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15 Little Life Hacks

How to avoid being a dumb investor: The Smartest Investment Book You’ll Ever Read

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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

Funny Without Context

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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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24 Comments

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  1. I read this constantly on blogs, and I have not read this book but simply based on the review I can tell I’d be irritated the entire way throughout. Why is there an obsession by “everymen” to insist that any and all trading (ie, the “dumb” investors labeled above) is a bad thing.

    Trading is not investing.

    They are two different games played by two very different rules. This distinction is unfortunately not made enough, though it’s fairly straightforward and clear. It’s unfortunate that it is so often mislabeled as a “fool’s errand” or dumb when contrasted with investing advice.

    Ramit and others often find it necessary to announce that it’s impossible to time the market in every thread about investing, and while that’s true in the one context, time and practice and yield significant results via short term trading. They’re apples and oranges, and instead denouncing on consistently I think time would be best served explaining why they are different, and the rules of each game.

  2. The 4th bullet is possibly the worst investment advice you could give stock market novices. This is what the author is suggesting (in very simple terms):

    You buy $100 worth of two funds each on January 1st. You go back to review your “portfolio” on December 31st to find one fund’s value is $150 and the other is $50. You are now out of balance. This advice says you should sell some of the $150 and buy some of the $50 so that you are in balance.

    The reason that is horrible advice is because it’s the opposite of one of the main tenets of investing which is…cut your losers and ride your winners. Be patient when you are right and impatient when you are wrong. Please don’t follow this advice, you will consistently be selling your good decisions so that you can double down on your bad ones.

  3. Jeff, since you don’t know which stocks or sectors will outperform over the long term, investors come up with an asset allocation and rebalance around that. Saying you should “cut your losers and ride the winners” is simplistic advice that misses the point that you can’t predict what will happen, especially in the short term. In Chap 6 of my book, for example, I show you how some of the very same funds that were top performers one year were some of the worst performers just a few years later. You really want to play the picking game?

  4. Hi Ramit, I agree that we don’t know which (top down) asset classes or sectors or stocks will outperform in the long run, which is why it’s so important to cut your losers and ride your winners. I just wrote on the topic yesterday that trailing stops are the best way to protect your capital when you are wrong and allow for the accumulation of profits when you are right. I don’t want to play the picking game, so I think we are arguing for the same side. My post about all this is here: http://theartofprofit.com/blog/?p=28

  5. I bought into the Vanguard Total Stock Market index back in May of last year. I only bought this particular fund because of the relatively high starting price for the fund ($3,000 at that time). I would have like to have gotten a more balanced portfolio at that time, but unfortunately I didn’t have the money to buy enough of those assests. So yes, as Ramit notes, you may need upwards of $25,000 to get a balanced portfolio.

  6. Brian, if you open an IRA (roth/regular) and have money deposited every month, many places will waive the fund minimums and allow you to purchase with what you have available.

  7. I have a couple of comments. My first comment is that I have read this book and agree that it is a great read and has great advice. My next comment is in response to Jeff’s. I don’t think your outlook of cutting your losers and ride your winners is correct. Of course there are times when you need to cut a consistently underperforming fund and on the other front you wouldn’t want to completely wipe out a fund that consistently performs well. That being said, rebalancing is basically the act of selling high and buying low. This is assuming you haven’t invested in some junk funds and that all of the funds in your portfolio are long term investments that will, over the course of your working career, provide you with good returns. If you look at studies that compare two portfolios, one that rebalanced and one that didn’t, you will see that the one that rebalances, even if only once a year, will outperform the other.

  8. Hi Lance, thanks for having the discussion. I’m guessing that my points are just not well communicated because I don’t disagree with what you wrote. All I’m saying is that if you limit your max loss to 7% of a purchase while allowing an appreciating asset to accumulate profits while moving up your stop so as to not give back all your profits, you will have a very high return in relation to risk assumed. And you’ll avoid getting killed. One big problem we have right now is the notion that investing for the long term and riding it out is a sound strategy. Stocks are worth today what they were 12 years ago. Just because someone has time on their side doesn’t mean it’s a good idea to ignore sound risk management. If you exited after a 7% max loss in 2008 you would now be well positioned for 2010 because of it. Those who rebalanced would be holding different versions of losers which has never helped an overall portfolio return, in good times or bad, long or short term.

  9. Most average people aren’t trading to play the stock market, they’re investing to save for retirement. But both are called ‘investing.’ The reason books say that index funds are ‘smart’ and timing the market is ‘dumb’ is to teach those who don’t know the difference, that index funds are better for retirement. Certainly TRADING on the stock market is not dumb if you can devote a lot of time and energy … but most people don’t do that, so index funds are smart for them.

    I’m about to open a Roth IRA and have been debating between Vanguard’s Total Stock Market index and the their Target Retirement 2050 fund. Since I only have the minimum amount to open an account, I’m leaning towards the 2050 fund to get the little bit of diversification that I want–just as the book suggests.

    Very well written review Rachel!

  10. Jenni, What is so hard about explaining the difference between the two? Just because most people don’t have time to learn to trade doesn’t mean it’s acceptable to call it dumb. That’s like an overprotective parent telling their kid there’s monsters at night so they wont sneak out. Explain the difference and educate people why and when you can use each strategy.

    I don’t find it acceptable to put out misinformation just because “most people don’t have time to learn the difference” but it seems like that is the accepted position amongst these types of authors and bloggers.

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