The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below is an overview of how to calculate it by hand, and in Excel.

The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, ending value, and the time period. Online tools, including Investopedia’s CAGR calculator, will give the CAGR when entering these three values. The CAGR represents the growth rate of an initial investment assuming it is compounding by the period of time specified. Specifically, the formula is:

CAGR in Excel

The CAGR formula can be recreated in Excel. The formula to use is:
= ((FV/PV)^(1/n)) – 1

Where FV is the investment’s ending value, PV is its beginning value, and n is the # of years.

The XIRR function in Excel also calculates an internal rate of return (IRR) that can also be used to calculate the CAGR. The XIRR function is:
= XIRR(values,dates, guess)

Again, what is needed are the beginning and ending investing values, and date periods. This function is more flexible as it can include multiple values and dates beyond just the ending and starting value. The one rub to this approach is the user must enter an estimated CAGR value, but this also helps intuitively understand the return values.

A Brief Example of the CAGR Calculation

Assume an investment’s beginning value is $1,000 and it grows to $5,000 in 10 years. The CAGR calculation in Excel is as follows:
= ((5,000/1,000)^(1/10)) – 1

The CAGR is 17.4% and details that the investment grew at this annual rate for a decade.

Limitations of the CAGR

The CAGR is superior to average returns because it considers the fact that investment returns compound over time. One limitation is that it assumes a smoothed return over the time period measured. In reality, investments experience significant short-term ups and downs. CAGR is also subject to manipulation as the time period used can be controlled by the user. For instance, a five-year return period can be shifted by a year to avoid a negative period (such as 2008), or to include a period of strong performance (such as 2013).

The Bottom Line

The CAGR helps frame the steady rate of return of an investment over a certain period of time. It assumes the investment compounds over the period of time specified, and it is helpful for comparing investments with different returns across periods, as well as for comparing investments in different asset classes.

Size is one of the most widely followed investment factors. The conventional wisdom ascribed to the size factor is that, over long holding periods, smaller stocks can outpace large caps. However, that outperformance often comes with small caps being more volatile than their larger peers.

During the current bull market, those trends have held true. Since the birth of the current bull market on March 10, 2009, the Russell 2000 Index and the S&P SmallCap 600 have returned an average of 383 percent compared with a gain of "just" 284 percent for the S&P 500. But volatility has been predictably higher for the small-cap benchmarks. In this bull market, average annualized volatility for the two small-cap benchmarks has been about 21.4 percent compared with 16.1 percent for the S&P 500.

The world of smart-beta exchange-traded funds (ETFs) gives investors alternatives for small-cap exposure, some of which have the potential to enhance returns with smaller stocks while reducing volatility. While the WisdomTree SmallCap Dividend Fund (DES) has been only slightly less volatile than the aforementioned small-cap benchmarks during this bull market, that ETF has returned a staggering (almost) 400 percent. As a dividend ETF, DES avoids some of the more speculative, profitability-challenged names that are found in some small-cap funds. DES weights its holdings by dividends paid.

Proving the point that profitability can make a significant difference with small caps, there is the WisdomTree SmallCap Earnings Fund (EES). While EES has been slightly more volatile than traditional small-cap indexes during this bull market, the risk-adjusted returns prove that EES has been a winner. The ETF has returned a whopping 435.1 percent during this bull market.

"By avoiding the small caps with lower operating profitability and focusing on those with higher profitability, there was a return advantage over simply focusing on small caps alone," said WisdomTree in a recent note. The index EES tracks, which is weighted by earnings, is home to just over 800 stocks that meet an important requirement – they must have posted cumulative earnings for the four quarters prior to entering the index.

While DES and EES are obviously small-cap ETFs, indicating that the size factor is somewhat at play here, they can also be seen as quality funds by virtue of their focuses on profitability. "Intuitively, the requirement of paying ongoing dividends or generating positive profits could lead to a focus on higher quality, predominantly by avoiding the more speculative firms that may not meet these criteria," said WisdomTree. DES is more than 10 and a half years old, while EES celebrated its 10-year anniversary last month.

