An investment blogger posted a graphic of stock market prices that looked like the one below, but he hid the index, the dates and the prices. Then he asked his readers whether we believed we were at point A or point B.
My answer is in italics below, including the Pascal quote.
It is impossible to know. Most people get in trouble when they try to predict the future.
"All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” -Blaise Pascal
I should have added that the more confident we are of our predictions, the more trouble we are likely to experience.
Given that the future is unpredictable, the best way to prepare for either point A or point B is by controlling all of the things we can control and disregarding the rest.
Here are eight items we can control that put us on the same path to financial success that was taken by JP Morgan and Warren Buffett:
Know your goals, so that you know how much you will need and when you will need it. To truly know your goals, create a comprehensive financial goals plan. If you create that plan with the help of sophisticated planning software such as MoneyGuidePro, you are less likely to make the small input mistakes (e.g., spreadsheet formula/cell-reference mistakes) that often lead to big mistakes in outcomes. Sophisticated software also makes it less likely that something falls through the cracks ("Did I properly account for taxes on Social Security when I start collecting it in 30-years, and adjust for the higher inflation in college and medical costs?"). This one step will put you ahead of most of your peers;
Learn as much as you can about yourself and your ability to tolerate risk. Are you a JP Morgan or Warren Buffett capable of buying when everyone is panicking, and capable of selling when it seems everyone is euphoric? Or, are you more likely to buy and sell at the worst possible times? Could a professional advisor help you make better choices and stick with those choices like the exercise trainer who meets you at 6:00am? Psychometric testing relating to risk tolerance can help you find these answers;
Match the characteristics of your investments with the characteristics of your goals and your ability to tolerate risk. For example, to pay for your long-term goals, invest in asset classes that have historically generated high returns over long periods even if they are volatile in the short run because you will not need that money in the short run. High-returning asset classes are mainly equities or equity-like investments that the Morgans and Buffetts of the world buy. History suggests that if you do not buy asset classes that deliver equity-like returns for your long-term goals, you are leaving lots of money on the table and you run the risk of losing purchasing power to inflation, which can be as large and is as real as any stock market loss except that it occurs slowly. Conversely, to pay for your near-term goals, invest in asset classes that have lower volatility and higher liquidity over that shorter term;
Diversify well and globally;
When allocating to equities for your long-term goals, exploit the equity “factors” that have historically outperformed. The Value, Small Cap, Quality and Momentum factors are the most well-known. Investing in these factors is sometimes called "Smart Beta" investing. Invest with fund managers such as Dimensional Fund Advisors, which has a lot of experience finding and executing on these factors;
Allocate to low-cost funds with low turnover. Funds that try to beat the market by superior stock picking (active managers) tend to have high turnover and higher management and tax costs. Those costs eat into your investment performance. Index funds and funds that try to deliver higher returns by merely tilting portfolio weights toward the investment factors, tend to have lower turnover and lower management and tax costs (I will add a post soon to demonstrate how those costs add up over the decades);
Maximize the benefits that come from tax-advantaged investing in 40X(y) accounts (e.g., a 401(k) or 403(b)) and IRAs, especially if your employer matches some of your deposits in a 40X(y). Deposit as much as possible to get the full employer match, which is “free money” all other things being equal. Save in Roth retirement accounts when your taxable income and tax burden is low, so that any funds in the Roth accounts are permanently tax-free after age 59.5. Also, with some restrictions, Roth contributions (but not investment earnings on contributions) can be withdrawn tax free before age 59.5, if necessary. The latter withdrawal option should only be used when absolutely necessary because of the great tax advantages of a Roth account. It is probably best to use traditional IRA or 40X(y) accounts when your taxable income is higher so that you can get an income tax deduction (and save the difference in your tax owed for that year!), but check with your advisors; and
Don't "trade" your investments. Instead, rebalance periodically only when your investment allocations no longer match the characteristics of your goals. For example, if your investments have become unbalanced because one asset class has appreciated more than another, sell (high) from the asset class that has appreciated, and buy (low) from the one that has not kept up, to bring your allocations back into appropriate balance for your goals. Automate this process as much as possible to remove the human emotions of fear and greed. But sit in a room quietly if your allocations still match your goals;