I encourage my clients to ask lots of questionsabout investing. The more, the better, and sometimes what seem to be very superficial questions hold the key to the most important fundamentals of investing. Here are some valuable insights from the most common questions I've heard from clients.
1. What do you think the stock market will do this year?
I refrain from making such predictions because I don't actually know. In fact, no one knows — some just think they do. Trust me, if I did know I would be raking in billions. A better approach is crafting a disciplined strategy that makes the day-to-day movements of the stock market less traumatic. By picking an asset allocation of stock, bond and money market investments, sticking to it and rebalancing (selling after markets go up and buying when they drop), the investor is positioned for the long run regardless of what wild ride the capricious stock market takes us on. Who needs predictions when you've got a plan?
2. Why did the stock market plunge (or surge) today?
Typically, such movements can be chalked up to the volatility that's always present in the stock market. Though it's natural to want everything explained, much of the market short-term moves are simply random variation. It's the media that scrambles to find news items to support the market movement of the day so that we can make sense of it. Media headlines can be dangerous.
3. Why would I buy bonds since interest rates have to go up and bond prices fall when that happens?
The easy answer is that no one knows how interest rates will move. Sure, the Federal Reserve knows what they will do with the Fed Funds rate, but that's only the overnight interest rate for banks. Longer-term rates are set by the market, and economists have predicted these rate changes poorly. Their track record on correctly calling the direction of intermediate and long-term rates is less than we would expect by flipping a coin (a 50 percent chance).
4. Why should I take any risk with my money when cash is safe?
Though there is an emotional comfort in having it readily available, cash may be the ultimate risk. Cash earning 0.01 percent annually in a money market fund is virtually guaranteed to underperform inflation and thus lose spending power. Don't let the fact that cash feels good keep you from investing it in something that at least has a chance to keep up with inflation. Stash the cash where it earns at least 1 percent annually. Longer-term CDs with lower early withdrawal penalties give bond-like returns with less risk.
5. Why should I buy this index fund when this other fund has outperformed it over 10 years and the manager is regarded as brilliant?
Because past performance has been shown to be a lousy predictor of future performance. Some funds do outperform the broad index fund but fewer than random luck would have predicted.
6. How do I get income from my investments?
This is a very common question, especially for retirees who are no longer working. My answer is always that total return — that is price appreciation plus the income from interest or dividends — is far more important than income alone. All too often, I've seen people lose a ton of their principal by chasing riskier investments that promise to generate higher income. It's OK to live on the principal if you have it invested so that it generates price appreciation as well as income.
My answers may not be particularly satisfying or comforting, as they are lacking in predictions and guarantees. Yet the answers to these "dumb" questions lead to a much better understanding of investing and offer investors important insights that can be applied to their own portfolios.
As I tell clients, the only real dumb question is the one never asked.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.