You’ve probably heard a popular definition of what a stock is: “A stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater.” Unfortunately, this definition is incorrect in some key ways.

To start with, stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belong to the corporation, and not to the shareholders.

This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off her creditors.

What shareholders own are shares issued by the corporation; and the corporation owns the assets. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”

So what good are shares, then, if they aren’t actually the ownership rights we think they are? Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.

If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors. This becomes most apparent when one company buys another: the acquiring company doesn’t go around buying up the building, the chairs, the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation, and often does so by hiring professional managers, or officers, such as the Chief Executive Officer, or CEO.

For ordinary shareholders, not being able to manage the company isn't such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company's profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.

Stocks – sometimes referred to as equity or equities – are issued by companies to raise capital in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.

Companies can instead raise money through borrowing, either directly as a loan from a bank, or by issuing debt, known as bonds. Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation, and are entitled to interest as well as repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that bonds.

The same is true on the upside: bondholders are only entitled to receive the return given by the interest rate agreed upon by the bond, while shareholders can enjoy returns generated by increasing profits, theoretically to infinity. The greater risk attributed to stocks has generally been rewarded by the market. Stocks have historically returned around 8-10% annualized, while bonds return 5-7%.

Despite the benefits of putting some money away, most people take a passing interest in actually doing it. If you'd like to make regular saving a part of your life, read on to find out how to conquer the first step: finding that extra money.

You can begin by paying attention to these top money wasting activities

  • Convenience Stores

    Many people don't think about the markup they pay for convenience store items. Here's a hint: it's huge. This is because, unlike grocery stores, convenience stores don't purchase food in large quantities, and also because they make you pay more for the convenience they provide. So, unless it's an emergency situation, avoid shopping at convenience stores.

    The premium you pay for convenience is not worth the assumed convenience you get. For example, a bottle of Coke at a convenience store might cost you around two dollars, while you can go to Amazon and buy a 12-pack for $16. If you tend to pull over for a drink, buy a 12-pack and keep it in your car. If you visit convenience stores often, the annual savings of cutting out these visits can be tremendous.

  • Cell Phone Plans

    Take the time to check your monthly cell phone bill - you may be paying more than you need to. If you are using fewer minutes than your monthly plan allows, switch to a lower-rate plan. If you are using more minutes than your monthly allotment, then upgrade to a higher minute plan.

    Before making any changes to your plan, sit down with a list of your cell phone company's offerings and compare and determine which plan provides the most value based on your needs. You should also scan through your cell phone plan for added features like text messaging and mobile internet. If you aren't really using these features, get rid of them - they're costing you money each month!

  • Soft Drinks

    This one is a sneaky money waster. Not only does ordering beverages along with a restaurant meal boost your total expenses, but soft drinks also have one of the highest markups of any restaurant item, and thus provide lower value for your money.

    Consider a typical family of four that eats out twice a week at fast casual restaurants. Assuming an average price of $1.50 for a fountain soft drink, that totals $12 a week, $48 a month, $624 a year. Just cutting out this one item from your meal could mean significant savings that could go into something much more productive, such as a retirement savings plan. If you invest $624 at a 9% rate of return year every year, you would have almost $32,000 at the end of 20 years. So dine out, but opt for water!

  • Unnecessary Bank Fees

    Many people unknowingly pay a lot to their banks in the form of fees. If you don't know what fees your accounts are subject to, spend a few minutes finding out. Some banks charge ATM fees for using another bank's ATM, for example. These can be as high as $3! This amounts to a 15% one-time fee for a $20 withdrawal. The key with this type of fee is simply knowing about it. You would be better off using a credit card to make the purchase.

    Go back and examine the rules governing your checking and savings accounts. Also consider consolidating bank accounts, as often one account with a larger minimum can eliminate numerous fees that might otherwise exist.

