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Investing for the Financially Challenged
By Walter Updegrave
Warner BooksCopyright © 1999 Walter Updegrave
All right reserved.
Chapter OneThe Deep, Dark Mysteries of Investing Revealed: Exposing Wall Street's Most Closely Guarded Secret
Okay, I want your undivided attention now because I'm about to reveal a secret that could put hundreds of thousands of stockbrokers, money managers, investment planners, and financial journalists out of business. Ready? Psst! Investing is actually pretty damn easy. We're not talking brain surgery here. The basic principles and strategies you must master to invest successfully are embarrassingly simple. Which is probably why investment professionals spend so much time trying to make the investing process seem more complicated than it is.
Think about it: you really have only two big decisions to make. The first is how you should divvy up your money among the three main classes of investment assets: stock funds (or individual stocks), bond funds (or individual bonds), and cash (essentially money-market funds, though bank accounts and short-term certificates of deposit would also qualify) .The answer to that one is determined largely by how much you can tolerate seeing the value of your investment portfolio drop over the short term if the stock or bond market falls apart and how long you plan to keep your money invested before you start tapping your investment accounts for cash. The longer your money will be invested, the more you should tilt your mix toward stocks. The shorter the time period, the more toward bonds. Not exactly rocket science.
The second big decision is what specific stock funds (or individual stocks), bond funds (or individual bonds), and cash investments (money-market funds) you buy once you've determined the answer to question number one.
With more than 5,000 stock funds, 3,700 bond funds, and 1,100 money-market funds to choose from - not to mention thousands of individual stocks and bonds - this question may seem complicated. But the beauty of investing is that you don't have to pick the absolute best ones to succeed. Fact is, "pretty good" is a plenty high enough standard when it comes to picking investments. And average ain't bad, either. Consider this: If at the beginning of 1980 you had invested $10,000 in a stock mutual fund that earned just the average return for all funds that invest in a broad range of U.S. stocks, by late September 1998 your ten grand would have grown (before taxes) to just over $140,000. That translates to an average annual return of about 14.3 percent. Most people would-and should-be happy to settle for those kinds of numbers.
So if investing is so easy, you may ask, why do so many people screw it up? That brings us to another little-known fact about investing: What stands between most of us and investing success isn't our inability to master the principles of investing; it's our inability to master ourselves, by which I mean the emotions, mental lapses, and psychological quirks that often subvert our thinking process and make us do dumb things. In short, it's our behavior as much as the financial market's that ultimately determines whether we make or lose money over the long run. Don't believe me? Read on.
STOP LOOKING AT THE MARKET AND START LOOKING INSIDE YOURSELF
For years economists assumed that whether we were choosing a car or picking stocks or funds, we acted in a perfectly rational manner. That is, we gathered information and, with our brains whirring away like Pentium processors, arrived at a consistent and logical choice. To everyone but economists, this was obviously not true. Evidence abounds that we make all sorts of illogical and inconsistent decisions. People who claim to like music buy Michael Bolton albums. We not only elect politicians who later prove themselves to be of dubious integrity, but we reelect them. With a few notable exceptions, however, most of us don't make boneheaded decisions because we're dumb, we make them because a variety of mental and emotional quirks we never think about screw up our thought processes.
In recent years a number of economists, psychologists, and other researchers have begun to explore the way our brains work when we grapple with questions like investing. The result is an emerging academic discipline called psychoeconomics. Not to be confused with economics for psychos, psychoeconomics attempts to shed light on the irrational psychological tendencies and predilections that can lead us to make lousy decisions. I'm not going to claim that by understanding your emotional and psychological peccadilloes you'll be able to rid yourself of them and always make logical, clearheaded choices. But if you at least know a bit about how subconscious impulses might lead you awry, you stand a better chance of guarding against the errors in judgment they help cause. In this section I've outlined four common psychological mistakes or traps that we can all fall prey to:
THE FRAIDY-CAT SYNDROME: Psychologists and economists who study individuals' behavior when weighing financial alternatives have found that most of us experience about twice as much pain from losses as we do pleasure from gains. In other words, we fear losing 10 percent on an investment twice as much as we look forward to gaining 10 percent. At the same time, most people, even when they're investing money for long-term goals, tend to check the results on their investments frequently, sometimes as much as weekly or even daily. Put these two tendencies together, and you get a phenomenon that Schlomo Benartzi of the University of California and University of Chicago's Richard Thaler call myopic loss aversion-loosely translated as being overly concerned with short-term setbacks. Benartzi and Thaler hypothesize that investors' fear of short-term losses may sabotage their long-term investment strategy by leading them to put too little of their money in stocks, which are prone to many short-term setbacks but nonetheless have the highest long-term returns. The idea is that our shortsightedness, so to speak, about losses prevents us from focusing on stocks' ability to generate superior long-term gains and makes us pay too much attention to the temporary dips in market prices.
