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The 3 Simple Rules of Investing

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What if the most effective investment portfolio was also the easiest to manage and the least expensive? As the authors of this clear, practical, and enlightening book—part financial guide, part exposé—prove, there are just three simple rules you need to follow and only a few, very inexpensive investment products that are necessary for an ideal portfolio. The authors deftly bust investing’s myths—what they call investing's Seven Deadly Temptations—and dispense with all that complicated, confusing, and self-serving advice of the Wall Street wolves. By embracing commonsense solutions and rejecting investments that seem enticing but are overpriced, needlessly complex and risky, you'll put not only yourself in a stronger position, but the entire economy as well.

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Rule #1

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You may not believe this: Whether you’re a small investor with a few thousand dollars to invest, or a wealthy investor with a few million dollars, or a gigantic pension fund with a hundred billion dollars, you need only consider at most about 10 investment products. The rest are of no use and aren’t worth thinking about.

If you were going to buy a computer, how many brands do you need to choose from? About 10? And the same thing for a smartphone—maybe 10 models, at most? This point applies whether you’re a teenager doing homework or a top executive at a Fortune 500 firm.

Shopping for investments is a little different. You’re faced with tens of thousands of investment vehicles to choose from, offered by thousands of investment firms. There are more than 80,000 mutual funds and ETFs (exchange-traded funds) worldwide. There are almost 10,000 hedge funds. The array is mind-boggling. And it keeps expensive financial advisors busy trying to guide confused investors through the mess. They let you know it’s difficult to choose because there are so many choices.

 

Rule #2

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Now that we’ve pared the number of investment vehicles you should consider by about 99.9%, we’ll reduce them even further, and we’ll delve into how you should use them. If you read only one section of this book, this is it. It will tell you what your winning investment strategy is. This advice applies whether you’re an individual creating her lifetime saving and spending plan, or the administrator of a multi-billion-dollar pension or endowment fund.

First, let’s note how different this will be from the usual investing frenzy that people go through. They’ll often comb through the past history of the thousands—indeed, tens of thousands—of available investment alternatives, or hire a high-paid advisor or consultant to comb through it for them and make recommendations. Then they’ll often choose based mostly on which ones had better returns historically, completely ignoring the perfectly accurate admonition required by the U.S. Securities and Exchange Commission: past results are no guarantee of future performance. Then once these typical investors have made their choices, they’ll stress constantly about how well their investments are performing, wondering if they should replace them with others.

 

Rule #3

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Rule #3 will be short, because the chapters in Part II will explain in detail why it’s so important to follow this rule. For now, we’ll simply identify some of the noisy opinions and recommendations you’ll hear if you follow the two-asset portfolio route, and to all of it we say, “Tune it out.”

You’ll hear that you can and must beat the market, yet you aren’t trying to beat the market. Tune it out.

You’ll hear that you must diversify among many asset classes and many mutual funds or ETFs, yet you’re only investing in one or two. Tune it out.

You’ll hear that you must rebalance regularly to maintain constant allocations to asset classes, yet you aren’t rebalancing regularly. Tune it out.

You’ll hear that you must use a mathematical optimization model to perform an asset allocation, yet you haven’t run an asset allocation model. Tune it out.

You’ll hear that gold is a hedge against inflation, yet you aren’t investing in gold. Tune it out.

You’ll hear that scientifically designed funds perform better than total market index funds, yet you’re investing only in the global market index. Tune it out.

 

Deadly Temptation #1

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We told you that you must tune out siren calls to “beat the market.” Now we’ll tell you why. The basic reason is this: You are extremely unlikely to find a manager, an advisor, or a strategy that will enable you to predictably beat the market. It will be even more difficult to know whether you have found one. It will certainly not be worth the cost to try.

In their textbook Principles of Corporate Finance, authors Richard A. Brealey and Stewart C. Myers report the following event in stock market history:

In 1953 Maurice Kendall, a British statistician, presented a controversial paper to the Royal Statistical Society on the behavior of stock and commodity prices. Kendall had expected to find regular price cycles, but to his surprise they did not seem to exist. Each series appeared to be “a ‘wandering’ one, almost as if once a week the Demon of Chance drew a random number … and added it to the current price to determine the next week’s price.” 1

In other words, each change in price seemed to be drawn at random from a bowl full of pieces of paper with percent price changes written on them—“up 1%,” “down 0.5%,” “up 2/3%,” and so on. If that was how price changes were determined, what would be the use of trying to predict securities prices—or the stock market as a whole? Whatever you predicted, something random would happen that might agree with your prediction or might not, but it would be no better than any other prediction.

 

Deadly Temptation #2

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We told you in Rule #3 that if someone—a friend of yours, perhaps—tells you that a particular broker or financial advisor has done very well for her clients, and you should consider hiring her, you should tune it out. Wouldn’t it be great, though, to have someone take care of your investments? They would grow nicely, and you wouldn’t have to worry about a thing. It sounds very comforting to have someone just deal with the whole realm of investing for you, especially if you’re convinced it’s all too complicated and you just don’t want to think about it.

But is it worth giving up one-third to three-fourths of your investment gains for this comfort? If you knew that another, lower-cost advisor—offering simpler, less technical-sounding investment advice, or even no advisor at all—would provide you half again to three times more in investment gains, then how comfortable would you feel?