  • Magazines

    If you're the type of person who likes to occasionally pick up your favorite magazine from the local grocery store or newsstand, consider getting an annual subscription. Even if you don't want the magazine every month, a couple of issues at the newsstand are enough to cover the entire annual subscription.

  • Annual Credit Card Fees

    Unless you have a poor credit history, there is no reason to pay annual credit card fees. A host of Visa, MasterCard and Discover cards have no annual fee, yet many people pay $100 or more a year for the privilege of holding a premium credit card. Unless you're a wealthy, exclusive holder of an elite-level credit card with exclusive perks, most people should not be paying annual credit card fees.

    And speaking of credit cards, make sure you make a payment on time every month, even if it's the minimum. Many credit cards charge high monthly late fees, charges which accrue interest along with your existing balance.

  • Be Proactive

    Spend a couple of hours and go over the above categories along with any other regular habits you may have accumulated over the years. The time will be well spent as it could mean hundreds of dollars of recurring annual savings.

The Bottom Line

Shopping at convenience stores, wasting money on magazines, and high credit card and bank fees are easy ways to waste money. Taking some time to go over your spending habits could be well worth your time.

We saw in the last section that once a company completes an initial public offering (IPO), its shares become public and can be traded on a stock market. Stock markets are venues where buyers and sellers of shares meet and decide on a price to trade. Some exchanges are physical locations where transactions are carried out on a trading floor, but increasingly the stock exchanges are virtual, composed of networks of computers where trades are made and recorded electronically.

Stock markets are secondary markets, where existing owners of shares can transact with potential buyers. It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis (companies may engage in stock buybacks or issue new shares, but these are not day-to-day operations and often occur outside of the framework of an exchange). So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company – rather you sell them to some other investor.

The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or trading hubs such as Antwerp, Amsterdam, and London. These early stock exchanges, however, were more akin to bond exchanges as the small number of companies did not issue equity. In fact, most early corporations were considered semi-public organizations since they had to be chartered by their government in order to conduct business.

In the late 18th century, stock markets began appearing in America, notably the New York Stock Exchange (NYSE), which allowed for equity shares to trade (the honor of the first stock exchange in America goes to the Philadelphia Stock Exchange [PHLX], which still exists today). The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior to this official incorporation, traders and brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares.

The advent of modern stock markets ushered in an age of regulation and professionalization that now ensures buyers and sellers of shares can trust that their transactions will go through at fair prices and within a reasonable period of time. Today, there are many stock exchanges in the U.S. and throughout the world, many of which are linked together electronically. This in turn means markets are more efficient and more liquid.

There also exists a number of loosely regulated over-the-counter exchanges, sometimes known as bulletin boards, that go by the acronym OTCBB. OTCBB shares tend to be more risky since they list companies that fail to meet the more strict listing criteria of bigger exchanges. For example, larger exchanges may require that a company has been in operation for a certain amount of time before being listed, and that it meets certain conditions regarding company value and profitability. In most developed countries, stock exchanges are self-regulatory organizations (SROs), non-governmental organizations that have the power to create and enforce industry regulations and standards. The priority for stock exchanges is to protect investors through the establishment of rules that promote ethics and equality. Examples of such SRO’s in the U.S. include individual stock exchanges, as well as the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

The prices of shares on a stock market can be set in a number of ways, but most the most common way is through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.

Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers. A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth. Stock markets of high quality generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality, large companies tend to have the same characteristics.

In addition to individual stocks, many investors are concerned with stock indices (also called indexes). Indices represent aggregated prices of a number of different stocks, and the movement of an index is the net effect of the movements of each individual component. When people talk about the stock market, they often are actually referring to one of the major indices such as the Dow Jones Industrial Average (DJIA) or the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and that it only consists of 30 stocks – when there are many thousand to choose from – it is not really a good indicator of how the stock market is doing. The S&P 500 is a market cap-weighted index of the 500 largest companies in the U.S., and is a much more valid indicator. Indices can be broad such as the Dow Jones or S&P 500, or they can be specific to a certain industry or market sector. Investors can trade indices indirectly via futures markets, or via exchange traded funds (ETFs), which trade like stocks on stock exchanges.