THE OVERCONFIDENCE TRAP: It's amazing how quickly we can go from feeling we know very little about investing to the certainty that we've got it mastered. But psychologists and behavioral economists have found that in many cases our investing mistakes are caused from our own overconfidence, especially when we believe we have information that gives us special insight, such as a hot tip from a friend or supposed expert. This feeling that we really know what we're talking about also arises when we're considering investing in a company we're familiar with or whose products or services we use. Investment publications help foster this notion by supplying us with accounts of superstar investors like Peter Lynch, who supposedly invested in Dunkin' Donuts after he found he liked its coffee. (Of course, Lynch no doubt did tons of research on the company as well before he went from Dunkin' Donuts java to its stock.) But familiarity doesn't necessarily breed great stock picks. By investing in companies we know, we may be doing little more than satisfying an underlying need to feel comfortable about where we invest our cash.
For example, after examining the stock-ownership records of all seven of the Baby Bells (the regional Bell operating companies that resulted after AT&T was split up), Columbia University professor Gur Huberman found that in all but one state (Montana) more people hold shares of their local Baby Bell than any of the other six. What's more, in forty-four states the amount of money invested in the local Bells exceeded the average amount invested in "outsider" Bells by a margin of more than three to one. Presumably the investors in each state bought their local Bell because they believed it was a better investment than the other Bells; otherwise why would they have chosen the local company? But all these investors can't be right; every local Bell can't be a better investment than the other six. What is probably at work here is the notion that investors who live in a particular state feel they know more about the companies in their area. This notion also probably explains why Apple Computer fans might be more likely to invest in Apple than Microsoft, or people who've had good luck with Whirlpool appliances might be inclined to buy Whirlpool stock.
THE HERD MENTALITY MIND-SET: If you're at a cocktail party and during the evening three different people mention a terrific mutual fund they've invested in, would you be tempted to buy it yourself?
If you're like most people, you probably would, because researchers have found that we tend to invest with a herd mentality - that is, we often abdicate our independent judgment and instead rely heavily on the advice, opinions, and actions of others. Not even professional investors are immune to acting like sheep; indeed, they may be even more prone to it than novices. Finance professors Josef Lakonishok, Andrei Shleifer, and Robert Vishny have theorized that one of the reasons fund managers lag the S&P 500 so badly may be because they gravitate toward "glamour stocks" - that is, shares are already so popular with investors that they tend to be overpriced. So why would managers buy stocks that would seem to have limited potential for outsize gains? Well, the profs hypothesize that the managers may feel they'll have an easier time rationalizing mediocre performance as long as they stick to stocks that no one would ever doubt are good companies.
Problem is, the more you're willing to follow the crowd, the more likely you are to get swept up in investment fads that have little chance for long-term success, and the greater your chances of buying a hot stock or fund do your that might be a flash in the pan.
THE CRYSTAL BALL PITFALL: This foible probably wreaks the most havoc with investors' money. Investors have a knack for assuming that recent trends will continue indefinitely into the future. When an investment has had a phenomenal year, as gold funds did when they soared to average 90 percent gains in 1993, many investors see that as a sign to put their money into a winner. Indeed, that's why the funds that get high ratings from fund-tracking firms like Morningstar tend to attract the most cash flow from individual investors. The same goes for stocks. The prices of stocks of companies that have posted rapidly grooving profits often get bid up to ever higher prices because the investors believe the company will keep churning out those earnings in the future just as it has in the past. In fact, there's little, if any, evidence that the mutual funds that came out on top in the past will continue to do so in the future. After their spectacular returns in 1993, for example, gold funds lost 12 percent in 1994, gained a modest 3 percent and 8 percent the next two years, and then dropped 43 percent in 1997. Sizzle can turn to fizzle pretty quickly on Wall Street.
Excerpted from Investing for the Financially Challenged by Walter Updegrave Copyright © 1999 by Walter Updegrave. Excerpted by permission.
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