Keeping “The Market” In Perspective

by Lee Distad

I have to admit to an interest in the equities market that borders on the unhealthy.

I’m well aware that, over the long term, saving and buy-and-hold investing are the keys to growing personal wealth. But still, like a siren call, the excitement and adventure of short-term trading is a seductive distraction.

Like any vice, whether it be alcohol or jelly donuts, a little indulgence in “playing the market” won’t hurt you. But it’s important to keep things in perspective, and not be blinded by either greed or an appetite for excitement.

Something that helps me maintain a balance in my financial life is to keep to a few principles. Some I’ve learned from my own errors, and some I’ve learned from the errors of others.

Risk And Return Are Not Correlated At 1:1

Some people like to brag that they have a great appetite for risk. They’re the ones who toss around phrases like “the greater the risk, the greater the reward.”

That, by the way, is demonstrably false. What they mean to say is that they “have a great appetite for returns.” Those two are not the same at all.

My favorite example is this: the reason a Canada Savings Bond pays 2.8% interest is because it’s guaranteed. The reason 00 on the roulette wheel pays 35-1 is because on any one play, you only have a 2.7% chance of your bet paying off.

If you had $100,000 in your pocket, and you were standing in front of the roulette table, would you still have that avowed appetite for risk?

Question Everything

In Nassim Taleb’s book Fooled By Randomness, he discusses the difference between signal and noise, and how difficult it can be to determine which is which.

Internet bulletin board, blogs devoted to “hot tips” and even 24-hour business news television outlets like CNBC are perfect examples of high noise, low signal.

Anyone who tells you an “inside scoop” on a particular stock or instrument may have other motivations beyond an altruistic desire to help you make money. This applies equally to commentators on either TV or the Internet.

Many people seem to have trouble grasping this. Don’t fall for it.

Expert Opinion Isn’t All That Expert

I don’t have a lot of patience for financial advisors, although I’m sure that many of them are nice people. When you work with a financial advisor, you’re paying someone to do your thinking for you.

While there may be situations where you need that, remember that by and large, very few advisors and very few actively managed funds continuously beat market indexes (especially after fees).

Let’s put this into another perspective: if you own your own business, do you trust someone else to make your critical decisions? If you don’t trust yourself to manage your own money, you probably shouldn’t trust anybody else either.

Exercise Reasoned Self Control

Just like at the casino, the need for action — any action — and the itch to make a trade — any trade — is a negative behavior. Only go “in” when something meets the pre-determined criteria you’ve set for your investment decisions, not because you have the fever.

This is a hard one for most of us, since enthusiasm and our emotions can often trump prudence.

A friend of mine is fond of saying that the steps to reaching your goal are “Plan, Achieve, Stick To Your Plan, Repeat.” Remember your goals, and hearken to the wisdom of both your own experience and that of others.

Keep focused on the basics, rather than the distractions.

Lee Distad consults with CE integration firms on design, installation and project management processes and Best Practices, and offers provides professional copy writing services for websites, brochures, and marketing initiatives. His freelance work covers topics from CE to global business to finance in both print and online.

{ 1 comment… read it below or add one }

Phil July 20, 2009 at 9:24 am

Excellent post. Now that everyone can see how variable correlations are, I think there might be a resurgence of stock-picking investing, relative to asset allocation… which is very dangerous, as you pointed out. Your points about active managers under-performing are worthy of a dedicated post.

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