HOW TO BE A BETTER INVESTOR

Let’s face it, most individual investors produce sub-par results for their own retirement portfolios. Study after study by firms like Morningstar and Dalbar Financial Services, both outstanding independent investment research firms, have shown that the current gap between stock market returns and the average investor returns are not very good.

According to the 2014 Dalbar study, the S&P 500 20-year return was 9.22% compared to the average investor return of 5.02%―a gap of 4.2% for the last two decades! To say that this is a big deal is a gross understatement. On a million-dollar portfolio that represents a $40,000 a year (give or take a few thousand dollars) difference in the average investors pocket―every year.

For a family needing more income, it may be as easy as getting their investing act together. The Dalbar report went on to say: ”We need a fundamental change that transforms investment thinking into meaningful decisions and choices for retail investors.” The report also said, “The major cause of the shortfall has been withdrawing from investments at low points and buying at market highs. In other words, buying high and selling low, just the opposite of what people know they should be doing. Investor behavior clearly is a problem. Besides an attitude adjustment, successful investing requires hard work, discipline and a great deal of time.

Expecting to make a lot of money in the stock market with only a small amount of effort is like expecting to shoot a great round of golf the first time you play. It's just not going to happen. The one big difference in this analogy, is that investing is not a game. Investing is not easy, if it were, then everyone would be rich, and, as we all know, everyone is not rich.

So, how do we become better investors? The first thing you should internalize is that there is no magic formula to successful investing. If there were, then everyone would be using it, and if everyone was using it, it wouldn't be magical any longer. Secondly, there is no guarantee you will be successful. Investors in stocks and stock mutual funds will always, I repeat, always, encounter crises and uncertainty. It's how you react to these events that will impact your success. Avoid self-destructive behavior at all cost. Instead, do yourself a favor and work with a financial advisor to outline your long-term goals and develop a plan to achieve them. Thirdly, harness your expectations. The decades of 20% plus returns in the stock market may well be over.

According to Jeremy Siegel, Professor of Finance at Warton School of Business and author of Stocks for the Long Run, the long-term return on stocks is between 6.5% and 7% per year, after inflation.* Not 20%, 25% or 30%. Both Warren Buffett and John Bogle (of Vanguard Funds Fame) agree that in all likelihood, returns on equities going forward will average around 7%, the historic norm.

The next principle is:  Know thyself. Emotions can wreak havoc on an investor's ability to build long-term wealth. I like the warning Mr. Buffett gives to potential investors: “Unless you can watch your stock holdings decline by 50% without becoming panic stricken, you should not be in the stock market.” I completely agree. The stock market is not for the faint of heart, and it certainly is not a get rich quick scheme.

In spite of the above warning, the stock market can be a great place to invest for a person with a long-term time horizon. Here's a couple of facts:  It took the S&P 500 index only 4.4 years** to recover from the Great Recession of 2007-2009, which was the second worse decline (-50.9%) in the last 100 years. Having said that, how many readers experienced losses over that period of time? My guess would be, just about everyone. Investors have a knack for turning short-term market declines into permanent losses by selling at the wrong time, just before things start to turn around, at or near the bottom. Here's another interesting fact, according to Dalbar, the typical holding period for investors in mutual funds is only 3-4 years. The average stock is held for only six months. Even though most people will tell you they are long-term investors, the numbers say otherwise.

Here's the point: There are no negative 20-year holding periods for the S&P 500 Index―none! Yet investors continue to lose money on a regular basis. Why? Because as it turns out, they are, in reality, short-term investors. They buy at the wrong time and sell at the wrong time. They chase hot stocks and hot mutual fund managers. If investors would simply stop getting scared out of the market and hire a professional to guide them through the ups and downs of the market gyrations, they should be much better off over the long-term. The self-destructive madness they employ needs to stop. While we are on the subject of professional help, allow me to share a few thoughts from "Quantitative Analysis of Investor Behavior" from a Dalbar study done a number of years ago. The study found that over a ten-year period, investors who had advisors came out ahead of the do-it-yourselfers by a wide margin, 90.21% vs. 70.23%. Dalbar observes, ”The advantage is directly traceable to longer retention periods and reduced reaction to changes in the market.” As investors, we continually let our feelings overcome reason and logic. We know historically that the markets have fully recovered and have gone on to new highs after each downturn over the past 200 years. The waves of time have always washed away the effects of market declines. Downturns create opportunities to buy―not occasions to sell.

