This page is for some tips that are more advanced than our basic money management tips.
There are so many different schools of thought and approaches to investing. We will share our own personal favorites. To start, here are some ideas that are accepted as conventional wisdom by people who are serious about investing:
- Trust bonds for a reasonable return with minimal risk. Bonds (like the ones issued by the US Treasury) are regarded as extremely safe: there is a chance that they will default and you will lose your investment, but this chance is very close to zero. At the same time, they have a rate of return that is higher than zero, which is roughly the return you get if you are storing your money under your floorboards or in a typical retail savings account. Bonds pay low-ish rates of return like 1% or 2%, usually just enough to compensate for inflation plus a small amount of real growth. Low risk, low reward is the bottom line here.
- Trust stocks for a better long-term return with slightly higher risk than bonds. The stock market has historically had a better rate of return than bonds. In the short term, like a day or even a few years, it is common for individual stocks or the whole market to go down and for investors to lose money. But for longer-term investments in the stock market, like diversified investments that last ten years or more, it is very likely (though not guaranteed) that an investor in the stock market will have returns that are a few percentage points higher than the returns on bonds. The stock market is regarded as relatively safe. Low to moderate risk with moderate to high rewards are the bottom line here.
- Index funds are much more safe and reliable than individual stocks. When people start thinking about stock market investment, they often think about buying stock in one particular corporation that they admire. People hear stories about someone who had one share of Burger King stock 50 years ago and is super-rich today, or they hear about "penny stocks" whose shares only cost one cent today, but may rise 1,000% overnight. Some beginners want to put all of their investment cash into single corporations because of these ideas. However, this tends to be dangerous. The stock market as a whole is relatively safe and relatively reliable, but each individual stock in the market is highly unpredictable from one day to the next, and betting all or most of a portfolio on one stock or a few selected stocks is a mistake that has caused many people to get burned and lose a lot. Selecting individual stocks may be a good strategy for experts who spend weeks or months studying the balance sheets and particulars of thousands of corporations to find one that is a good investment. But for a non-expert who doesn't want to spend all day every day carefully poring over the details, it is much safer and wiser to buy diversified "index funds." An index fund is simply a "basket" or collection of many different stocks - sometimes of every stock on the market. By diversifying, index funds avoid the sharp, unpredictable ups and downs of individual stocks, and reliably return the decent stock market average to investors - this is the right investment choice for most stock market amateurs.
- Don't forget the Efficient Market Hypothesis. The Efficient Market Hypothesis (or EMH) is very commonly discussed both among investors and scholars. Basically, the EMH says that market prices take all market information into account. One way to think about this is to imagine all of the millions of people who have access to the stock market. There are many ordinary people who follow the market and put money into it. There are also thousands of intelligent, dedicated experts who are constantly trying to earn money from it. If there is some information (like an SEC report) that indicates that a stock will go up soon, some or all of the thousands of stock-market experts will see those signs and "immediately" buy the stock, and it will "immediately" go up and reflect that information. Things are never perfectly immediate, but with anxious experts working around the clock and around the world, and with experts' computers hooked up to trading desks via light-speed fiber optic cables, stock market prices can change very fast, and certainly faster than almost any amateur could keep up with. And that is the implication of the EMH: when you make a bet in the stock market, you are not just betting for or against a stock, you are betting against a legion of experts who may know more than you and can probably act faster than you. This is why a lot of people stick to bonds and index funds - they are so safe that the amateurs know about as much as the experts about their slow, steady growth. That is not to say that it is impossible to succeed - it certainly is possible to make money and have fun investing. After all, the experts have been totally wrong thousands of times, and they will be wrong many more times in the future. But the EMH means that we shuold all have some humility and also that we should all work hard to make the right decisions rather than playing the market like a roulette wheel.
The following ideas are believed by many people, but are not as commonly believed as the first set of bullet points above. They are personal favorites so we will present them here.
