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The Most Important Investment Concepts I Have Learned

As a follow up to my previous post on How a Bad Investment Experience Changed My Life, I will discuss in this post what I think are the most important investment concepts I have learned from my investing experience and research. I have talked about these concepts in previous posts but, to start off the New Year, I think they are worth calling attention to again.

There are many things about investing that people should keep in mind, such as, do not engage in frequent trading, keep investment costs low, and ignore Wall Street fads. However, based on my investing experience in the last 20 years which included both a significant bull and bear market, there are four important investment concepts that I think contributed the most to my long term investment returns. They are:

1. Future investment returns are most affected by the valuation of the investment at the time of purchase; in other words, the better the investment valuation at purchase, the better the investment return down the road,
2. When investing do not follow the crowd,
3. It is OK to hold cash,
4. Invest for income rather than capital appreciation.

I will make some brief comments on each investment concept.

Investment Valuations

In the post on my California real estate investing fiasco I explain the many things I did wrong. But the biggest mistake I made was not buying properties that represented good valuations. Because real estate is an illiquid investment, it is very important to buy real estate when it is in a long term down cycle like today and hold the investment for many years. I talk about real estate cycles in this previous post. When investing in stocks, current valuations are also a very important predictor of future returns. You can read my discussion of this topic in this post.

Do Not Follow the Crowd

In recent years there has been a lot of research in the area of behavioral finance. Much of this research revolves around investor “herd” mentality and the investor psychology of greed and fear (i.e., buying stocks after they increase in value due to greed and selling stocks after they fall in value due to fear of loss). Many studies confirm that the average investor prefers to buy an investment after the prices have already shot up. Extreme examples of this behavior are the late 1990s technology bubble and the mid-2000s real estate craze. Buying high and selling low is in direct violation of the first concept listed above, but it happens a lot.

Greed and fear notwithstanding, I have never understood why the average investor will wait until a flat screen TV goes on sale before purchase, but has no patience to do the same thing when investing. I can only conclude that the average investor does this because they do not know the true value of the investments they are buying. This is one of the best reasons that the average investor should stick to index investing. In any case, in this post I discuss in more detail the benefits of not following the investment herd.

Let me be clear, I am not suggesting that you should try to determine how the crowds are investing and then do the opposite.  If you just employ the practice of periodically rebalancing your portfolio, you will automatically avoid following the investment “herd.”

If you ever deliberately try to invest against the crowd, I would advise doing so on rare occasions and only with small amounts when certain investments seem to be hitting extreme highs or lows. I call this investing practice “tactical” investing. I discussed this concept in my post on Tactical versus Strategic Investing.

Do Not Be Afraid to Hold Cash

This concept is obviously not difficult to grasp for people over 50 years old. However, many financial advisors advise young people to invest close to 100% of their long term retirement in the equity markets. This works if you are in the beginning of a long term bull market like the United States was in the early 1980s. But in more normal market periods, holding some cash will lower your risk without sacrificing too much in total return. Too many investors have this attitude of “I must be fully invested in the markets so my money is working for me at all times.” The problem with this approach is most people cannot handle the volatility of a 100% equity portfolio. How did you react to the stock market in 2008 and 2009? Did you stay fully invested or did you sell during the crisis?

The 20 year period from 1990 to 2009 included both a significant bull and bear market. In this post I present a table showing the 20 year annual return during this period for 11 different portfolios with different percentage equity allocations. Of course having 100% in stocks did better than having 70% in stocks. But I think giving up the 1.3% per year (i.e., 10.1% versus 8.8%) is more prudent if it allows you to maintain your 70% equity allocation. What I am suggesting here is, if someone tries to hold a 100% equity allocation, at some point they will not be able to handle the market volatility. They will sell in a panic and ultimately they will achieve an annual return less than 8.8%. It is the rare person who can be 100% invested in equities and handle market volatility like we experienced in 2008 and 2009.

Of course you should never stop adding new money from your paycheck to stock funds in your retirement accounts through dollar cost averaging, but I think it is always best to keep part of your assets in cash whether in retirement accounts or outside retirement accounts.

Invest for Income Rather Than Capital Appreciation

There are several reasons why I focus on income generating investments, beyond the cash payments I receive. When you purchase assets based on maximizing income, you are usually purchasing the assets at very good valuations. Moreover, an investment with increasing income is very likely to experience capital appreciation over time. This is true for both real estate and stocks. Because of all the costs associated with owning real estate, it is critical that the real estate pay income to cover the expenses. But, in my opinion, it is also important that stocks pay income in the form of dividends as well.

When I invest in stocks, I almost always invest in a stock that, not only pays a regular dividend, but one that has been increasing for many years. As I discussed in this post on “Equity Income Investing,” since 1926, dividends have contributed almost 44% of the stock markets total return. And this part of the total return is much more reliable than capital appreciation.

I will add one other stat regarding equity income investing. According to Standard & Poors, in the 33 years from 1979 through 2011, if you had invested $10,000 in 1979 in all the S&P500 stocks that did not pay a dividend, you would now have $250,000. However, if you invested $10,000 in 1979 in all the S&P500 stocks that did pay a dividend (no matter how small), you would now have $414,000.

Finally, in addition to better total returns, there is one other fundamental reason why I favor companies that pay a consistent dividend. By law a company cannot pay a dividend unless they are solvent. I think that is pretty important in today’s volatile equity markets.

This post basically summarizes what I have found to be the most important investment concepts. In reading this post, you have learned in one sitting what took me many years of investing to discover. There are, of course, many other investing details to be aware of, but if you keep these concepts in mind, you should do well in the markets without having to make investing a part time job.

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