5 Major Investment Principles - dummies

5 Major Investment Principles

By Russell Wild

If you know nothing else about investing, know the following five eternal, essential investment truths — all real-world tested — and you’ll be way, way ahead of the game.

Risk and return are two sides of the same coin

If you see an investment that has gained 50 percent in the last year, sure, at least consider taking a position. But know this: Any investment that goes up 50 percent in a year can just as easily go down 50 percent in a year. That’s the nature of the investment world.

Risk and return go together like fire and oxygen. Short-term, high quality bonds bring modest returns but bear little risk. Long-term, low quality bonds bring more handsome returns but bear considerable risk. Lower quality bonds must offer greater potential for return or no one but maybe a few loonies would invest in them. Higher quality bonds must offer lower rates of return or so many investors would flock to them that the price would be bid up (which would effectively lower the rate of return).

Financial markets are largely efficient

If someone says to you that a particular investment is “guaranteed” to return 15 percent a year with no risk, take that with a big, big, big grain of salt. Financial markets are efficient, which means that thousands upon thousands of buyers, sellers, fund managers, and market analysts are constantly out there looking for the best deals. If a truly safe investment were to offer a guaranteed return of 15 percent, so many people would make offers to buy that investment that the price would surely be bid up . . . and the return would then drop.

The efficiency of the markets is why even so few professional investors can beat the indexes. In numerous studies — each supporting the findings of the others — actively managed mutual funds (funds whose managers try to pick stocks or bonds that will outperform all others) very rarely manage to beat the indexes. Over the course of a decade or more, the number is infinitesimally small, and even those chosen few fail to beat the indexes by very much.

Bond index funds are funds that try to capture the returns of the entire market rather than attempting, usually in vain, to beat the market.

Diversification is just about the only free lunch there is

So if you can’t pick certain securities that will outperform, how can you become a better investor than the next guy? Not that hard, really. Keep your costs low. Keep your taxes minimal. Don’t trade often. Most importantly, diversify your portfolio across several asset classes — various kinds of investments, such as bonds, stocks, and commodities — so that all the components can contribute to your returns. Because the components move up and down at different times, the volatility of your entire portfolio is kept to a minimum.

The Modern Portfolio Theory (MPT) states, in essence, that you can add a highly volatile (high risk, high return) investment to a portfolio, and — if that investment tends to zig while other investments in your portfolio zag — you may actually lower the volatility (and risk) of the entire portfolio. So who says there’s no such thing as a free lunch?

Reversion to the mean — it means something

Sometimes called reversion to the mean, sometimes called regression to the mean, what it means is that most things in this world — from batting averages to inches of rainfall to investment returns — tend over time to revert back to their historical averages.

Suppose, for example, that a certain kind of investment (say, intermediate-term Ginnie Mae bonds) showed extraordinary returns for the last two to three years (perhaps 18 percent a year). That kind of return on a bond would be rare, but it does happen. Intermediate-term, high quality bonds such as Ginnie Maes typically return about one-third as much. Would you be well advised to assume that Ginnie Mae bonds will continue to earn 18 percent for the next two years?

In fact, most investors assume just that. They look at recent returns of a certain asset class and assume that those recent returns will continue. In other words, most fresh investment money pours into “hot” investment sectors. And this often spells tragedy for those who don’t understand the concept of reversion to the mean. In reality, hot sectors often turn cold — and they are generally to be avoided.

In fact, if anything, you might expect an asset class that overperforms for several years to underperform in the upcoming years. Why? Because all investments (like batting averages and inches of rainfall) have a tendency to return to their historical average return.

To look at it another way, investments tend to move in and out of favor in cycles. It is hard, if not impossible, to imagine that any one investment that has historically yielded modest returns would suddenly, for any extended period of time, become a major moneymaker. That would be akin to Chili Palmer’s rented Oldsmobile minivan suddenly becoming the favored vehicle of pistol-packing mobsters.

Investment costs matter — and they matter a lot!

Oh, sure, 1 percent doesn’t sound like a prodigious sum, but the difference between investing in a bond mutual fund that charges 1.50 percent annually in management fees and one that charges 0.50 percent is enormous. Over the course of the next ten years, assuming gross returns of 5 percent, compounded annually, a $20,000 investment in the more expensive fund would leave you, after paying the fund company, with $28,212. That same investment in the less expensive fund would leave you with $31,059 — a difference of $2,847.

Of course, fund companies that charge more tend to have a lot of money to spend on advertising, and they do a great job conning the public into thinking that their funds are somehow worth the extra money. That is very rarely true.

Studies galore show that the investors who keep their costs to a minimum do best. That’s especially true with bonds where the returns tend to be more modest than with stocks. Whether you are buying bond funds or purchasing individual bonds, transaction costs and operating expenses need to be minimized.