Attention, Earthlings! My name is Curiosity. I am a land rover that NASA recently sent to Mars to explore this planet. I will be picking up rocks, drilling holes in the ground and analyzing lots of stuff. I’m also moonlighting as an investment adviser. Isn’t everyone these days?
Would you like advice from Mars? It’s free!
You’ve may be thinking that you’ve heard enough advice from Mars over the years after listening to those talking heads on television. I understand your frustration. This is a different type of advice. It comes from a different perspective. You will like it.
Let’s start with an observation about humans. Earthlings who become good investors possess three things: 1) a sound philosophy, 2) a stable strategy, and 3) a diehard discipline. Winners hold strong convictions about the markets, construct prudent portfolios based on their beliefs, and stay the course during clear skies and meteor storms.
Is this you? Do you have a strong philosophy, sound strategy and diehard discipline? If so, you are a rare human indeed. Many humans have a few of these strengths, but few possess all three.
Philosophy – if you don’t have one, get one.
What is the philosophy of investing? It is what you believe deep down about the markets and your abilities to invest. It’s your religion. The direction you walk.
How do you know what your philosophy is?
Let’s start with a talk about control. What can you control and what is out of your control?
Even the richest person in the world cannot control the financial markets, nor can they change the direction of the economy, control inflation, or fix interest rates. Some humans may believe otherwise, but it is just not true.
Certainly, you have no control over these things. You don’t decide what price Facebook stock will trade at today or have any influence on whether Greece leaves the Euro. You can’t control the tax code or create laws that favor your investments.
Ah! But you can control some things! You can decide whether to invest or not. You can determine how much to put in stocks, bonds, cash, real estate, etc. You can choose to buy, sell, or hold, and that, in some cases, affects if you pay taxes. You can spend your money, give it away, or bury it in the ground. It’s up to you.
Now that we agree on what you can and cannot control, we’re ready to talk philosophy.
Philosophy is like religion – everyone believes in something – even those who choose not to believe. What is your investment belief? Are you passive or active?
Passive management is a belief that the markets provide good returns naturally. Any attempt to beat the markets is costly and typically leads to lower returns. Accordingly, passive investors are happy to accept the natural market returns.
Assume the stock market earns 8.0 percent. An index fund that tracks the stock market will also earn an 8.0 percent less a small fee. If bonds return 3.0 percent, a passive bond index fund will return very close to 3.0 percent. A passive, balanced portfolio of stock and bond index funds will earn whatever the allocation is to those two asset classes without trying to switch back and forth between the two. Capital gain taxes are typically low with passive strategies because there is little trading.
Active management is the opposite of passive in that investors take an active role in the ongoing process of investment selection and risk management with the objective of improving a portfolio’s risk/reward relationship, according to the National Association of Active Investment Managers (NAAIM). In English, this definition refers to people who select fewer investments than a market holds with the hope of earning better returns after risk than the market. There is a higher cost to active, though, and this cost needs to be overcome. Active management also implies higher turnover than passive, which often results in frequent, realized capital gains and greater tax burdens.
So, are you passive or active? You must pick one. There is no middle ground. Are you not sure?
Do you believe that you or other people can predict future prices with enough consistency to beat the markets after adjusting for risk and fees? If so, then you should invest actively.
On the other side, academics have studied passive versus active management for years. They compared performance inside and out, backwards and forwards, covering many different asset classes over many different time periods. Their conclusions overwhelming favor passive investing.
I am biased, but the fact remains that it’s just very hard to beat the market, especially when investing in several asset classes at the same time. See this recent article for a flavor of the data, and The Power of Passive Investing for greater depth.
A chapel is built upon religion and portfolio strategy is built upon philosophy.
Whether active or passive, strategy is the framework for creating, consolidating, organizing and controlling a portfolio. It includes asset allocation decisions, the fund selection process, rebalancing methodologies when used, cash management, trading decisions, and many other aspects of portfolio management.
Passive investors create strategies that address long-term needs. They start with asset allocation, and then select low-cost index funds, exchange-traded funds, or other diversified investment vehicles to represent those asset classes. Finally, passive investors plan how often a portfolio needs to be maintained to keep its contents aligned with investor need.
Active investors create strategies that they believe will outperform the markets as described earlier. They may use a home-spun strategy or one involving a paid investment professional. Active investors monitor their portfolios frequently to gauge success and decide when changes are appropriate.
I’m going off topic here for second, but I have another observation about humans. For some illogical reason, people tend to jump immediately to strategy development without understanding philosophy. That makes no sense. Strategy without philosophy is a church without religion. It’s an empty shell.
Philosophy before strategy − always, always, always!
Discipline is the hardest part of the plan for humans. They don’t do what they’re supposed to, even when they know what to do! Even though they are well-intentioned, their hectic lifestyles often prevent them from keeping up with their investments, even if they have philosophy and strategy.
Here are three suggestions to get you on the path toward a more disciplined approach:
- Buy a balanced mutual fund: These funds diversify your money automatically across several asset classes and keep it in balance. Pick one balanced fund from Vanguard and put all your investment money in it. Use this one fund, all the time, with no change unless something changes in your life. It’s a simple, one step solution.
- Hire someone else to manage your money: A low-fee investment adviser takes care of all your portfolio needs. They help with asset allocation and other strategy questions, and then execute your plan with discipline. This takes the burden off you. Make sure the adviser shares your philosophy, has a good reputation, knowledgeable staff, a fair fee, and has been in business for several years.
- Use an online service: For those do-it-yourself investors who are almost disciplined, but not quite, an online service can help keep you on track. For an annual subscription fee, you’ll be notified by email when your accounts need attention.
And that’s it!
My batteries are wearing down as the Mars sun is almost setting.
I, Curiosity, bid you health, happiness and wealth! Go with purpose. Seek philosophy, strategy and discipline. You will be better investors for it.