Except for July and August in Arizona, when it comes to getting into the pool, I am a toe-dipper; an incrementalizer; a proceed-with-caution kind of swimmer.
Though I understand that diving in will acclimate me to the temperature more quickly, I’d rather shiver and shimmy my way into immersion. And that is also how I buy stocks. Most of us do the same when we invest. We begin with a modest position in a stock and add to it slowly over time. Investors call that dollar-cost averaging, a kind of second cousin to diversification. It is a satisfying approach except that it detracts from total return over time.
Yes, you heard me right. I employ the strategy although I know it hurts my performance. Still, DCA is the preferred approach of most people — especially if they receive a windfall. Putting a large sum of money to work all at once in the stock market is daunting to even the most experienced investor. DCA makes us feel better about investing in the face of uncertainty. And let’s face it, most investing involves uncertainty.
If the market has been strong, we often hesitate to invest all at once because we worry we are buying in at the top just in time for stocks to decline. If the market is weak, we worry it will continue to decline and we will lose our money. By averaging into the market, we are creating a natural hedge. (The most relevant, real-life example of dollar-cost averaging is the investment of our 401(k) contributions.)
DCA is like buying insurance when the dealer shows an ace in blackjack. We choose to give up some of our gains to insure against a loss.
Click here to read more: The Arizona Republic
Author and economist Peter L. Bernstein once wrote, “Diversification is the only rational deployment of our ignorance.” Which begs the question: What exactly is the optimal level of diversification to dilute our ignorance but not our performance?
In 2002, Morningstar analyzed the returns of large company stock mutual funds. They segmented the funds into six categories according to the number of stocks owned in each portfolio. The most concentrated portfolios held 10 to 20 stocks, while the least concentrated held more than 100 stocks. Results were measured over 10 years. The best-performing category? Portfolios holding 10 to 20 stocks. My experience proves what the research suggests: More is not necessarily better. When we own a few great companies across broad economic sectors, we will generate excellent returns over time.
This column has advocated owning shares in companies of industry leaders. Since economic sectors are made up of numerous industries, it is important for us to understand if we have too much or too little exposure to a particular sector to ensure proper, real diversification in our portfolio. To do so, I go to Fidelity Investments’ website, fidelity.com, then click on “research” and click on “stocks.”
Click here to read more: The Arizona Republic
Years ago, my husband and I worked for the same global-investment-management firm in the same West Coast office. One day, the decision was made to close that office and move our team across country to New York City.
We didn’t want to move but because we both worked for the same firm, we didn’t exactly have a choice. Had we diversified our employment and, therefore, our primary source of income, we would have put ourselves in a much stronger position to make the best decision for our family.
We ignored the cardinal rule of investing: diversify, diversify, diversify.
But rarely do investors understand what it means to be truly diversified. Simply owning shares in various companies will not provide real diversification if, for example, those companies are all in the same industry or economic sector. Diversification is actually about how different investments perform in various economic scenarios. Or to put it another way: Selecting investments is not so different from how we select our friends.
Each one of my friends exhibits an overriding attribute. Some are great in a crisis. Others are fun to be around when times are good. I have friends who like to exercise and those who prefer the theater. Supportive friends and the kind who are scarce in times of difficulty. Like you, I have different friends who shine in different seasons. The same is true of stocks — certain stocks do well when the economy is thriving and others outperform when the economy is soft.
Read more here: The Arizona Republic
Investing is like an essay exam rather than a multiple-choice quiz. Essay answers are more nuanced than multiple-choice — more like an informed judgment call than the unassailably right answer. As a professor, I give my students essay questions because they create a complete picture of what young scholars know and don’t know.
Similarly, investing, like real life, rarely presents us with questions that are as straightforward as those on a multiple-choice test. That is why I am interested in investing in the stocks of well-managed, industry-leading companies; I don’t have to know “the answer.” I simply need the confidence that management is moving the company in the right direction no matter the short-term trends of the market. These companies won’t always generate positive returns, but the dominant ones in each industry have a much better chance of succeeding than the second- and third-tier companies. I also know I increase my odds of success if I select the most attractively priced stocks with the greatest potential for total shareholder return.
Let’s examine two leaders in two very different industries with similar price-to-earnings (p/e) valuations. Click here to read my column in its entirety: The Arizona Republic