better than having spent all of it and not prepared for the future at all. It’s better than nothing, but still not the ideal situation.

    • HEY YOMAHA: You’re are “stealingt” my reply. Exactly my thoughts. I was going to summarize Greenblatt’s book, The Big Secret for the Small Investor, but you beat me to the punch. The keys are doing it and sticking with it, especially during ugly bear markets. .

  6. I would recommend reading “Quantitative Value” which argues that there are some flaws with the Magic Formula (mainly that it overpays for quality and that low price is more predictive of future returns). That said, I agree that consistency is important.

    I also agree that if you don’t have the time to dedicate to managing your own money due to work and family (which is something I struggle with. My wife thinks i am crazy when I spend all day Saturday holed up in my office reading this stuff) then finding a low cost fund is the next best option. It also frees up time to do other things that you may enjoy. But what can be more fund that slugging through a 10k?

    Here are what some experts say:

    http://finance.fortune.cnn.com/2013/01/24/buffett-hedge-fund-bet/

    http://www.bloomberg.com/news/2013-01-25/soros-says-hedge-funds-can-t-beat-market-because-of-fees.html

    I think our most valuable commodity is the time we spend here, and you should spend it doing what you enjoy doing. If that is investing, then go for it. If not, spend below your means, put your money in low cost funds, and spend your time doing what you brings you the most happiness.

  7. The hapiness element is idd important. Also remember the studies of dalbar which prove individual accounts just keep underperforming the market and mutual funds. I also see it over and over again that people keep underestimating their panic button..people are driven by their emotions and one of the most important things is to get these emotions under control.

    • Good point. Know thyself. Not easy when you start out. I always thought a good business would be, “Terror Dates.” Say you are going out on your first or second date and really want to know how your potential loved one would act under pressure and extreme stress. Hire my firm to stage a robbery or kidnapping with a good ending. You would prevent many bad marriages. You truly would have insight into the person’s character.

      Should I go IPO or private equity to get funding?

  8. 🙂 Well maybe you can help some people with ‘terror investment’. People can hire you to test their emotions, by for example letting their account decline overnight by 30%.

    See how they react
    Maybe give 50% of their portfolio in their hands…see what they do.
    Look at the frequency they check the portfolio afterwards

    Would be a nice experiment:)

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