Everyone knows that there are no crystal balls, except in fairy tales. Thus, no one knows what will happen tomorrow, next week or next year. This fact holds especially true with investment markets.

However, history does show that markets and economies go in cycles, up and down. Think about the technology stock bubble in the 1990s and its subsequent crash starting in early 2000. Think about the subprime mortgage crisis and crashes in real estate and the stock markets in 2008 and 2009. Market downturns are inevitable; we just don't know when one will happen, how long it will last and what depths it will plumb.

Therefore, despite an impressive six-year-plus run-up in U.S. stock prices, it is safe to say that a violent and/or prolonged downturn in stock prices will occur again. It has been said that history doesn’t repeat itself, but it often rhymes. Semantics aside, anything that “rhymes” with the vicious market downturns of 2000 or 2008 could decimate your portfolio and retirement prospects.


The intent of robo-advisors is to make investing easier and less expensive by largely automating the process, thereby taking relatively expensive human advisors out of the equation. They typically utilize pre-made portfolios from a limited palette of investing options, usually exchange-traded funds. An investor answers questions related to age, potential need for cash, investing horizon and perceived risk tolerance, among other topics. The investor's "risk score" is calculated from answers to these questions. This score then matches an investment portfolio to the investor.

There is one obvious issue with this process. There is wide discretion among questionnaires and risk scores with no universally accepted best methodology. Thus investors must contend with firms marketing varied approaches with no guarantee a particular approach will suit them.

A less obvious issue arises from the results of seemingly similar 60-40 (comprised of 60% equities and 40% fixed income) portfolios from different robo-advisor companies. On January 25, 2017, Investment News published an article showing investment returns over a one-year period from a test conducted by Condor Capital Management. Those returns varied from up 5.55% for a 60-40 Vanguard portfolio to up 10.75% for a 60-40 portfolio from Schwab.

Do those results mean Schwab offers better robo portfolios? No, it simply means that over the one-year period measured, the specific Schwab 60-40 portfolio returned more than other 60-40 robo portfolios. There was no mention in the article of the exact asset breakdown, but it is likely that the Schwab portfolio had more U.S. exposure and the Vanguard portfolio had more international exposure. U.S. stocks outperformed international stocks that year, so the Schwab portfolio did better. Had the test run for another year or two, the results could have reversed or, more likely, evened out. There were no risk measures cited.

The point is that seemingly similar approaches can yield significantly different results over any period, but one robo can't be measured as better than another simply based on returns. So, what is an investor to do? How can one know what is best? You likely need a discussion with a human being who is experienced in such matters to help you determine what is best for you.

A Bigger Problem With Your Robo-Advisor

Robo-advisors may be good for creating simple portfolios on the cheap, but they cannot help you when investments go wrong or when markets turn bad. Robos are programmed to rebalance portfolios to target allocations at specified intervals. They are not programmed to lessen your risk of financial loss in volatile markets. They are designed for long-turn investing, but short-term risks need to be considered, too. If you go broke in the short-term or get scared away from investing forever, your portfolio won’t last for the long-term.

Thus, risk of potential loss must be carefully considered and discussed. Robo-advisors can’t calculate how you will feel when markets go against you. What if the stock market (as measured by the S&P 500) goes down 25% tomorrow? How will you feel? What will you do? A robo-advisor cannot determine a best course of action for you individually.

Most of you will not feel qualified, or have the time, to make buying and selling decisions. You will likely not understand how to alter your portfolio based on potential risks in markets. Unless you are an experienced investor taking full responsibility for your portfolio, you should talk to an experienced human advisor before an inevitable market downturn, because investment decisions will need to be made for you. Your human advisor needs to know you in order to best help you.

