How to avoid being a dumb investor: The Smartest Investment Book You’ll Ever Read
March 02nd, 2009 - 23 Comments
I’ve asked some of my very best readers to contribute occasional book reviews to I Will Teach You To Be Rich. This is a guest review by Rachel Stephens. And I fully agree with her — this is one of my favorite investing books. -Ramit
The way information is presented matters. The way something is framed has powerful effects on our understanding of the issue (in this case, my friend was referring to a smaller MacBook screen). Simply put, context matters. And so it is with investing.
Many people associate activity with progress. We’re surrounded by people touting stock tips and media coverage that inundates us with unreliable and conflicting information. ‘Passive’ brings images of laziness and ‘average’ is seen as settling, not excelling. In short, our societal understand of investing is not based in the reality of fact.
Investing has been put in an incorrect context, and Daniel Solin seeks to remedy that in The Smartest Investment Book You’ll Ever Read. The book is refreshing: direct advice concisely written without any bullshitting. Solin begins by reframing smart and dumb investors. He proclaims smart investors to be those who invest for market returns through broad market indexes. Dumb, or ‘hyperactive investors,’ are those who have fallen for the illusion of being able to predict the stock market.
Anyone proclaiming to be able to pick stocks or time the market is either foolish or selling something. William Bernstein, author of The Intelligent Asset Allocator, says, “There are two kinds of investors, be they large or small: Those who don’t know where the market is headed, and those who don’t know they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends on appearing to know.”
Hyperactive trading is a fool’s errand. It results in higher fees and trading costs. There are typically unplanned tax implications that result from frequent trading. Portfolios tend to be unbalanced and fail to account for risk. The brokerage community is “fraught with conflicts of interest” and rarely does a broker serve a fiduciary role to their clients. In most cases, active trading (either on your own or through a broker) simply doesn’t make financial sense; it’s dumb investing.
Individual investors will find it hard to overcome the above listed inefficiencies. This means that for most, market returns are not average, they’re superior. Solin’s studies show that over the long-term, 95% of managed money is unable to match the returns of the market. Here’s a calculator that shows how expenses will eat away at the returns of your mutual fund. Warren Buffett makes million dollar bets about the S&P outperforming a portfolio of hedge funds. Both the logic and the numbers support long-term index investing.
So if this ‘dumb investing’ methodology is proven to be ineffective, why do some many people continue to pursue it? Marketing. Brokerage firms excel in selling their services, and the financial media is invested (through advertising dollars) in convincing people to chase returns. Index investing doesn’t make money for the middleman, and thus there are many businesses that rely on persuading dumb investors to keep dumping money into their services.
The book crescendos to the recommendation section: Daniel Solin’s smart investment plan. The plan is based entirely upon asset allocation and broad market indexing. It’s simple to execute and gets better results than the average person’s strategy.
- Find your ideal asset allocation based on your risk tolerance. A risk tolerance calculator is included on Solin’s website and can help you choose how to divide your portfolio. Your assets should be divided between a U.S. stock index, an international stock index, and a U.S. bond index.
- Open an account at one of the fund families. Solin specifically recommends using Vanguard, Fidelity, or T. Rowe Price as they are low-cost and uncomplicated. Some of the smaller funds are also possibilities, but you will have to purchase more index funds to achieve the same diversity that you can get with the larger companies.
- Select your investments. This is the easy part. If you have enough money to meet the minimums for the funds (usually this is $2,500 – $3,000 per index), then buy the appropriate broad market indexes in the fund family of your choosing. If you have less than $25,000 to invest, it may be hard to both meet minimums and achieve your ideal asset allocation. In this case, choose a lifecycle fund as this will allow you to achieve decent diversification with low costs.
- Rebalance your portfolio. As the value of your investments change, your asset allocation will change. You can rebalance by either selling some of the investments that have become overrepresented and buying those that are underrepresented, or you can just add new money to your portfolio and buy the assets you need to bring into balance. You should be able to rebalance you portfolio in less than 90 minutes a year.
“The investor’s chief problem – and even his worst enemy- is likely to be himself.”
-Benjamin Graham, The Intelligent Investor
Solin’s book is extremely successful in convincing readers that passive investing truly is smart investing. His explicitly lays out simple and intelligent strategies and provides ample supporting evidence as to why his methodology is proven. The Smartest Investment Book You’ll Ever Read shows an easier and less expensive solution that delivers better results. All investors should read this book.
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