In a recent article, I made the case for why researching stocks is a waste of investors time. Instead of engaging in the frustrating pursuit of trying to find mispriced stocks, I suggested a simple, and more effective, alternative.
Begin by determining your asset allocation -- the division of your portfolio between stocks and bonds. Then invest the portion allotted to equities in low-management-fee index funds with broad exposure to domestic and international stock markets. Invest the bond portion of your portfolio in index funds providing broad exposure to U.S. investment-grade bonds, primarily U.S. government bonds. Then, other than when you're rebalancing, leave your portfolio alone.
I also referred to the many studies supporting this strategy, appropriately known as "evidence-based investing." I listed a number of Nobel laureates and other famed investors, including Warren Buffett, who advocate this approach.
Buffett Supports Evidence-Based Investing
Some readers responded to my inclusion of Warren Buffett on that list with unconstrained hostility. In their view, Buffett's success validates doing research in an effort to uncover stock "winners." They believe he is the quintessential stock picker and scoff at the notion that they, too, couldn't engage successfully in this activity.
They are wrong for two reasons.
First, Buffett's "secret sauce" isn't stock picking. The well-credentialed authors of an exhaustive study rigorously examined Buffett's record. They compared it to the long-term performance of other stocks and mutual funds. They acknowledged that Buffett's performance has been outstanding, ranking him as "the best among all stocks and mutual funds that have existed for at least 30 years."
However, they found the secret to Buffett's success was a strategy few others could implement. He bought cheap, safe, high-quality stocks and used significant leverage, financed partly using an insurance float, with a low financing rate. The authors of the study concluded: "Leveraging safe stocks can largely explain Buffett's performance."
Second, we don't have to debate Buffett's views about evidence-based investing. In his 2013 annual letter to shareholders, he indicated that he had instructed his trustee to invest his wife's inheritance in low-management-fee index funds. He noted: "I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions or individuals -- who employ high-fee managers."
These views are consistent with his prior, unequivocal support for evidence-based investing. Here's what he wrote in his 1996 annual letter: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."
Here's what he stated in an appearance on CNBC in May 2007: "The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry. ... People ought to sit back and relax and keep accumulating over time."
Where's Your Data?
The most vocal advocates of doing research on stocks are brokers and the financial media. Brokers have a strong economic interest in encouraging you to trade because it generates fees. The financial media is incentivized to mislead you into believing that watching an endless parade of market "gurus" making recommendations about which stocks to buy or sell is critical to your investment success. The more viewers they lure, the more revenue they earn.
Conspicuously missing from the argument of stock research advocates is any peer-reviewed data indicating that "doing your homework" is anything other than an exercise in futility.
In fact, there's no shortage of contrary studies. An article to be published in the prestigious Journal of Finance reviewed the recommendations of consultants to 29 institutional investors. They represented 91 percent of the entire investment consulting industry's market share in the U.S. These institutional funds had approximately $3 trillion of assets under management. The authors of the study reviewed 13 years of data.
Study: Consultants Don't Add Value
Here's the stunning conclusion: "We find no evidence that consultants' recommendations add value to plan sponsors."
The study found, on average, that consultants' recommendations caused their clients to underperform their benchmarks by about 1 percent. The funds would have been better off if they had fired the consultants, pocketed the millions in fees paid to them and invested in low-management-fee index funds that tracked appropriate benchmarks.
%VIRTUAL-pullquote-What are your chances of successfully researching stocks and finding mispriced equities on your own?%Howard Jones, one of the authors of the study, was quoted in the New York Times as saying that the recommendations from consultants are a "useless" service.
If the most-skilled, highly paid consultants in the world are unable to make stock recommendations that add value, do you really believe your broker can do any better? What are your chances of successfully researching stocks and finding mispriced equities on your own?
When you objectively view the data, you are likely to conclude that improving your expected returns requires no time spent researching stocks or trying to "beat the market."
10 Financial Land Mines That Can Decimate Your Net Worth
Stop Researching Stocks, Part 2: Why Warren Buffett Agrees
Managed to get that raise or promotion? Fantastic -- now don't go out there and spend it all immediately. In classic "keeping up with the Joneses" fashion, too many of us see an increase in salary or a sudden windfall (like an inheritance) as an excuse to take our lifestyle up a notch. We buy bigger houses than we need, get the latest gadgets even though ours work just fine,and spring for fancy steak dinners just because we can.