Bionic Capital

An owner of a registered investment advisor would never guarantee any type of positive portfolio results. An honest, and knowledgeable investment professional can’t. Humans sometimes make mistakes, but we also make decisions. Would you prefer to have an unthinking machine or an experienced human helping you invest? How about a combination of both?

Either way, I can guarantee the machine will not take any responsibility for your portfolio results or your financial future.

The Bottom Line

When markets turn down, your robo-advisor will inevitably fail you. You need someone who will take responsibility for the risks and results in your portfolio. If that person isn’t you, you must find the right person who can make difficult decisions and take appropriate actions for you. Robo-advisors just can’t do either.

If the thought of investing in the stock market scares you, you aren't alone. False promises and highly public stories of investors striking it rich or losing everything skew perceptions of the reality of the average investor. By understanding a little more about the stock market – and how the stock market works – you'll likely find it isn't as scary as you may think and that it's a viable investment.

  • What Is a Stock or Share?

    When you buy a stock you're buying a piece of the company. When a company needs to raise money, it issues shares. This is done through an initial public offering (IPO), in which the price of shares is set based how much the company is estimated to be worth, and how many shares are being issued. The company gets to keep the money raised to grow its business, while the shares (also called stocks) continue to trade on an exchange, such as the New York Stock Exchange (NYSE).

    Traders and investors continue to buy and sell the stock of the company on the exchange, although the company itself no longer receives any money from this type of trading. The company only receives money from the IPO.

  • Why Buy Shares?

    Traders and investors continue to trade a company's stock after the IPO because the perceived value of company changes over time. Investors can make or lose money depending on whether their perceptions are in agreement with "the market." The market is the vast array of investors and traders who buy and sell the stock, pushing the price up or down.

    Trying to predict which stock will rise or fall, and when, is very difficult. Over time stocks as a whole tend to rise, which is why many investors choose to buy a basket of stocks in various sectors (this is called diversification) and hold them for the long-term. Investors who use this approach do not concern themselves with moment-to-moment fluctuations in stock prices. The ultimate goal of buying shares is to make money by buying stocks in companies you expect to do well, those whose perceived value (in the form of the share price) will rise.

    Mature and established companies may also pay a dividend to shareholders. A dividend is a cut of the company's profit, which the company sends to shareholders as long as the company continues to pay the dividend. Aside from the dividend, the share price will continue to fluctuate. The losses and gains associated with the share price are independent of the dividend. Dividends can be large or small – or nonexistent (many stocks don't pay them). Investors seeking regular income from their stock market investments tend to favoring buying stocks that pay high dividends.

    When you buy shares of a company, you own a piece of that company and therefore have a vote in how it is run. While there are different classes of shares (a company can issue shares more than once), typically owning shares gives you voting rights equal to the number of shares you own. Shareholders as a whole, based on their individual votes, select a board of directors and can vote on major decisions the company is making.

  • Why Sell Shares?

    For every stock transaction, there must be a buyer and a seller. When you buy 100 shares of stock (called a "lot") someone else must sell it to you. Either buyers or sellers can be more aggressive than the other, pushing the price up or down.

    When the price of a stock goes down, sellers are more aggressive because they are willing to sell at a lower and lower price. The buyers are also timid and only willing to buy at lower at lower prices. The price will continue to fall until the price reaches a point where buyers step in and become more aggressive and willing to buy at higher prices, pushing the price back up.

    Investors don't all have the same agenda, which leads traders to sell stocks at different times. One investor may hold stock that has grown significantly in price and sells to lock in that profit and extract the cash. Another trader may have bought at a higher price than the stock now sells for, putting the trader in a losing position. That trader may sell to keep the loss from getting bigger. Investors and traders may also sell because they believe a stock is going to go down, based on their research, and want to take their money out before it does.

