Do you know what it takes to be a successful investor?
Can you name the three drivers of asset class performance?
Are you aware of the upsides and downsides of each investment that you hold?
Not having the answers to these questions could leave your portfolio exposed to major risk.
That’s why David Stein, today’s guest, wrote an appropriately titled book: Money For the Rest of Us. His book outlines 10 thought-provoking questions to ask before making any investment decision.
David, a two-time guest on the show, was the Chief Investment Strategist and Chief Portfolio Strategist at Fund Evaluation Group, a $70 billion investment firm. While there, he co-founded the firm’s $2.2 billion asset management division and developed its investment philosophy and process as the lead portfolio manager.
In this interview, David discusses the 10 questions outlined in his book:
- What is it?
- Is it investing, speculating, or gambling?
- What’s the upside?
- What’s the downside?
- Who’s on the other side of the trade?
- What’s the investment vehicle?
- What does it take to be successful?
- Who’s getting a cut?
- How does this investment impact your portfolio?
- Should you invest?
Whether you’re new to investing or consider yourself an advanced investor, David has an asset allocation approach that can save you from the expensive mistakes investors often make.
Here’s how to think through each of these 10 questions and improve your investment decision-making process.
#1: What Is It?
Can you explain the investment in simple terms?
Let’s say that you’re thinking of adding an Emerging Markets Index Fund to your portfolio. Can you…
- Explain how that index fund is constructed?
- Name the countries that are considered emerging markets?
- Differentiate emerging markets from frontier markets or developed markets?
- Cite the historical risk and return of the fund over time?
- Explain the basics of the investment?
If you can’t check these off, that’s a sign that you need to do more due diligence.
David recalls an investment mistake that he made in grad school that we can learn from:
“I bought it – Novell – because I thought it would go up in price, and it did something with computers. And that was my investment thesis … That doesn’t explain what an investment is. It needs a little more detail than that.”
Next time you want to add a new component to your portfolio, get clear how to describe the investment and what function it will serve in your portfolio.
#2: Is It Investing, Speculating, or Gambling?
Many speculative bets and/or gambles masquerade as investments. Think about water cooler talk in the break room at work, or what real estate investors often say at a meet up.
“Have you seen the price of X going up? That must mean Y!”
“We should get in now while the price is reasonable. It can only go up from here!”
This chatter contains notes of speculation, which is harmful to your portfolio. Speculation and gambling aren’t investment strategies.
How can you make sure that you’re investing, and not speculating or gambling?
David breaks down the difference:
“An investment is something with a positive expected return. Typically because it has some form of cash flow – it pays interest, it has profits … so there’s a reasonable expectation that the return will be positive because there’s cash flow.”
Investments have intrinsic worth due to their cash flow. By contrast, speculation is an asset with an uncertain outcome, and gambling has a negative expected return over time. Who wants absolute uncertainty or negative returns in their portfolio?
To avoid this, look at the attributes of the investment that you want to buy. Do these attributes indicate cash flow or profit? If so, it has a better chance of being a sound investment. If it doesn’t have cash flow positive attributes, then you might want to avoid it.
If you enjoy speculation or gambling to a small extent, then dedicate the largest amount you’re comfortable losing to experimenting with your holdings.
#3: What’s the Upside?
David outlines the three drivers of asset class performance:
“All investments have return drivers. The first … is the cash flow. So for [a] bond it’s that yield to maturity. The second driver is – is the cash flow growing over that time? … And to what extent are earnings growing over time? And then the third component [is] – what are investors paying for that cash flow, and how has that changed over time?”
When you look at a potential investment, ask yourself, what type of return do I expect as it relates to each of these three performance drivers?
#4: What’s the Downside?
David recommends asking two big-picture questions in regards to risk:
- What’s the volatility and potential downside?
- What are the personal consequences to me if I were to suffer that volatility?
David explains the second question:
“If I’m … two to three years from retirement, maybe I don’t want 90 percent in the stock market right now because if stocks fell 60 percent, I’d have to delay my retirement because I don’t have a pension plan.”
