MONEY TALKS - A good friend of mine called the other day and we quickly got into the run-of-the-mill chatter about the kid’s going back to school, last week’s Patriots game, and how things were going at work. Before long, the conversation turned into a story about an airline stock he had just bought. As it turns out, his purchase was prompted by a recent drop in the share price and his perception that it couldn’t go any lower. Yet, after he purchased the stock, the price dropped ominously further. Fearing he would lose everything, he panicked and sold his holdings at a loss. Being the empathetic friend that I am, I sarcastically responded by asking if he wanted to go to the casino - because he might as well have been betting his money at the Roulette Table. I then tried to explain to him that what he was doing was called speculative trading, and he would be much better off if he developed an investment strategy instead.
Speculation - Speculation is defined as the act of taking on considerable risk for the opportunity to generate large gains. We have all heard the old adage; no risk, no reward. However, the word “risk” by default means that the reward is never guaranteed. In the case of my friend, he assumed or speculated that the price of the airline stock had dropped so low that it could only go up from there. When the price dropped even further, he had no long term investment plan to rely on, and ultimately let his emotions take control over his investment objectives. This over reactive mentality is shared by many and is basic human nature. It’s the same reason why, for the last 20 years, the S&P 500 Index averaged 9.22% per year, while the average equity fund investor earned just 5.02% over that same time period. Even though my friend was correct in that the airline stock had indeed dropped over 15% in the last 10 days, its year to date performance was actually up over 9%. So you tell me, was the stock up or down when my friend made his purchase?
Investment Strategy - An investment strategy on the other hand captures your investment objectives while taking into account your time horizon as well as your risk tolerance. A good investment strategy should be a clearly defined written document that you can refer to in times of distress. While investing with a disciplined approach may not be as exciting as speculative trading, it has been proven to yield higher returns over time. In fact, most experts will agree that trying to time the market is nearly an impossible strategy. Instead of purchasing an individual airline stock based on speculation, a better alternative would be to develop your own long term investment strategy that meets your goals and objectives. One might decide to invest consistent amounts of money in a mutual fund at regular periodic intervals. By investing over time, you are lessening the risk of investing a large amount in a single investment at the wrong time. Likewise, by investing in a mutual fund, it provides you with broad market exposure at a fraction of the costs of diversifying into individuals stocks.
Logic over Emotion - Many of us let our own emotions get in the way of making logical investment decisions. The most common of all is to buy when the market is high in hopes of riding the wave or to sell when the market is down out of fear of losing everything. Yet logically we all know that the market will eventually auto correct itself given enough time. Developing a sound investment strategy and sticking to it will likely yield you higher returns than any other investment moves you make. If fact I would argue that the actual selection of the funds within your portfolio is far less important than the strategy behind them.