  • Volume

    How many shares change hands in a day is called volume. Many stocks on major exchanges, such as the NYSE or NASDAQ, have millions of shares issued. That means potentially thousands of investors in a stock may decide to buy or sell on any particular day. A stock that has lots of daily volume is attractive to investors because the volume means they can easily buy or sell their shares whenever they please.

    When volume is inadequate, or no one is actively trading a stock, it's still usually possible to dispose of a small number of shares because the exchanges mandate certain traders (firms) to provide volume. These traders are commonly referred to as market makers, and act as buyers and sellers of last resort when there are no buyers or sellers. They don't have to stop a stock from rising or falling though, which is why most traders and investors still choose to trade stocks with lots of volume, and thus not rely on these "market makers," which are now mostly electronic and automated. There are still people on the floor of the NYSE. Those men and women in the blue jackets trade stocks for their firms and also help facilitate orders from the public.

The Bottom Line

Stocks are issued by companies to raise cash, and the stock then continues to trade on a exchange. Overall stocks have risen over the long-term, which makes owning shares attractive. There are also additional perks such as dividends (income), profit potential and voting rights. Share prices also fall, though, which is why investors typically choose to invest in a wide array of stocks, only risking a small percentage of their capital on each one. Shares can be bought or sold at any time, assuming there is enough volume available to complete the transaction, which means investors can cut losses or take profits whenever they wish.

Evidence-based investing integrates a similar methodology as the more widely known evidence-based medicine, which incorporates broadly accepted research with sound design to optimize the decision-making thought process for the best outcome for the patient. The Centre for Evidence-Based Medicine at Oxford in the United Kingdom has high praise for the process, noting that, “Evidence-Based Medicine is the conscientious, explicit, and judicious use of current best evidence in making decisions about the care of individual patients.” Evidence-based investing (EBI) is not in theory too dissimilar from the evidence-based medicine process.

Simply stated, EBI makes use of the best evidence currently available for the initial design and implementation of an investment portfolio as well as for subsequent ongoing management of that portfolio. Compared to the normal methodologies, EBI could be a huge and beneficial change to an individual’s investing strategy.

The concept behind EBI comes from lauded professors and scholars from around the world, including Myron Scholes, Harry Markowitz, Robert C. Merton, William F. Sharpe, Eugene Fama and Merton Miller, all of whom are Nobel Prize laureates; Kenneth R. French rounds out the list.

A Look Back at Investing Through History

Taking a brief look at the history of investing should shed some light on the significance of EBI.

Investing began in the simplest form, with an individual’s purchase of land for farming for personal use. That was followed with an investment in one’s own business. In those two examples, an individual’s investment was generally of a personal nature, i.e. in himself or herself. That followed with investing in other individuals’ businesses or companies by buying a “share” of their livelihood. Buying stocks in this way also offered another benefit: diversification. Finally, with the purchase of bonds, which is essentially the debt of a business or company, an investor could, for all intents and purposes, loan money to that business.

Later, an investor might hire a broker-dealer, whose job is to make recommendations on suitable investment opportunities. The broker-dealer would also help complete the transaction which, more often than not, would earn him a commission.

Years later came the development of mutual funds. Which stocks or bonds go into the mutual fund is decided by the fund manager. Using his or her expertise and knowledge, the manager will make the final choice as to which companies will be included, and in what proportion. The fund manager will also occasionally rebalance the fund when it is deemed necessary.

Generally, broker-dealers are quite fond of mutual funds because someone else (i.e. the fund manager) has already done all of the homework. And the fact that they often result in a hefty commission (for the broker-dealer, of course) makes them that much more attractive. Many broker-dealers have decided to get a bigger piece of the action by creating their own “family" of mutual funds, which means not only do they earn a commission when they sell the mutual fund to an investor, they also get some of the management fee.

Ultimately, a fund manager’s goal was to beat the market. They attempted to do that with frequent buying and/or selling of the shares or bonds within the mutual fund, often based on the predictions of so-called industry experts. While that worked out nicely for the fund manager and for the broker-dealer, it meant higher fees for the investor. Often it wasn’t very tax-efficient for the investor. It has since been determined that an active management style hardly ever beats the market, even over time; however, it did make a very nice profit for some financial services companies.