Because that is, indeed, how much it costs—even when the cost appears low as a percentage of your assets. Let’s go through the numbers to show what we mean.

 

Deadly Temptation #3

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We told you in Rule #3 that if you hear that asset allocation is the most important investment decision you can make—and that you must do it using a scientific optimization model—you should tune it out. Now we will tell you why you should tune it out.

Financial advisors will often give you the idea that they can very precisely control the risk and return of your portfolio. Their spiel often starts with “The most important thing is asset allocation.”

Back in 1986, a paper titled “Determinants of Portfolio Performance,” by Gary Brinson, Randy Hood, and Gil Beebower, was published in the Financial Analysts Journal.1 It got a huge amount of attention. It was cited, and re-cited, and cited again and again. Almost all of the references made to the article got its message completely wrong. It became conventional wisdom that “94% of investment performance is due to asset allocation.”

Well, that’s not what the paper said. The coauthors thought it must have been their title that threw people off—“Determinants of Portfolio Performance.” But, really, the confusion about what the paper actually said was largely due to the fact that misinterpreting it gave financial advisors a new lease on life. It offered them a new marketing pitch, which often sounded right to them but was a misconceived mish-mash of half-truths and falsehoods that they frequently passed on to clients for very substantial fees.

 

Deadly Temptation #4

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Standard financial advice often includes a few misguided prescriptions that are intended to help control your investment risk. We’ll now explore some of these, and the reasons they’re misguided. We told you that if you hear that you must diversify among many mutual funds or ETFs and asset categories, you should tune it out. Now we will tell you why you should tune it out.

The advice to be diversified comes from Nobel laureate Harry Markowitz’s 1952 paper. Markowitz, as we learned in Deadly Temptation #3, showed that if you diversify by buying a lot of stocks instead of only a few, then some of the stocks’ price fluctuations tend to cancel out, and you’ll have a portfolio that fluctuates less without reducing its expected return. As we explained before, reducing your portfolio’s fluctuations has been interpreted by the modern portfolio theory (MPT) folks as meaning the same thing as reducing your risk. It’s not really the same, though; portfolio fluctuation risk is not the risk that matters—the real risk is running out of money when you need it.

 

Deadly Temptation #5

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There are some things about investing you hear so incessantly that by now everybody just assumes they’re right. The conventional wisdom is so riddled with error that you should question virtually everything you hear. In this Deadly Temptation, we’ll address the following four things you hear that are either wrong or at least not always right:

The first thing you should always do is fund your 401(k) to the max.

You must be sure to rebalance your investments regularly.

Dollar-cost averaging always wins.

Gold is a hedge against inflation.

What?! Are we going to say it’s wrong to fund your 401(k) to the max? You may find this hard to believe, but yes, that’s what we’re going to say.

Now, it’s not always wrong, but it’s often the wrong thing to do, and it may be wrong more than half the time. So you need to think about it. You shouldn’t do it automatically.

To decide whether you should fund your 401(k) to the max, you need some information. Unfortunately, it may be extremely difficult to get the information you need. You may have to do a lot of demanding to get it, and even then you might not.

 

Deadly Temptation #6

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Wealthy and “sophisticated” investors actually get more wrong than ordinary investors. What they get wrong is that they think that because they’re fielding a lot of money, they can buy the best expertise—and that, of course, will get them the best return. But in the investment management business, there’s no relationship between what you pay for professional help and what you get in investment returns. We suspect it’s going to be hard to convince you how wrong this idea is.

Wealthy and sophisticated investors got wealthy somehow, right? Presumably because they knew how to make money. So is it possible that they don’t know how to make money better than the rest of us when it comes to investing?

Yes, that is exactly so. But it’s worse than that. They know how to lose money by paying the highest fees you can possibly pay. It’s understandable why they would make that mistake.

Let’s start with a humorous light-hearted fictional example, which also has an air of truth about it.

In the 1986 movie Down and Out in Beverly Hills, Nick Nolte plays a homeless drifter named Jerry, who accidentally wanders into a rich man’s backyard and somehow winds up getting intimately involved with his whole family. At one point Dave, the rich man (played by Richard Dreyfuss), proudly—but a little sheepishly—shows Jerry how he got rich: coat hangers. OK, someone has to make coat hangers. If you sell enough of them you’ll get rich. This was an ironic touch of realism in the film. It implied that many rich people get rich on what seems like a tiny little business niche—and in fact it’s true.

 

Deadly Temptation #7

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This is often the deadliest of temptations—and one of the most brazen. Science encompasses an array of serious, well-developed fields such as physics, chemistry, and biology. Modern finance bears no resemblance to any of them. To apply the term “science” to the field of modern finance is to taint all sciences. Both science and engineering use mathematics in practical and sound ways. The mathematics used in these fields is both much more sophisticated and more practical than the mathematics used in the investment field.

Let’s explore some of the ways investment products and services sold by Wall Street and the financial industry use—or pretend to use—mathematics and “modern scientific financial theory.”

You may sometimes hear about “quantitative investment strategies” and wonder whether an approach that’s disciplined by mathematics and computer programs will add value. It sounds right, of course—you’d rather have a surgeon who went to medical school and learned about human anatomy and knows how to use the latest medical technology than one who doesn’t.

 

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