As a financial planner, I get asked a lot of questions. Though many are savvy and on point, some are not. Yet there are valuable insights to be gained from these three common questions, usually driven by our instincts, which have been posed to me over the years from clients, friends, family and strangers alike.
1. “What will the stock market do over the next year?”
This comes in various flavors, but much of the time it’s about whether a correction or plunge is likely. Regardless of how the question is phrased, my response is always the same: “I don’t know.” I charge clients a hefty hourly rate to tell them that I don’t know the future, and it’s the best single piece of advice I give. No one knows what the market will do or when the next nosedive will occur. Those who think they do and try to time the market typically fail miserably. A much better question to ask: Am I at the appropriate asset allocation (between stocks and bonds), and can I weather a market plunge that doesn’t quickly recover? If the answer is no, it’s time to adopt the right asset allocation before any plunge.
2. “Will you recommend a few good companies I can buy stock in?”
My answer is a resounding no, for two reasons. First, if you own a few stocks, it presents more risk than owning thousands of companies through a low-cost index fund such as the Vanguard Total Stock Market Index Fund ETF (VTI) or the Vanguard Total International Stock Index Fund ETF (VXUS). Owning thousands of companies is admittedly risky enough, but it is far less risky than owning a few or even a few dozen. In fact, incoming Vanguard CEO Tim Buckley was recently asked, "What’s your favorite stock?" He replied, “All of them.” Money is flowing from actively managed funds to index funds because of the dismal stock-picking track record of portfolio managers. A much better question to ask is: “Do I want to take on uncompensated risk?” Since owning a few stocks is far riskier than owning thousands, but your expected return is the same, you are taking on uncompensated risk. If your answer is no to taking on that uncompensated risk, then consider index funds owning every stock.
Second, good companies generally don’t make the best investments. Good companies are fast-growing (growth stocks), while bad companies are either slow-growing or have declining sales (value stocks). But research demonstrates that over the very long run, value stocks do better than growth stocks. Growth companies have high valuations based on high expectations, while value companies have low valuations based on low expectations. It’s easier for the value companies to beat low expectations than for growth companies to beat high expectations.
Because an index fund doesn’t provide much amusement, every year I put a small amount of money in one or two companies, which I call my gambling portfolio. It exercises a piece of my brain that wants to have a little fun. However, rather than buying good companies, I buy bad ones ... actually awful companies.
3. “Am I right to buy this investment that has performed so well?”
Whether it’s a recent highflier like Bitcoin or a mutual fund with a long-term track record sporting the highest five-star rating by Morningstar, it turns out that past performance has virtually nothing to do with future performance. In fact, research indicates that the top-performing investments typically revert back to an average performance going forward. Morningstar says “Investors should make expense ratios a primary test in fund selection.” A much better question: “Do I understand how this will fit in with my entire investment strategy?” An easy-to-explain strategy is typically superior.
It’s human nature to want to know how the market will do over the next year, to want to own the next superstar stock and to want to buy investments that continue to climb. Unfortunately, we can’t predict the future, so the pursuit of these wants typically leads to poor investment performance. Though not as exciting, it’s better to know we have a portfolio that can weather a crash, that is low cost and diversified, and that has such a simple strategy even an 8-year old could understand it.