All of that eventually led to the development of index funds. In brief, an index fund contains stocks from a particular index (the Dow Jones Industrial Average (DJIA) is a good example) in a pre-determined percentage. One of the more well-known developers of index funds is Vanguard.

The Shortcomings of Conventional Investing

Let’s take a look at some of conventional investing’s shortcomings:

  • Generally, active money management doesn’t outperform the benchmarks, even over long periods (and despite assertions to the contrary).
  • Financial services companies tend to design and sell high-priced products.
  • Those products, quite often, result in a conflict of interest.
  • The resultant higher fees for the investor will negatively impact a portfolio’s performance.
  • An investor should never rely on past performance when choosing a money manager.
  • Timing the market hardly ever works.
  • Investors may make decisions that are behavior-based, generally to their detriment.

In a nutshell, the foregoing is essentially how “conventional investing” is viewed. Most financial services companies invest “conventionally” and are governed by the “suitability standard.” Simply put, their interests are often placed well ahead of yours! Evidence-based investing provides a better approach for the investor.

Why Evidence-Based Investing Works

Now, let’s look at why evidence-based investing works:

  • The asset allocation within a portfolio should be determined by an investor’s specific goals and timeframes, and influenced by his or her risk tolerance and capacity.
  • An investment portfolio should be diversified. That means the portfolio should contain stocks and bonds (both domestic and international), as well as REITs and/or cash equivalents.
  • A portfolio that is tax efficient can boost returns.
  • Low-cost investing can result in higher returns.
  • For the risks taken, small-cap stocks can increase returns compared to large-cap stocks.
  • Value stocks can offer premium returns over time compared to growth.
  • Evidence has shown that passive management outperforms active management.
  • Under the fiduciary rule, an investor’s interests would be maximized, as opposed to the suitability rule.

The evidence-based concept, as you might expect, is not well liked by the heavy hitters among the financial services companies (Merrill Lynch and Morgan Stanley, for example) or insurance companies and those firms that sell a product. Moreover, it isn’t embraced by advertisers or touted by “investment gurus” like Jim Cramer (among others). Why? Because EBI isn’t profitable for them.

But, it could well be profitable for you if you consider modifying your investing approach from the conventional methodologies to evidence-based. How do you start? With a financial advisor who incorporates EBI.

Of the mistakes made by investors, seven of them are repeat offenses. In fact, investors have been making these same mistakes since the dawn of modern markets, and will likely be repeating them for years to come. You can significantly boost your chances of investment success by becoming aware of these typical errors and taking steps to avoid them.

  1. No Plan

    As the old saying goes, if you don't know where you're going, any road will take you there. Solution?

    Have a personal investment plan or policy that addresses the following:

    • Goals and objectives
      Find out what you're trying to accomplish. Accumulating $100,000 for a child's college education or $2 million for retirement at age 60 are appropriate goals. Beating the market is not a goal.
    • Risks
      What risks are relevant to you or your portfolio? If you are a 30-year-old saving for retirement, volatility isn't (or shouldn't be) a meaningful risk. On the other hand, inflation – which erodes any long-term portfolio – is a significant risk.
    • Appropriate benchmarks
      How will you measure the success of your portfolio, its asset classes and individual funds or managers?
    • Asset allocation
      Decide what percentage of your total portfolio you'll allocate to U.S. equities, international stocks, U.S. bonds, high-yield bonds, etc. Your asset allocation should accomplish your goals while addressing relevant risks.
    • Diversification
      Allocating to different asset classes is the initial layer of diversification. You then need to diversify within each asset class. In U.S. stocks, for example, this means exposure to large-, mid- and small-cap stocks.

