How to beat the odds and make random event more predictable in your path to building wealth
If you didn’t listen to the first episode of my new Financial Planning Blueprint podcast yet, you missed the story I told about Lester Moore. His experiences illustrate a fundamental principle about investing that you really need to hear and understand, so before reading any further, pause where you are and take a minute to listen to Less’s story, and then come back to pick up on where I’m going to take you today. Do that now if you need to, and for the rest of you, let me quickly review the concepts I’ll build on in this article.
Any time you’re performing a task whose best odds of success are only 50%, the more times you attempt that task, the more likely it is that your results will be nothing more than average over time. That’s what we find in the investment markets where people are buying and selling investments. But today I’m going to show you how to take that 50% chance of success all the way up to a 100% chance of success simply by applying three important principles of investing.
So, you think you’re an investor Now notice that I said investing, not speculating. So many people who say and think they are investors, they’re really nothing more than speculators. And it’s not just amateur individual investors who are trying to manage their own money. The pros fall prey to this, as well.
We can see with the investment markets that when you look at mutual funds, most of them end up failing or get merged with other mutual funds because they can’t outperform or even keep up with the averages. In fact, if you look at the 15 years leading up to the beginning of 2017, only 17% of stock based mutual funds and only 18% of bond funds beat their target market’s average return during that period of time. So even the pros who have ivy league educations and tremendous access to the best, most accurate information in the world have a hard time beating the market too.
And it’s simply because they’re playing the same game Less Moore did with his coin flips.
Be like Warren But I’m going to show you 3 principles here that will help you become a better investor and when we think about investors, one of the most successful investors of all time is the Oracle of Omaha, Warren Buffett. Warren implements each of these three principles and anyone who follows these principles can be successful too.
The first principle is “Market timing doesn’t work.” If you try to get in and out of the market at the appropriate times, you have a very high likelihood of missing some of the best days. And just missing a few of the best days over a longer period of time can have a devastating impact on your investment performance.
Let me explain that further. If you take the stock market’s performance and go all the way back to 1990, you’ll find that your average total rate of return would have been 9.81%. If you missed the best single day during that period of time, your total average return would have dropped from 9.81% to 9.38%. If you missed just the 5 best days in this long period of time, it would have lost 1 ½ percentage points in your returns and brought it down to 8.21. If you would have missed just the best 15 days, you would have lost about 1/3 of the total return on your investments dropping it down to 6.18. And finally, if you would have missed just the best 25 days in 27 years, you would have more than cut your investment performance in half with a total return of only 4.53%.
So trying to time the market is really nothing more than speculating and that’s not what investors do.
Time in the market vs. timing the market Now, with that in mind, let’s go to the second principle. We talked about timing the market – the next principle is time in the market because the market has rewarded those who have been patient and disciplined. Just think back on all the terrible things that have filled the headlines and caused us to worry over the last 50 years. We have everything from the big recession in the early 70’s to double digit inflation a few years later. The stock market crashed in October of 1987 and the Gulf War impacted oil prices around the world in the 90’s. We’ve had dot com bubbles burst and a global financial crisis that almost bankrupted our country. There are the tragic events of 9/11, the Y2K scare, Brexit, and a regular stream of political issues in our own country with elections and policies – plus the numerous physical and economic conflicts we’ve had with other nations, including the recent trade wars with China.
This is only a small sample of the news that made headlines and elevated people blood pressures, but the market always recovered. So someone who was patient and disciplined with their investments and who was able to withstand those storms was rewarded for their patience. In fact, a $10,000 investment in the world index in 1970 would have grown to almost $600,000 today. That sort of takes the pressure off doesn’t it?
Your investments for the WIN! Also, if we’re talking about increasing your odds of success from 50% up to 100%, time in the market is one of the most effective ways to do that. Let me show you what I mean.
If you just hold an investment for one year, your chances of success there really aren’t very good – somewhere between 50-60% in most years. However, if you hold your investments for 3 years, your odds of success go up a lot. By 5 years, your odds of success have reached close to 90% and by 10 years you’re almost at 95%, assuming you have high quality investments, of course.
Now here’s the best part. There has not been a 20 year period of time or longer when people who owned a mix of high quality investments have lost money on those investments. In other words, for those who are willing to remain in the market through all the ups and downs that happen over time, those folks have had a 100% success rate when it comes to getting positive results on their investments.
Speculators don’t hold on to investments that long. So that’s where having an investor’s mind set really does add more value over time.
Diversification vs. allocation One of the best examples of a true investor’s mindset is found in our modern day investment legend, Warren Buffett. Warren understand this principle of market timing and how it doesn’t pay off, he understands how choosing high quality investments and holding them for the long haul pays off, and finally, he also applied this third principle, which is diversification.
Buffett's holdings are diversified from financial companies to tech companies. He owns energy companies, health care companies, and consumer staples companies that make things, like tooth paste and toilet paper we all use no matter what’s happening in the economy. Even with all of his success, experience, and knowledge, Warren Buffet is just like everyone else when it comes to investing, because he doesn’t know with any certainty which area of the economy is going to do well at any given time.
The markets can be random and unpredictable, but by having things diversified, you can have each part of your portfolio moving in different directions at different times. That can make the average return of all of those investments, the weighted return of your portfolio, a much smoother ride. And it helps to increase your prospects of growth while reducing your exposure to risks and losing money.
Diversification is important, but even more important than diversification is allocation. Diversification is basically not putting all your eggs in one basket, but allocation is like following a recipe. And, if you have a good, solid proven recipe, all you have to do is simply follow it and you’ll get the results you’re looking for every time.
Customizing your success When you’re building a financial recipe, you have to consider different ingredients, just like you would if you were baking cookies or making a cake. By combining these different ingredients together, you can throttle the risk levels up and down and also capture the upside while hedging the downside just by adding more or less of these ingredients. And that’s really what diversification and allocation are all about.
If you’ll focus your energies and attention on not trying to time the market, on leaving your investments in place so you can benefit from time in the market, and properly allocating and diversifying your portfolio, I think you’re going to see your results improve a lot.
This sounds like common sense, but unfortunately common sense isn’t often common practice. I hope you’ll take the opportunity to use these principles and put them to work for you. They can definitely help you beat the odds and make random events more predictable in your path to building wealth.