Whenever you want to add a new investment to your portfolio, ask how losses could impact your personal plans. Would you have other savings to live off of, or is this it? Your answer can help inform whether the downside is worth the risk.
#5: Who’s On the Other Side of the Trade?
This question is particularly critical if you want to buy an investment from an alternative platform.
David illustrates this with an example from real estate crowdfunding:
“You would think, okay, I’ve made a loan to somebody, and they bought the house, and so we have security in the house if they go bankrupt – we’re fine. But no, if you actually look at the document, it’s a mortgage-contingent payable note. So you only get paid if that person gets paid. But you as the participant on the platform, you don’t have a security interest in that property. The platform does. You have an unsecured liability with the platform.”
Yikes.
What can you do about this?
When you know the potential downside when making an investment, you can decide the type of return you want to demand. Given the higher level of risk, you might demand a higher return.
The most you want to put into a deal like this is the amount you’re comfortable losing. You don’t want to dump tens of thousands of dollars into an investment that goes south, only to find you have no or limited recourse.
#6: What’s the Investment Vehicle?
Do you know the container within which the investment is held?
For example, are you buying an actively managed mutual fund? A passively managed index fund? An ETF? Are you buying bonds directly, or are you buying bond funds? And what does this mean with regards to the cost, liquidity, and structure?
Again, it’s important to understand what you’re holding.
David elaborates:
“It’s really understanding the criteria such as – what’s its expected return … what’s the risk in terms of potential maximum drawdown? But it also gets into other characteristics: what are the fees? How liquid is it? Am I able to get my investment out quickly, or is it a longer-term investment?”
#7: What Does It Take to Be Successful?
You know that all investments have return drivers like income, cash flow, and cash flow growth. But what are the attributes that drive a particular investment to succeed?
David says that there are many factors, but the primary one is that:
“The success depends on outsmarting other investors. And I think as individual investors, we should tend to avoid that.”
He recommends buying broader asset classes through ETFs and mutual funds rather than investments that are dependent on being “precisely right.”
#8: Who’s Getting a Cut?
Before making any investment, research the fees and trading costs associated with it. Know what you’re paying for, and why you’re paying for it.
David summarizes this as:
“We all pay fees. Keep them as low as possible and make sure we’re getting benefit for the fees that we pay.”
Analyze your portfolio and note any high-fee or high-cost investments. Do the returns of these investments make the fees easier to swallow? Are you getting good value? If so, there’s no need to make a change.
However, if you aren’t getting enough value in exchange for the fees, look for a low-fee alternative.
#9: How Does This Investment Impact Your Portfolio?
Consider the investment you want to buy. Do you know how well it fits into the overall context of your portfolio?
David notes that there is no one single “correct” type of portfolio. The mix of assets you want should reflect your goals, age, timeline to withdrawal, risk tolerance, and understanding of the assets that are inside that portfolio. If your mix doesn’t reflect these factors, it’s possible you’re over-optimizing.
Instead, give yourself permission to experiment. David recommends it:
“I find that if we don’t feel like it’s an optimization problem, we’re more willing to make changes and add things … Again, we’re just looking at it on a portfolio basis as opposed to just focusing on one particular investment and that’s really the idea.”
Do your best and don’t be afraid to change up your portfolio and experiment when needed.
#10: Should You Invest?
You spent a lot of time thinking about a particular type of investment – a rental property, a REIT, a bond, or an individual stock.
Now that you’ve asked yourself these nine questions, what’s your conclusion? Should you move forward and invest? Or ditch your plans?
As you contemplate this question, remember that the decision-making process matters much more than the temporary or momentary result.
As David says:
“You can’t necessarily always control the outcome. You have to go back and say, did I have a good decision-making process? And oftentimes our, what we call our investment mistakes, were in part because our decision making process was not good. We made a mistake.”
Judging your decisions based on the outcome that they generated is an imperfect evaluation strategy.
Judge your decisions based on the process you used to arrive at the decision, not on the outcome that it generated. Judging the process improves both your decision-making skills and your investment skills.
Resources Mentioned:
- Money For the Rest of Us, by J. David Stein
- Money For the Rest of Us Podcast
- Thinking In Bets, by Annie Duke
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