Investing doesn’t need to be nearly as complicated as Wall Street makes it out to be. In fact, the basic principles are really very straightforward. And, while there are a thousand different ways to evaluate investments, I recommend starting with just four:
1. Funds with low costs, because:
Investors are in a zero-sum game with Wall Street. Every dollar you pay them in fees is a dollar less in your account. What I call the “law of small numbers” makes it very difficult to see these fees, but because of compounding, the effect of these fees can be enormous.
2. Simplicity, because:
Wall Street is akin to a junk food manufacturer – always looking to create new products in response to the latest headlines, and often with hefty fees. As a result, the investment landscape facing today’s consumer is unprecedented in its complexity. In addition to the thousands of individual stocks listed on U.S. exchanges, there are nearly 8,000 mutual funds available. The average workplace 401(k) menu has more than eighteen different fund choices, up from just two when the first 401(k) hit the market in 1980. The reality, though, is that the overwhelming majority of these investments are unnecessary.
3. Investments must have intrinsic value:
What this means is that each investment should represent ownership in an underlying asset that produces income. These include stocks, bonds and real estate. But this does not include things like commodity funds, or other high-cost, complex financial instruments, that can gyrate in price because they lack any basis in value. Gold, for example, is only worth what someone else is willing to pay for it. Something like a stock, on the other hand, can fluctuate in value, but ultimately its price will be anchored to the earnings of the underlying company.
4. Funds should not be reliant on anyone’s crystal ball:
Years and years of data have demonstrated that it is extremely difficult to predict the future. For that reason, you shouldn’t buy a fund that is run by a manager who believes he or she can predict where the economy, or any particular investment, is going tomorrow. Those people get paid a lot, which detracts from your returns, they generate taxes with all of their buying and selling, and they are often wrong, which causes your investment to underperform the benchmark.
Investing isn’t simple, but it also isn’t as complicated as many investment managers would have you believe. You could do worse than applying these principles as a four-part litmus test in evaluating any investment.