The stock market can be a very dangerous place for the average investor. When times are good and stocks are rising, investors feel too clever for their own good and enter a state of euphoria. When stocks decline, people often hold on in disbelief until they sell at the worst possible moment — the bottom. However, knowing your financial goals and having a plan can dampen the emotional turbulence.
Investors should familiarize themselves with Mr. Market, a character Berkshire Hathaway’s Warren Buffett introduced to readers of his annual shareholder letters nearly 25 years ago. Mr. Market is the mental attitude toward market fluctuations. He is reliable in the sense that he appears daily to provide market quotations, but his mood is anything but reliable. If Mr. Market were a real person, he would have a prescription for every bipolar pill under the sun, and it still wouldn’t be enough.
If allowed, Mr. Market will boss investors around on a daily basis. Sometimes he feels euphoric and names very high prices for stocks. At other times he becomes the ultimate pessimist and names very low prices. This has been demonstrated this week as major indices like the Dow Jones Industrial Average and S&P 500 sold off on Thursday after strong gains one-day earlier. Fortunately, Vanguard offers some simple ways to keep Mr. Market from interfering with long-term returns. Let’s take a look at three charts that the average investor needs to see.
1. Why are you investing?
Despite what you might hear on television or see on magazine covers, you shouldn’t be investing in order to find the next hot investment or become rich overnight. Instead, you should be investing to accomplish your financial goals. These vary among different people, but your financial goals should be clear, measurable, and attainable. They should also recognize constraints.
“Most investment goals are straightforward — saving for retirement, preserving assets, funding a pension plan, or meeting a university’s spending requirements, for example. Constraints, on the other hand, can be either simple or complex, depending on the investor and the situation,” explains Vanguard in a recent report. “The primary constraint in meeting any objective is the investor’s tolerance for market risk. Importantly, risk and potential return are generally related, in that the desire for greater return will require taking on greater exposure to market risk.”
Without a plan, investors risk being lured into flavor-of-the-month investments. Far too often, investors will rush into funds with the highest rating — after the oversized gains have already been realized. As the chart above shows, funds tend to underperform their benchmarks after receiving high ratings. In fact, five-star rated funds from Morningstar have the biggest gap over 36 months following the high rating.
2. Spread the risk
Finding balance is an important part of the investing process. All investments involve risk, but it can be managed through portfolio holdings. Several studies show that a diversified portfolio of stocks, bonds, and other investments can improve returns and reduce volatility. Asset allocation accounts for as much as 88 percent of a diversified portfolio’s return patterns over time, according to Vanguard. Security selection and market timing only account for 12 percent of returns.
Asset allocation can also help investors tolerate any mood swings by Mr. Market. The middle numbers in the chart above show the average yearly return since 1926 for various combinations of stocks and bonds, ranging from 5.5 percent to 10.2 percent. The numbers on top of the bars represent the best one-year returns, while the bottom numbers show the worst one-year returns. Investors should keep this mind as they think about their financial goals. Obviously, an investor with a 90 percent allocation to bonds should expect a different outcome from an investor with a 90 percent allocation to stocks.
Most investors realize there are risks associated with a heavy concentration in stocks, but you can also be too conservative. Vanguard notes that “One such risk is ‘opportunity cost,’ more commonly known as shortfall risk: Because the portfolio lacks investments that carry higher potential return, it may not achieve growth sufficient to finance ambitious goals over the long term. Or it may require a level of saving that is unrealistic, given more immediate demands on the investor’s income or cash flow (in the case of an endowment or pension fund, for example).
“Another risk is inflation: The portfolio may not grow as fast as prices rise, so that the investor loses purchasing power over time. For longer-term goals, inflation can be particularly damaging, as its effects compound over long time horizons.”
3. Don’t be afraid to be cheap
Unlike most parts of life, you don’t always get what you pay for when it comes to choosing investments. Higher fund fees are not correlated with higher returns. In fact, lower-cost investments tend to outperform higher-cost alternatives over long periods of time. On the positive side, investors do have some control over costs and can improve their returns with cheaper choices.
As the chart above shows, a hypothetical portfolio with a starting value of $100,000 grows to $532,899 over 30 years with an annual cost of 0.25 percent. However, the same portfolio in which an investor pays 0.9 percent of assets every year only reaches $438,976 over the same time period, representing a difference of almost $100,000.
“Minimizing cost is a critical part of every investor’s toolkit. This is because in investing, there is no reason to assume that you get more if you pay more,” according to the Vanguard report. “Instead, every dollar paid for management fees or trading commissions is simply a dollar less earning potential return. The key point is that — unlike the markets — costs are largely controllable.
“Investors cannot control the markets, but they can often control what they pay to invest. And that can make an enormous difference over time. The lower your costs, the greater your share of an investment’s return, and the greater the potential impact of compounding.”
More From Wall St. Cheat Sheet:
- Will Millennials Become the Lost Generation?
- Retirement Reality: 5 Charts You Need to See
- 10 States Most Dependent on the Federal Government
Follow Eric on Twitter @Mr_Eric_WSCS