This article originally appeared on the Independent Observer Blog.
Over the past couple of days, I've had several conversations about investing. Nothing new there, but a question came up that deserved some serious thought: What do you really believe, or really know, about investing?
Trying to boil down my set of beliefs, desires, and biases to a handful of things I'm really convinced about was surprisingly difficult, but I found the exercise useful. They're not exactly revolutionary, but the four foundational ideas below have shaped my investing approach considerably.
Markets aren't always efficient.
This idea is best expressed by the notion that you can fool some of the people all of the time and all of the people some of the time, but you can't fool all of the people all of the time. Markets are, at bottom, people making decisions. Markets can indeed be fooled some of the time - and run up (or down) to levels that make no sense - but eventually, they'll come back to reality. Over the long run, markets can be efficient, but that's not necessarily true in the short run.
In an investing context, when things look out of whack and we hear that somehow it's different this time, it isn't. That's because...
One predictor of future returns, in the 5- to 10-year range, is initial market valuations. I don't care how you calculate it: When the market is expensive, chances are excellent that your actual returns over the next decade will be below what you expect. Over time, the market cycles around fundamental values, so if you buy at a high, you're very likely to see a low over that time period.
It's not quite that simple, of course, but you should respond when things get significantly above or below normal. That means...
One strategy doesn't work all the time.
There are many ways to deal with this, but one of the best is basic rebalancing. On a regular basis, sell some of your winners and buy some of your losers. This very simple take on market timing has been proven to provide better performance over time.
Using other strategies along with the common buy-and-hold technique can also add risk-adjusted returns by ensuring that your portfolio can benefit in the tough times. Speaking of tough times...
We measure risk the wrong way.
Emotionally - and, for many investors, practically - risk should be expressed as how much money you lose. Even if it's "house money" from previous gains, a loss hurts, affecting not just our net worth, but our subsequent decisions. Losses at certain times - early in retirement, for example - may result in failure of an entire investment program. Investors need to consider the risk of failure over their entire time frame, rather than looking at short-term variations in return.
As you can see, I'm a real believer in diversification, and I think we should be diversified among strategies, as well as asset classes. I believe that equities are an essential part of an investor's portfolio, but they're not always equally attractive. There are times when return of capital is more important than return on capital. I believe that losing money is the real risk, not how much your returns vary.