Investment Traps

Here are four traps to avoid.

Varying Definitions

Benjamin Graham advocated changing stock and bond allocations each year to between 25% and 75% based on valuations. Yet, he spoke out against market timing.

Many people ignore what Benjamin Graham meant. They keep his words. They change definitions. They ignore valuations. They advocate fixed allocations.

Academics’ Insanity

Academics routinely model investing based upon the stupidest strategy conceivable.

Typically, they will select a winning stock fund based upon the best recent performance. Then they will buy at that price.

Perhaps, the most fundamental investment discipline is to buy low. It is OK to look at past performance. This helps you identify good stocks and funds. It is not OK to buy at the top. Rather, disciplined investors identify several attractive stocks and funds. Then they wait for good prices. Only then do they buy.

Blind Precision

Too often, people insist on more precision than makes sense. If you follow a model in all of its exact details, you are likely to make serious mistakes.

Consider our early work with switching. We varied stock and TIPS allocations in accordance with P/E10. Blindly following our best thresholds and allocations could cause you to buy and sell stocks too often (i.e., once per year) as P/E10 fluctuates above and below a threshold. You need to overrule such costly actions. Hold onto an allocation for a longer time.

We have learned that the best switching algorithms overall do not produce the best performance under all conditions. When stocks are especially attractive, lower stock prices translate into better prospects going forward. Higher fixed stock allocations produce larger returns and they maintain safety.

Forests and Trees

Professor Robert Shiller made a bold prediction early in the bubble. He predicted that people would be better off by being out of stocks entirely over the following decade.

Professor Shiller was wrong about the exact amount of time. He was right about everything else. The stock market reached unprecedented heights. It has come down a little bit. It has farther to fall.

There are many ways to estimate what will happen to the stock market as a whole. If we insist upon being overly precise, we hurt ourselves. Instead, look at future performance from a variety of vantage points. Identify a reasonable range of opportunities.

Demographics suggest that the market will bottom around 2015 to 2020. If we look carefully, trends downward have been a little faster than upward trends. This favors 2015. P/E10 has also trended down faster after a peak. But we should not insist upon such precise information. We need to look for buying opportunities throughout the entire period. We should also allow ourselves to make reasonable adjustments for the market as it actually exists.

Have fun.

John Walter Russell
May 22, 2006