Investing: Critical Success Factors

Factor #1: Always keep in mind why you are investing.

Consider this possibility: You are a "saver." You have some money that you don't want to spend right now but instead want to hold onto and spend sometime in the future.  You know that inflation eats away at the value of a dollar and some day in the future you want to be able to buy at least as much with those excess dollars as you could buy if you spent them now.

Or how about this one: You are a "speculator."  You have some money that you don't need right now but instead want to parlay into a much bigger sum.  You're a bit of a gambler and you see the chance to buy something with that money that you think will be worth a lot more in the future.

These two scenarios dramatize two wildly different reasons for investing. Neither is right or wrong, and they are not even mutually exclusive--it's legitimate to speculate with a small fraction of your assets even if you are essentially a "saver."  But if you want to wear both hats at the same time, be disciplined and keep your two pots of assets segregated.  That is, if you blow away your speculative pot, don't dip into your savings pot to refill it.  Just call it quits.

The two scenarios above represent two extremes, and "savers" have many ways to accumulate and preserve purchasing power.  A basic rule is that younger investors can be more aggressive and assume more risk because they have more time to make up for losses.  Economies, businesses, interest rates move in cycles, and younger investors are in a better position to wait out the lean years.

Factor #2: Seek advice from people you trust.

Professional investors spend their time looking for investment opportunities, evaluating them, and tracking them once the investment is made.  It's a full-time job.  The rest of us stay busy earning a living as doctors, plumbers, salesmen, office-workers and so forth.  Although it's important for everyone to understand the basics of stocks, bonds, mutual funds and the other investment vehicles described in the BBRC articles, rather than research individual investment opportunities, you will probably make better use of your time finding the right professional to advise you.    Few of us would attempt to write our own will or real estate contract. We would hire an attorney.   Why is it then that many people think they can manage their own stock portfolio?  It's a job better left to a professional.

So what kind of people are out there to provide investment advice?  Lots!  But first consider the two general categories of advice that is available. The first is referred to as "financial planning."  Financial planners, who should have passed a series of exams and earned the right to put "CFP" (Certified Financial Planner) after their names, specialize in assessing an individual's financial situation, including the need for insurance, and often help with issues like estate planning.  The second category is best described as "investment management."  People in this field, who must also be licensed and typically have earned a "CFA" (Certified Financial Analyst), provide investment advice, and either manage money or recommend investments to investors.

Investment firms like MorganStanley, MerrillLynch, SmithBarney, UBS, to name a few, are in the business of advising small investors in managing their assets.  Their brokers are typically out there looking for people with assets who want advice.  Once they have reviewed an investor's financial circumstances, they will recommend appropriate mutual funds and/or individual stocks and bonds.  In the old days fees were commission-based and brokers were paid per transaction.  The tendency these days is to charge a small percentage of the assets being managed so there is no incentive to "churn" an account by constantly buying and selling.  And don't forget: besides the big players, there are many smaller firms and even individuals that manage money and/or provide financial planning.

In working with advisers one critical decision is whether to work on a discretionary or non-discretionary basis.  In a discretionary account the adviser decides what is best for you.  In a non-discretionary account the broker recommends investments but you make the final decision.

Factor #3: Invest Globally

In the last 100 years the U.S. economy has fared extremely well--better than Europe, better than Asia (until recently). Investors just had to tag along for the ride.  And by building diversified portfolios of stocks, blending in some fixed income and perhaps a slug of commodities they were able to do that.  Some investment pros contend that diversification is a formula for mediocrity, arguing that you will only get closer to the averages as you spread your money among more and more asset classes and individual picks.  But over the years hitting the averages has been more than acceptable--since total annual returns for common stocks has averaged better than 7% after inflation in the last 80 years.

But the future will not necessarily be as good as the past. Consider these comments by Peter Bernstein of the New York Times:

The history of the United States stock market over the past century or more is only one sample of many that might have occurred over such a long time span. Stock markets in Britain, France and Germany have had significantly lower long-run returns than ours. How relevant is the long stock market history of the United States to what will happen over the next 20 years?
     
The next 20 years will be far more a result of the past 20 than what happened in the distant past. History is not a random sample like throwing dice. History is a sequence of causes and effects. Just because something good, or bad, happened in the past is no basis for expecting — without a shadow of a doubt — that it will repeat itself.

Finally, all of this gleaming data has serious limitations. It assumes no taxes, no investment expenses and brokerage fees, and 100 percent reinvestment of dividends.
And those dividends really matter. From January 1926 to December 2007, the monthly return from dividends exceeded the monthly return from price appreciation in two of every five months. Over the last 20 years, dividends have provided 39 percent of the total return.

BUT that was the past. Today, the dividend yield is only about 2 percent, compared with the long-run average of more than 4 percent since 1925. Achieving the long-run, inflation-adjusted annual return of 7 percent when starting with dividend yields of only 2 percent is a tough call, especially as earnings per share over that long run have grown more slowly than real gross domestic product, or only about 2 percent a year after inflation.

Even with an expanded foreign component, expectations of 5-percent-a-year growth in real earnings over the long run are risky, despite buybacks that would reduce the number of shares outstanding.

If such is the case, and I believe it is, the expectation of a long-run, inflation-adjusted total return of 7 percent a year from stocks may be little more than a lovely dream. Investing is much more complex than a replay of historical returns. The markets of the future will be determined by the tempestuous seas of the future, not by the past.

Whew!  How's that for a bearish but well-argued point of view.  So what's an investor to do?  The answer seems to lie in Bernstein's own words.  Go for dividends and international exposure.  Currently dividends get favorable tax treatment, and you get to decide whether to spend them if you have to or reinvest in new opportunities.   Regarding Bernstein's "foreign component," the world is shrinking and the rest of the world is nipping at our U.S. heels.  Workers in developing countries work longer and harder than most Americans and Europeans, to say nothing of the vast difference in the pay scales.  This may or may not spell doom for the older economies, but it certainly bodes well for the economies of emerging countries.  So your investment portfolio must include international exposure.  It might just be U.S. multinational corporations doing business around the world--like CocaCola, the U.S. auto manufacturers, IBM and the like--or it might be a basket of leading companies in India.