- Play at the extremes. In financial markets, just like in life, there is a balance between events that are common and have tiny importance, and events that are rare that have huge importance. One of our heroes, Nassim Taleb, has popularized the belief that the extreme events and "black swans," despite their scarcity, are of the utmost importance to understand, prepare for, and profit from. One strategy we like based on a belief in the importance of extremes is a 90/10 strategy. The idea of a 90/10 strategy is to allocate a large portion (90% maybe) of your investment capital to extremely safe investments like bonds and index funds. This portion of your portfolio will be "guaranteed" a reasonable return like 2% or 3% per year. Allocate a small portion (10% or less) of your investment capital to extremely high-risk, high-reward bets like venture capital or promising IPO's. The safe, conservative 90% will ensure that you don't go broke every year, and the risky, high-potential 10% will (hopefully) pay off in a huge way once every ten years or so. Most years you will lose a little money, but once in a great while you will win really big. This is not a guarantee or a universally accepted plan, it's just an idea we like.
- Adopt a convex strategy. One way to classify investment strategies is by whether they are convex or concave. Concave strategies look like the graph of y=log(x) - steep descent on the left, shallow climb on the right. In a concave strategy, if your investments do poorly, you will lose a lot (corresponding to the steep descent), and if your investments do very well, you will only gain a little (corresponding to the shallow climb). Convex strategies look like the graph of y=exp(x) - shallow descent on the left, steep climb on the right. These strategies are the opposite of concave strategies: if your investments do poorly, you will only lose a little (the shallow descent) and if your investment strategies do well, you will gain a lot (the steep climb). Concave strategies are worse than convex strategies at the extremes of the market doing extremely well or extremely poorly, but are a little better than convex strategies in the middle, where things are volatile and so-so. Convex strategies are resistant to large losses and have the potential of huge gain, and that's why we like them here at Five in Gold. As an example of concave vs. convex, consider re-balancing a portfolio. Let's say that you start with an investment portfolio that is 50% stocks and 50% bonds. The bonds, we will assume, will always perform OK, but the stocks could go up a lot or go down a lot. After some time has passed, even though you started with a 50/50 split, you will probably have something like a 55/45 balance between stocks and bonds (if stocks have gone up more than bonds) or 45/55 balance (if stocks have gone down). Some people, since they started with 50/50 and like the idea of an even split, will "rebalance" after this happens. So if stocks are taking up 55% of the portfolio, they sell a little and buy bonds with the proceeds, and are back to 50/50. Or if stocks are at 45%, they sell some bonds and buy back stocks until they are at 50/50. Rebalancing may have a superficial appeal, but it leads to a concave strategy. The reason for this is that if stocks continue to do well and you are constantly getting rid of them, you won't benefit from their gains. Or if stocks continue to do poorly and you are constantly re-buying them, you will accelerate your losses. Conversely, a "momentum" strategy is convex: if stocks do well and go up to 55%, buy more, and if they do poorly and go down to 45%, sell more. With a momentum strategy, you don't lose much if losses continue, and you gain a lot if gains continue.
- Stick to your guns. Once again, this is not only good financial advice, but also good life advice. Before you make a decision (e.g. about a stock purchase), consider all of your options carefully, do your homework, and be confident that it is the right decision. But after you make the decision, trust yourself and stick to it. Sometimes people buy a stock, and then 5 minutes after they bought it, they check it and are horrified to see that the price went down one tenth of one percent. Then they check it five minutes later. And again. They second-guess themselves and sometimes they sell the stock within a day if they get spooked by these tiny losses. In our opinion, the best approach to the stock market is a long-term approach. Don't buy a stock for what you think it will do in a day, but rather buy it for what you think it will do in a year or 10 years. Most of what happens during the course of a day is just "noise" anyway. Sometimes it's best to think hard about the decision, then buy the stock, then forget about it for at least a few months - don't constantly check its progress.
Go back to the tips page.
Find our basic tips here.
Find our advanced tips here.
Find our guide to volatility here.
Please note: this site is meant to provide information. It is not meant to offer financial advice or recommendations. Recent trends are not guarantees of future performance. Top growth stocks may continue growing, but they are often inflated and poised for a sharp decrease. Sometimes recent drastic trends are only corrections that are part of a longer-term trend in the opposite direction. While we strive for both accuracy and timeliness, we guarantee neither. Use the information here as a source of ideas rather than a set of recommendations, and always do thorough research before making any trades.
Please visit our Facebook page and our Twitter page. Feel free to contact us at info at fiveingold.com.