Investing tips and fundamentals to be aware of
Investing for beginners: Part 7 of 8
All of the information in this beginner investing series so far is to help get started with investing. This article will be a list of tips and additional information to hopefully prevent common mistakes and misunderstandings when beginners start investing.
Contents
Behavioural pitfalls
Emotions and human irrationality are the single biggest enemies that every investor faces.
This famous article reported that a Fidelity study found inactive, dead accounts to be the best performers. Although the study may be a hoax, it still serves as an important lesson that behaviour can negatively impact your performance. This can involve selling at the wrong time, emotionally buying funds, and tinkering with allocations. Topics that I’ll be talking about will involve behaviour in some way.
Investment plan
The purpose of an investment plan is to lay out all your goals and make it clear how you’ll achieve them. It is also a great way to reduce the behavioural risk of tinkering with your portfolio. This can be done by justifying the choices you made for your portfolio and having conditions in place that you must satisfy if you want to make changes to it.
Read more about creating an investment plan here.
Priced in
The term “priced in” is not commonly taught to beginners but has important implications for properly understanding how the stock market works and, in turn, making better investing decisions.
What the term means is that the market is forward-looking. For a given stock, all investors will arrive at a different opinion and expectation of how the stock should be priced based on available information, rumours, and trends. This leads to buying or selling a stock until the stock price reaches an equilibrium that reflects the combined expectations of all investors.
For example, with the recent hype around AI, retail investors have been flocking towards tech stocks to ride the potential boom when AI transforms the industry in the future. But as we now know, this expectation of AI has already been priced into the stock market. So if these retail investors want to profit, then tech stocks would need to exceed the expectations of the market. Not only that, but these retail investors are competing with institutional investors whose job it is to quickly get information about tech stocks and incorporate this information into the stock prices.
You may get lucky, but luck can only go so far. If an investor accepts that they don’t know more than what the market knows, then by definition, this investor should stick with the market portfolio.
I’d like to credit David Creekmore for writing this article that helped me write this section, and I also want to include the “Everything is priced in” reddit post that they linked below, as I found it too good not to include:
Don’t even ask the question. The answer is yes, it’s priced in. Think Amazon will beat the next earnings? That’s already been priced in. You work at the drive thru for Mickey D’s and found out that the burgers are made of human meat? Priced in. You think insiders don’t already know that? The market is an all powerful, all encompassing being that knows the very inner workings of your subconscious before you were even born. Your very existence was priced in decades ago when the market was valuing Standard Oil’s expected future earnings based on population growth that would lead to your birth, what age you would get a car, how many times you would drive your car every week, how many times you take the bus/train, etc. Anything you can think of has already been priced in, even the things you aren’t thinking of. You have no original thoughts. Your consciousness is just an illusion, a product of the omniscent market. Free will is a myth. The market sees all, knows all and will be there from the beginning of time until the end of the universe (the market has already priced in the heat death of the universe). So please, before you make a post on wsb asking whether AAPL has priced in earpods 11 sales or whatever, know that it has already been priced in and don’t ask such a dumb fucking question again.
Mean reversion
Mean reversion is an assumption of the stock market first documented by Poterba and Summers (1988), where stock returns have a tendency to revert to their long-term average. This implies that periods with above-average returns tend to be followed by periods with below-average returns, and vice versa. This theory has important implications for two common beginner mistakes:
- Performance chasing: the recency bias of investing in a fund because of recent good performance (5-10 years). If this good performance is above the fund’s long-term average performance, then investors expect this performance to continue to be sorely mistaken when the performance mean reverts. This leads to buying high and selling low.
- Panicking in a downturn: a downturn refers to a period when the market is declining and can also be referred to as a bear market if the decline is -20% or more. Although it is scary to experience a downturn, the market always recovers, in part due to mean reversion.
Market timing
Many investors are tempted to time the market as a way to earn an extra return or lessen the impact of a downturn by buying and/or selling at opportune times. This also includes holding cash and waiting for the right time to invest. Because of how unpredictable the stock market is, market timing tends to be a losing game on average.
A topic that is adjacent to market timing is dollar-cost averaging (DCA) vs lump-sum investing. Say one receives a large windfall of $100k. They could either lump sum invest by putting it all into the market at once or DCA by investing the windfall in chunks over some period of time. Intuitively, DCA seems to be the better option; however, this is not the case.
This report, written by Ben Felix, analyses the possible outcomes using historical data from Australia, Canada, Germany, Japan, the United Kingdom, and the US. He found that over 10-year periods, lump-sum investing beats DCA on average 65% of the time. When looking at the 10% of best outcomes vs 10% of worst outcomes for lump sum investing vs DCA, the gains outweigh the losses. For example, in the 10% of best outcomes, lump sum investing outperformed DCA by 2.04% annualised return in the Australian market vs a -1.34% annualised return in the 10% of worst outcomes. Now, this doesn’t mean that DCA does not offer protection against downturns; however, this comes at the cost of lower expected returns.
The author also investigated lump sum investing vs DCA during bear markets and expensive periods and found that, on average, lump sum investing still beats DCA.
With all that being said, there is credence in DCAing to avoid the psychological pain of investments falling. However, as the author notes, “We also think that if a fear of loss is so great that DCA needs to be employed to make an asset allocation decision more palatable, that asset allocation may be too aggressive. It should feel comfortable to invest a lump sum in a risk-appropriate portfolio. We do not want to imply that DCA should never be employed, but we do believe that if it feels necessary to use DCA in order to implement an asset allocation decision, it may be wise to revisit the portfolio altogether.”
In conclusion, it is better to not time the market and hang on through tough markets, this fact became more evident when analysing the outcomes of lump sum investing vs DCA. This is why finance has the popular saying, “Time in the market beats timing the market.”
Note: There are two meanings to DCA. The first meaning is the one I described above, and the other is investing regularly from paycheck to paycheck. The second meaning is more common in discussions.
Dividends
Throughout this beginner investing series, I have not mentioned dividends at all. For those who don’t know what dividends are, they are money that companies pay out to their shareholders as a kind of reward for investing in their company. Now, the reason why I haven’t mentioned dividends is because, in the grand scheme of things, dividends are just a byproduct of investing. I’m not saying that dividends aren’t important, but it is a common beginner trap to buy companies that pay high dividends.
Why this is a trap is because receiving dividends is mathematically equivalent to selling shares (ignoring taxes), a fact known by academics since 1961 from Miller and Modigliani’s paper. When including taxes, it is more advantageous to sell shares and receive the 50% Capital Gains Tax (CGT) discount if shares were held for >1 year than to pay full tax on dividends. Dividends do not have any special properties that make them safer during downturns. It is no safer than selling shares during a downturn. Focusing on dividends also means a less diversified portfolio, which could hurt the performance of the portfolio.
There is more nuance to dividends that I haven’t explained here, but that is for a future article. The main takeaway is to be indifferent to dividends, neither for nor against them. What matters in the end is the total return, which is equal to the price return plus the income return.
For those interested, a thorough discussion on dividends can be found here.
Conclusion
This marks the end of the series and I hope the information I have presented makes the path towards long-term investing as clear as possible. The final article in this series contains a list of links to resources for additional learning: Resources