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The stock market reflects changes in the economy filtered by the public’s perception of profitability. Unsophisticated investors tend to trade frequently in response to feelings of fear or greed. Unfortunately, acting on these emotions tends to result in losses.
Market gurus attempt to capitalize on the hopes and fears of investors by selling “expert advice” and premium investments that promise high profits. Inevitably these hot stocks and funds revert to market averages, failing to deliver on their exaggerated claims.
Alternatively, the empirically based approach pioneered by John C. Bogle, William J. Bernstein, and Burton G. Malkiel provide guidelines for a rational approach to cost-effective investing. Their results show that a passive, index based approach produces consistently higher profits over time then the recommendations of the majority of expensive, professional money managers.
Rational Investing
Rational investing is a a long term, disciplined process of purchasing stocks and bonds often referred to as the strategy of “buy and hold” where diversified funds that replicate the market averages are keyed to one's risk tolerance and investment objectives. A winning investment strategy combines the empirical factors that govern market growth with an understanding of investor psychology. This approach to building wealth is very different from emotion driven investing that fosters the gambler’s irrational belief that sustained profits or a predictable windfall can be achieved chasing hot leads, trading frequently, or following the predictions of market gurus.
Buyer Beware
The stock market has been carefully researched and the findings indicate:
- Stock profits are governed by the market average over time.
- Individual Stock or fund gains cannot be reliably predicted.
- Profits of this year's hot stock, fund, or money manager will decline and revert to the market average.
- No one continuously beats the market average legally.
- The cost of so called expert advice will eat into your profits and will seldom produce superior performance in the long run.
- There is always a hot new investment ( sub- prime mortgages), a fancy strategy (hedge funds), or a new scheme for making big profits (online trading). These shortcuts to wealth are illusions and may turn out to cost you your financial security or your freedom. The old adage holds “If it looks too good to be true, it is too good to be true.
- As an individual investor you cannot compete with the large corporate firms that can leverage large purchases, command larger margins or have access to privileged information.
Winning Formula
The winning formula for successful investing isn’t predicting the performance of individual stocks or funds, acting on hot tips or so called expert advice. Research indicates that Investing success is associated with the following guidelines:
- Saving early and regularly using dollar cost averaging to make the most economical purchases and maximizing your profit with compounding interest.
- Making a long term plan keyed to your investment objectives and risk tolerance that reduces unnecessary costs, utilizing simple, low cost, low turnover, index funds.
- Understanding that Index funds outperform the majority of more expensive, actively managed funds over time.
- Having realistic expectations. Rates of return in the coming decade are likely to be lower than the last. A seven per cent annual return before costs and inflation for stocks and a 2.5 per cent return for bonds before costs and inflation is reasonable.
- Sticking to your asset allocation plan and ignoring the pundits and fluctuations in the markets.
Summary
Rational investing is a a long term, disciplined process of purchasing stocks and bonds often referred to as the strategy of “buy and hold” where diversified funds that replicate the market average and are keyed to one's risk tolerance and investment objectives. A winning investment strategy that outperforms the market gurus, utilizes these empirical factors that govern market growth when combined with an understanding of investor psychology that emphasizes “staying the course.”
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