Another key to successful investing is taking advantage of dividends. Through the decades, dividends have been a significant component of the total return of the S&P 500. In fact, since 1926, dividends have represented over 50% of the total return.*** Some additional reasons to consider using dividend paying stocks in a portfolio are:

• Favorable tax treatment

• Tend to be lower risk and less volatile

• They generally have stable cash flow and stable profits. For the most part, they are steady, mature businesses.

According to The American Association of Individual Investors (AAII), from 1929-2013, dividend paying stocks returned 10.1% annually vs. 5.8% for non-dividend paying stocks. Dividends really do matter!

Here's another piece of my mind:  Tune out the noise. Most of the "experts" we see on TV or read in the newspapers majored in journalism or English, not in finance. Most of the people they interview are expressing their opinions, not facts. For example, Jim Cramer is a reasonably good entertainer but not necessarily a good stock picker. According to Pundit Tracker, Cramer gets a "D" grade. Of his 678 predictions since January 2011, he has been correct 47% of the time. Which means he is wrong more often than he is right. Nothing is more costly than bad advice. It is also a good idea to remind yourself, do not believe everything you read. Check out these headlines from days gone by:

Unanimous agreement that businesses will be good this coming year. From “The Wall Street Journal” on the expectations for 1929, the year of the great crash.

The Death of Equities. Business Week, August 1979 cover story. The Dow Jones Industrial Average was at 875. It is now around 25,000, not quite a 2,700% increase!

Buy Stocks? No Way! Time Magazine cover story, September 1988. The DJIA was trading at around 2,000 when the story was published. We again defer to Buffett's wisdom:  Let the blockheads read what the blockheads wrote.

Remember, Dewey did not defeat Truman. The next principle is a reality check. The future is unknowable. No one has a crystal ball. Period. Analysts have a hard time predicting the future of a single company, let alone a market made up of thousands of companies. Know this, the markets are complex and unfathomable. Zack’s Investment Research tracked the stocks recommended by eight full service brokers over a three- year period and found that five failed to beat the S&P 500. That's a 63% failure rate before commissions.

In October of 2001, 15 of the 17 analysts following Enron still had a "buy" or "strong buy" recommendation on the stock even though it had already lost 50% of its value in the midst of the company's accounting scandal.**** I recommend that you do not take these guys too seriously. The function of economic forecasting is to make astrology look respectable. ―John Kenneth Galbraith

Our final piece of advice for you to digest:  Risk and volatility are not necessarily the same thing. I would argue that there is a big difference between the two. Volatility is how much the price of a stock or bond moves around over a period of time. There is not much you can do about volatility except ignore it and stay the course. According to noted investor and author, Howard Marks, ”Risk is the price you pay for an asset and is the principal determinant of its riskiness. Or, stated more boldly by Dr. Mike Burry, a hedge fund manager who made almost a billion dollars in the sub-prime mortgage debacle and one of the main characters in the movie The Big Short played by Christian Bale, ”Real risk is not volatility, real risk is stupid investment decisions.”

Here are a couple of final thoughts:  Avoiding making mistakes is the most profitable strategy of all. Never confuse a bull market with being a genius. In other words, when the markets are red-hot, and you are making a lot of money, remember, a rising tide lifts all boats. You won't know how smart or how dumb you are until the bears come calling. Lastly, do your homework or hire a professional financial advisor. Most folks would rather be playing golf or bridge than spending hours in front of a computer, reading a prospectus or a financial statement. The learning curve for someone wanting to do it themselves can be a killer. As someone once said, “Life is a tough school because the exams come first and the learning afterwards.” Most people I know do not self-diagnose or self-prescribe when something is wrong with them―they seek professional advice from a qualified doctor. I think that makes a lot of sense when it comes to investing as well.

Allow me to leave you with a “HOT TIP.”

If at first you don't succeed - don’t try skydiving or managing your own portfolio. It only takes one mistake for disastrous results!

Do you have financial questions? email Richard at info@GreatInvestor.org

*starting in 1802-2013

**with dividends reinvested

***Source: Strategas Research Parterns as of 12/30/2013

****Enron filed bankruptcy on 12/2/2001