Successful investors must embrace fears
Risk is an unavoidable part of daily life. Every time we drive a car, board a plane or engage in a favorite activity -- from pickup basketball to hang gliding -- we are dancing with some degree of risk.
Investing also is full of danger. And because there is no way to avoid risk, our best bet is to embrace it, says Robert O. Weagley, chair of the Personal Financial Planning Department at the University of Missouri in Columbia, Missouri.
Weagley says that properly diversifying your investments can mitigate risk over time. He also says that some strategies -- such as trying to time the market -- are doomed to fail.
In the following interview, Weagley offers his thoughts about the elements in a sound long-term investing strategy.
For risk-averse investors, how would you characterize the necessity of purchasing stocks and other risky investments to achieve their financial goals?
If one is truly risk averse, they need to learn that the best way to reduce risk is to embrace it. This sounds counterintuitive, but diversification across and within asset classes is one of the only things we "know" about achieving investment performance over the long run.
Many people only perceive the potential for a loss of principal as risk, but risk also includes opportunity costs, particularly a loss of purchasing power, if one does not achieve after-tax rates of return that exceed the rate of inflation.
All of the traditional non-diversifiable risks -- such as market risk, interest rate risk, exchange rate risk, inflation -- must be balanced across one's portfolio. We know they will each take their turn as the "winning risk" each year.
On the other hand, we can diversify away from business risk and financial risk by investing in the stock market through mutual funds, preferably index funds or (exchange-traded funds) for most investors.
In your opinion, do individual investors accurately assess the importance of accumulating retirement assets?
No! The average household in America is woefully unprepared to accurately calculate this number, and even less prepared to have the discipline to save for their retirement.
What is the single biggest mistake you see individual investors make?
Believing they can time the market, as they inevitably sell after prices have come down quite a bit, and buy after prices have come back quite a bit. By the time they get on the bandwagon, the parade is about over.
Having a loyalty to the markets for risk -- perhaps weighting them differently at different stages of a household's financial life cycle over time, and riding the ups and downs -- will work over the long run. Timing markets is not possible, but having confidence in your plan is possible. Do what is possible.
What are the pros and cons of including international investments in an investor's portfolio?
Pros: Greater diversification, different rates of growth in different countries. Some countries' markets have been shown to be inefficient when they are frontier markets, and momentum can add to one's returns.
Cons: Political risks are much greater outside of North America and Europe. Exchange rate risk, where currency fluctuations can affect the value of your international investments, can add to or take from your realized return on your overseas investments.
What are the pros and cons of including real estate investments in an investor's portfolio?
Pros: Greater diversification, good place to use leverage in your investment (borrowed money), relatively good return over time.
Cons: Markets don't always go up. (This approach) should only be used after a solid base of conventional investments is in place. Many people mistakenly believe that you make money on real estate when you sell it. That is wrong. You make your money when you buy the property. That is the only time you have any control. Thus, having a liquid source of funds for the occasional buying opportunity is key.
What role should alternative investments play in an individual investor's portfolio?
Of course, this depends on what you call an alternative investment, as yesterday's alternative is today's mainstay. Investopedia defines alternative investments as (including) "hedge funds, managed futures, real estate, commodities and derivatives contracts." Most of these investments are for the wealthy -- those with a large base of traditional holdings.
Remember, if you can't understand it, don't buy it. If it sounds too good to be true, it is not true.