I believe in holding a diversified, low-cost, passive investment portfolio. However, at the same time there is so much financial hype out there that I understand the natural tendency of people (especially intelligent, hard-working, competitive people) to actively manage their investments. They may think they can pick the best growth stocks like AAPL or GOOG, they may be Buffett disciples and search for durable competitive advantages, or they may be stable dividend seekers. Or maybe they just want to pick the best fund managers instead.
But what if you suck at it? By investing in low-cost index funds, you are essentially guaranteeing yourself to be somewhat above average every year. Wander off-course, and you could do great, or more likely you could crash and burn.
Many people decide mitigate this risk by doing some form of Core and Explore investing, where you keep most of your money in passive funds and gamble a bit with the rest. Since I do this myself to a (very) small degree, I’ve been toying with an idea that takes this one step further.
1. Start Out Small
Let’s say you are young and aggressive, and want your portfolio 100% stocks. Let’s say you carve out 5% of that, throw it into a cheap discount broker, and start trying some ideas out.
2. Track Your Performance Honestly
Thinking you’re doing well at stock-picking without knowing your relative performance is like running around the track alone with no stopwatch and saying “Gee, I’m fast!”. To gauge your self properly, you need to:
- Keep track of all investment inflows and outflows. This means keeping track of all your contributions, buys, sells, and fees/commissions paid.
- Account for uninvested cash. If you would have put $1,000 into an index fund, but instead bought $500 of GE, that means you also have $500 of idle cash earning 0-4%.
- Calculate your return properly, taking into account the information from the previous two steps. Here are two ways, one provides an estimate while the other gives more accurate numbers.
- Pick the appropriate passive benchmark portfolio. For example, the S&P 500 only works if you are investing in large, US-based companies.
3. Adjust Based On Your Relative Performance
You should run a comparison with your benchmark regularly. Each year that you beat your benchmark, you can increase the percentage of your portfolio which you actively manage. If you lag behind the benchmark, you must decrease the percentage of your portfolio which you actively manage. A really crude rule might be simply to increase or decrease the active amount by 2% each year based on performance.
If you are truly horrible, you’ll be out of stock-picking completely in a few years. For most people, you’ll probably be out of it within a decade or so, having learned a valuable lesson. If you are the proper mix of skillful and lucky, then soon you’ll be controlling the entire portfolio.
Sound reasonable?
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Good advice. Most investors have a hard time keeping their emotions out of their investing decisions. An absolute must is to keep an accurate diary of your investments. Have you ever noticed that most investors always talk about their winners and never about their losers? Those who go to Las Vegas do the same thing.
I read the Zecco post – it’s been about a year now. Are things with Zecco still OK?
Great post! I’d been pumping myself up on all these investment books–Warren Buffet Way, Peter Lynch’s One Up On Wall Street, The Little Book That Beats the Market, etc etc.
The books make it seem very easy, and to a certain extent it is easy to avoid some of the mistakes many people make. It’s as simple as avoiding herd mentality.
But thinking I can be Warren Buffett is pure delusion. There’s a reason why so few do well: It’s hard!
So this approach is great. Dip your toes in before diving.
I like how your first paragrah managed to list 100% of my individual stock/play money portfolio. AAPL and GOOG it is.. I guess I’m very predictable.
You said it just right! I have been a passive investor for many years, however I have always been intrigued with the idea of managing a small portion of my portfolio. Luckily, I have a few friends that are doing something similar to what you explained and they gave me the courage to get my feet wet. They told me to start small and when the money was all gone, to consider it tuition well paid!
It is hard. I worry more about the few % I am playing with, but I am also enjoying the ups and learning from the downs.
Tracking everything is also very important as you mentioned so that you remain realistic. It is good that you mentioned fees/commissions as well. I always factor them into every trade before moving forward. I trade with TradeKing and enjoy their low commission and user community, but have been really considering moving over to Zecco after reading your posts!
Thanks again for the great post today.
i like this approach
the being honest with yourself part is easily the hardest part…
It is indeed a delusion to think one can beat index funds these days. Few mutual fund managers can (I think it is less than 5%).
Great post. I think many people forget that someone like Buffett is a very, very, very smart guy with a Ph.D.
I’m not an idiot, but I am no where near as smart as Warren Buffett.
I have many talents, but picking great individual stocks is not one of them.
Marketocracy is a nice site for tracking portfolio performance. I have tracked 2 portfolios their for years. It is a nice way to see how you actually can do (though when you use your actually money people often get more emotional). See my results http://curiouscat.com/invest/investingclub.cfm
I have had an account with Zecco since the review, it does provide what it promises – 10 free trades/month if you have $2,500 in the account. The website is a little slower than I’d like, but I’m willing to take the trade-off for cheaper trades as I’m not a daytrader.
They also have ZeccoShare, which actually shares your trades and calculates your performance. However, I have had a hard time figuring out exactly how they come up with their numbers. My figures always seem to be slightly different.
I’m not a big fan of paper trading. It’s just not the same as the real thing. Try playing poker with fake chips and then with the real thing. 😉
I think the biggest problem with the investing public is that they’re too focused on the decisions that have the smallest impact on their long-term investment returns and success. And to make matters worse, this is reinforced by the financial media (and media in general) that promote moment-to-moment information and decision making.
My experience tells me that it’s much less important which investments you own, and that market timing and stock picking are a loser’s game at best — they can be a dangerous game in the worst scenarios.
The most important factor in investment success is your behavior. In other words, do you have the discipline to buy when everyone else is selling? Do you have the nerve to rebalance your portfolio at market highs instead of chasing the fad du jour? And perhaps most importantly, do you have the wherewithal to leave your investments alone and just let the market work for you over time?
It’s all about your behavior, folks. Great behavior, even with average investments, will put you way above the average returns of the investing public and will lead to long-term wealth building success.
My 2 cents 🙂
Does anyone use the The Turnaround stock newsletter or the Prudent Speculator? I use No Load Fund X and Bob Brinker’s MarketTimer and have been quite successful.
I share those newsletters with others and they are quite happy with there results.
Hope everyone is doing well and staying cool in this hot weather.
Paul
There is no right way to invest in the stock market, the style you pick should be what you feel comfortable with. Some of the styles are dividend only, value, growth, swing trading. Whatever style one chooses it is most important to have a goal, keep records, have stop losses and try to not emotionally attached to a stock when it is dropping but sell and preserve your cash.
Nasdaq has an article on their website that gives tips on having a profitable portfolio of ETFs. http://www.nasdaq.com/investing/3-steps-profitable-etf-portfolio.stm I think that it is something worth looking into.
You like to tinker a lot Jonathan.
Thank you Jessica
just an fyi, the chart you have comparing fmagx and vtsmx is completely misleading to your readers. FMAGX has declared some significant cap gains and dividends during this period driving down the NAV (which I believe is charted above). Including reinvested dividends and cap gains you’d probably be a lot closer in performance
Does anyone know a website that allows you compare the mutual funds you own to see if you are overlapping?
Thanks,
Paul