Why the Average Investor Does Well

An investor who tries to be average will probably do well. How can average be well? Because success in investing requires balancing risk and reward. Risk and reward walk hand-in-hand down Wall Street. The higher the potential payoff from an investment, the greater the risk of loss. The lower the payoff, the safer the investment is likely to be. The payoff from stocks can be good; sometimes, very good. But you can also lose your shirt. The payoff from a bank account is much lower. But they are federally insured up to $100,000, so your risk of loss is essentially zero (unless you have over 100K in the bank).

Many, and perhaps most, people underestimate financial risk. The proof of this is in the tendency of markets to become over-valued and then deflate painfully. The stock market did this in the late 1990s and 2000. The real estate market did it in the early 2000s and is still deflating today. Going back in time, stocks did it in the 1970s and the 1920s. Real estate boomed and busted in the early 1980s and then again in the late 1980s and early 1990s. These cycles occur because people tend to underestimate the potential for markets to fall and buy too much.

On the level of the individual investor, the problem shows up as the tendency to “chase returns.” As we discussed in our May 20, 2007 blog “Why the Tortoise Ends Up Wealthier Than the Hare” (http://blogger.uncleleosden.com/2007/05/why-tortoise-ends-up-wealthier-than.html), investors often invest when an asset is increasing in value and sell after it has dropped. They end up buying high and selling low. That’s not much of a way to make money. Buying and holding is a better long term strategy.

If you control your risks, you’ll get lower returns. But that also means smaller swings in the ups and downs of your portfolio, so you'll be less tempted to buy too much when prices are rising or sell too soon when they're falling. In other words, if you try to get returns that approximate market averages, you’ll be taking reasonable risks while enjoying the potential for the long term returns that the stock market offers. Your portfolio will swing up and down more gently, and that will lessen the temptation to buy into an asset bubble.

An easy way to invest in a well-diversified portfolio with reasonable risk is to use lifecycle or target date funds. These mutual funds are designed for long term retirement planning, and the fund personnel allocate your money into a diversified portfolio for you. You don't have to do the investment strategizing yourself. For more information about these funds, read our May 16, 2007 blog, “Investing Made Simple” (http://blogger.uncleleosden.com/2007/05/investing-made-simple.html).

So, just this once, you can ignore your parents and try to be average. You might be rewarded for it.

Monster News from Loch Ness: http://www.cnn.com/2007/WORLD/europe/05/31/britain.lochness.ap/index.html