Academic finance has a lot of good advice about how to invest. But the simple precepts at the core of this advice often get obscured by geeky mathematical interpretations.
Sometimes, a simple example helps to drive it all home. Here's my attempt to come up with some real-world parallels to explain a few basic investing rules.
Past Performance Can Be Misleading
The phrase often turns up in mutual fund advertising as: Past performance is no indicator of future performance.
It shows up in mutual fund advertisements and disclosure documents for a reason -- because it's true.
A mutual fund that's done exceptionally well for a year or two -- easily beating the market and its peers -- is very often on the verge of running out of fuel. That fund might have taken a big bet on one hot sector that's about to crack. Or maybe the manager just got lucky one year and doesn't really know how to pick solid stocks.
Consistency is what you really want -- a fund that's been able to deliver solid, reliable returns year after year.
A hot manager can lose his way. What worked before may not work again.
Real-World Example: Francis Ford Coppola's Godfather: Part III
Chasing Performance Doesn't Work
If a fund's scorching performance can be fleeting, then it makes sense that you don't want to run after those attractive numbers. You'll end up following the mob and investing your money at exactly the wrong moment.
By the time everyone is jumping on a craze, it's already over.
Remember what happened with technology stocks? In February 2000 the trailing 12-month return on the average tech fund was 186% and it was then that people really starting pouring money into those funds. The trouble was: The sector started its collapse the following month.
However, people continued to invest money in those faltering tech funds, undoubtedly because of the impressive performance they'd seen in the past. According to analysis by Charles Schwab's Center for Investment Research, most of the $77 billion invested in tech funds between January 1997 and June 2002 went in during 2000. And that year the average tech fund was down almost 30%.
The same thing just happened, with bond funds seeing huge in-flows of money in September after the hot performance. The next month, stocks posted a huge October rally.
Running after a trend can be a disaster in investing and in life.
Real-World example: First, there was the martini. Later: Apple Martini, Cran-tini, Sake-tini, Chocolate Martinis, Creamsicle Martini.
Of course, these days no one is going to be piling into tech funds. You know the trauma they can cause. But you still don't want to have your portfolio concentrated in any one type of fund, investment style or asset class.
A varied mix of stocks, bonds and cash can do a lot to reduce the swings in a portfolio's performance. According to Schwab, from 1970 through the end of last year, a portfolio with 60% stocks, 30% bonds and 10% cash fell 13.1% in its worst year. One with 80% stocks was down 19.4%.
You should also break it down even further. You want to own some growth and value, some big stocks and small ones.
Preaching to the Unconverted
10 Questions With Legg Mason Focus Trust's Robert Hagstrom
Today, value funds might look the most attractive. They have held up better than growth funds over the past three years. And nowadays plenty of 401(k) plans are starting to offer more and more value funds for your choosing. These funds might be reliable long-term bets. But that's not where all your money should be.
A fixation on one style just doesn't work.
Real-World example: A closet full of leather clothes. You might get mistaken for a member of the Village People and you certainly won't have anything to wear to your great aunt's funeral.
High Costs Hurt
Paying close attention to costs is one of the most important things you can do when you invest. A fund's fees are the one constant you can count on -- not its performance. The expense ratio is the amount of money you're going to pay to own a fund every year. It's the hole you're in as a shareholder for a year.
And you'll be standing in an even bigger ditch if you're investing in load funds. Yeah, yeah. I know. You have to compensate your broker for the valuable advice you're getting and you do that through sales charges.
But if you want to know exactly how much you'll lose over the next few years take a look at the fee table in a fund's prospectus before you buy it. You'll be shocked and might decide to do some investing on your own.
You cut your costs and get to keep what you save.
Real-World example: Walking into a car dealership and handing the salesman a signed blank check.