Review Lessons Learned in Investing 101

At the end of each semester, I write a wrap-up e-mail to the MBA students who just finished my Investment Management for Individuals class to remind them of a few key lessons from their lectures. I thought it would be interesting to share with you some of the points I am making this year.

These may seem simple or even simple- minded, but in the long run most students and investors waste a lot of time and money because they fail to internalize these.

Indexing Is Hard to Beat

The idea that students find hardest to accept is that even with all of their education, intelligence, and willingness to work hard, very few if any of them will be able to outperform low-cost broadly diversified index funds (openend or exchange-traded funds) over time. Based on fairly reliable research results, it is possible to design portfolios of index funds emphasizing value stocks and small cap stocks that will most likely outperform the broadbased indexes such as the S&P 500 or Total Stock Market Index over time. But doing better than that through stock picking and market timing is very difficult—most academics will even say it's impossible.

It is easy to see imaginary patterns in stock or market price history and chase them because human beings are hardwired to look for patterns in everything. But stock prices are mostly random and therefore unpredictable.

Make up Rules at Your Peril

Most amateurs and professional investors make up investment rules (ie, models) to identify good stocks or mutual funds. The rules are mostly based on what sounds reasonable based on intuition and what one has heard or read. For example, a very simple rule can be that when a stock sells below 60% of the price/earnings (P/E) ratio of its industry average, it is a good buy. Professionals also create elaborate models using sophisticated mathematical techniques and plenty of historical data.

The problem is that almost none of these models, whether they are simple or sophisticated, work. After all, if the market is random or nearly random, no model can work. But instead of accepting that reality, investors pat themselves on the back when their models work for a while by chance. And when the models do not work, they modify them claiming that they have now learned from their mistakes and keep trying. Such trial and error can go on for a lifetime and can be very expensive.

Finding investment methods or funds that have done well in the past is easy. Finding ones that will do better than indexes in the future is nearly impossible.

Costs Matter a Great Deal

Investment costs can have a significant effect on the money you will make in the long run. Fortunately, this is one thing you can control to a great extent.

If your investments earn a 10% return per year before costs and you incur a total 3% per year investment costs, then over 20 years about half of your returns will be eaten up by those costs. It is hard to believe, but true. And it gets worse over longer investment horizons.

Unless you are watching very carefully, you are probably paying 2.5% to 3% in total costs (including unnecessary taxes), although much of it is carefully hidden from your sight. The trap that most investors fall into is to think that the manager of a good mutual fund or individually managed account will be able to make up for these high costs through superior performance. In reality, the opposite is true. These managers will almost always do worse than the comparable index funds precisely because of their high costs.

The worst offenders in this respect are load funds. It almost never makes sense to pay the 3% to 5% load (which is a sales commission) because you can always find equally good no-load funds. In addition, I am skeptical about the advice you get for that sales commission because a lot of it is self-serving.

Watch for Overconfidence

Probably the biggest mistake most investors make is being overconfident. For example, despite all the research findings to the contrary, millions of investors still believe that they can pick the stocks or funds that will outperform others in the future. Such false confidence can be detrimental to one's financial health.

The Bottom Line

• Low-cost broadly diversified index funds work best over time.
• High investment costs can eat away at your profits.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (Wiley; 2004), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.