    Your written plan's guidelines will help you adhere to a sound long-term policy, even when current market conditions are unsettling. Having a good plan and sticking to it is not nearly as exciting or as much fun as trying to time the markets, but it will likely be more profitable in the long term.

  2. Too Short of a Time Horizon

    If you are saving for retirement 30 years hence, what the stock market does this year or next shouldn't be the biggest concern. Even if you are just entering retirement at age 70, your life expectancy is likely 15 to 20 years. If you expect to leave some assets to your heirs, then your time horizon is even longer. Of course, if you are saving for your daughter's college education and she's a junior in high school, then your time horizon is appropriately short and your asset allocation should reflect that fact. Most investors are too focused on the short term.

  3. Too Much Attention Given to Financial Media

    There is almost nothing on financial news shows that can help you achieve your goals. Turn them off. There are few newsletters that can provide you with anything of value. Even if there were, how do you identify them in advance?

    Think about it – if anyone really had profitable stock tips, trading advice or a secret formula to make big bucks, would they blab it on TV or sell it to you for $49 per month? No – they'd keep their mouth shut, make their millions and not have to sell a newsletter to make a living.

    Solution? Spend less time watching financial shows on TV and reading newsletters. Spend more time creating – and sticking to – your investment plan.

  4. Not Rebalancing

    Rebalancing is the process of returning your portfolio to its target asset allocation as outlined in your investment plan. Rebalancing is difficult because it forces you to sell the asset class that is performing well and buy more of your worst performing asset classes. This contrarian action is very difficult for many investors.

    In addition, rebalancing is unprofitable right up to that point where it pays off spectacularly (think U.S.equities in the late 1990s), and the underperforming assets start to take off.

    However, a portfolio allowed to drift with market returns guarantees that asset classes will be overweighted at market peaks and underweighted at market lows – a formula for poor performance. The solution? Rebalance religiously and reap the long-term rewards.

  5. Overconfidence in the Ability of Managers

    From numerous studies, including Burton Malkiel's 1995 study entitled: "Returns From Investing In Equity Mutual Funds," we know that most managers will underperform their benchmarks. We also know that there's no consistent way to select – in advance – those managers that will outperform. We also know that very few individuals can profitably time the market over the long term. So why are so many investors confident of their abilities to time the market and select outperforming managers?

    Fidelity guru Peter Lynch once observed: "There are no market timers in the Forbes 400." Investors' misplaced overconfidence in their ability to market-time and select outperforming managers leads directly to our next common investment mistake.

  6. Not Enough Indexing

    There is not enough time to recite many of the studies that prove that most managers and mutual funds underperform their benchmarks. Over the long-term, low-cost index funds are typically upper second-quartile performers, or better than 65-75% of actively-managed funds.

    Despite all the evidence in favor of indexing, the desire to invest with active managers remains strong. John Bogle, the founder of Vanguard, says it's because: "Hope springs eternal. Indexing is sort of dull. It flies in the face of the American way [that] 'I can do better.'"

    Index all or a large portion (70%-80%) of all your traditional asset classes. If you can't resist the excitement of pursuing the next great performer, set aside a portion (20%-30%) of each asset class to allocate to active managers. This may satisfy your desire to pursue outperformance without devastating your portfolio.

  7. Chasing Performance

    Many investors select asset classes, strategies, managers and funds based on recent strong performance. The feeling that "I'm missing out on great returns" has probably led to more bad investment decisions than any other single factor. If a particular asset class, strategy or fund has done extremely well for three or four years, we know one thing with certainty: we should have invested three or four years ago. Now, however, the particular cycle that led to this great performance may be nearing its end. The smart money is moving out, and the dumb money is pouring in. Stick with your investment plan and rebalance, which is the polar opposite of chasing performance.

The Bottom Line

Investors who recognize and avoid these seven common mistakes give themselves a great advantage in meeting their investment goals. Most of the solutions above are not exciting, and they don't make great cocktail party conversation. However, they are likely to be profitable. And isn't that why we really invest?

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