Instead, whenever your financial situation gets a boost, consider the best ways to put that money to work for you. The truly wealthy are those whose money continues to grow and earn them more, even when they're not actively doing anything with it.
The average American household that carries credit card debt holds a balance of around $15,000. If you're among those who have a credit card balance, you've probably seen the little chart on your monthly statement telling you how much you'll pay in interest over the next several years if you make only the minimum payment. (If you haven't, look at it.) The same chart will also compare that to a "suggested" payment that's slightly higher.
Our recommendation? Throw everything you can at paying your balances off as fast as possible. And make sure not to take on any additional debt in the future; if you can't pay for a consumer good out of pocket, don't finance it.
We don't demonize student loan debt the way we do credit card debt because we see an education as an investment -- and higher education often is the difference between one income bracket and another. Similarly, many people justify taking out a car loan by stating that they need a car to get to work.
That said, debt is still debt, and the longer you take to pay it off, the more interest you'll pay. Once you've freed yourself of credit card debt, paying down your car and student loan balances should be next on your list.
Whether it's to handle an unexpected car repair, a sudden illness or a major plumbing problem, you should always have some money set aside to cover unforeseen expenses. Set up a regular monthly transfer from your checking to your savings account to earmark this money before you're tempted to touch it. If necessary, cut back in another budget category (like eating out or entertainment) to free up the funds to save more.
Putting aside a little each month could prevent you from getting socked with a hefty bill you can't afford and then need to finance.
No matter your age, you should be adding to your retirement funds -- such as your 401(k) or individual retirement account -- each month. Just setting aside money sporadically won't cut it; you need to identify how much you'll need to live on once you stop working and monitor whether you're on track to reach that amount.
Here's a quick-and-dirty rule of thumb: multiply your annual spending by 25. This is the amount you'll need in your retirement portfolio, if you assume that you'll withdraw 4 percent per year to live on during your retirement. In other words, you'd need $1 million in your portfolio to live on $40,000 annually. Creating a plan will help you make sure you're able to retire the way you envision.
A home is a big investment, and sometimes that investment doesn't wind up netting you the return you thought it would.
The biggest culprit is having too large a balance on your mortgage, which detracts from your own personal stake in the current market value for your home. The sooner you pay this amount down, the better your home equity will be.
You also want to be careful when purchasing a new home. Buying in a neighborhood that's on the downward spiral or buying the most expensive home on the block, likely won't net you a good return when it's time to sell. Also take care to stay away from custom renovations (like turning the garage into a recreation room), which could negatively affect your resale value.
Paying high investment fees eats away at your gains. And since your gains compound over time, this creates a domino effect that can really chip away at your wealth. Take a close look at your investment companies' fees and shop around to make sure they're not taking more of your money than they need to be.
If you don't have a long-term investment vision and are simply playing the market, you could seriously undermine your wealth-building potential. Stop paying attention to market fluctuations, media pundits and the stories of your friends and family. Instead, create your own long-term investment strategy that will maximize your overall returns. Resist the urge it play it ultra-conservative (or fall for get-rich-quick schemes) and educate yourself on the best way to make your dollars work for you.
If you're having trouble making sense of your options or want a second opinion, seek the help of a trusted financial adviser.
Based on your experience and seniority level, education and industry, you should have a fairly good idea how much you ought to be making at your job. If you don't, check out a site like PayScale to get a ballpark figure.
If you're not making what you're worth, you're doing more than leaving money on the table; you're also losing all the compound growth and investment returns that money could be generating for you. Invest in yourself with professional development and continuing education, make the case for that raise or promotion, or seek out a company who will value you higher.
If you don't have proper insurance coverage, you're taking a very big risk that could come back to bite you. Too many people think the worst can't happen to them, but the hard truth is you can't predict the future, and scrimping on sufficient insurance is never a good idea.
Of all the things we're hesitate to part with our money for, adequate insurance coverage should not be one of them. No matter your age, everyone should be properly covered with:
Homeowner's or renter's insurance.
Flood insurance (if you live in a flood-prone area).
Umbrella liability insurance (especially if you own a small business).
If a spouse or children relies on you for support, make sure you have a decent term life insurance policy, as well.