Navigating the stocks world

Eminent author and equity analyst Barry Ritholtz says even the greatest trading strategy is worthless if investors lack the discipline and the emotional resilience to stick with it. Ritholtz says investors should consider a globally diversified portfolio, including asset classes that are less correlated to equities such as corporate bonds, treasury inflation-protected securities and treasuries. “A portfolio that is 60 per cent equities and 40 per cent fixed income should suffer drawdowns of about 26-28 per cent in markets that get cut in half, such as 1973-74 or 2008-09. If you cannot live through a 25 per cent pullback in the value of your portfolio, you have no business owning stocks,” he wrote in a column for a financial website.
Barry L Ritholtz is the co-founder, chairman and chief investment officer of Ritholtz Wealth Management LLC. His career’s focus has been on decoding how the intersection of behavioral economics and data affects investors. Ritholtz did his graduation at Yeshiva University’s Benjamin N. Cardozo School of Law in New York, where he focused on economics and antitrust & corporate law. Launched in 2013, Ritholtz Wealth Management is a financial planning and asset management firm, with over $2.3 billion in assets under management. In 2017, the firm was named ETF Advisor of the Year. In 2019, it was on the Financial Times Top 300 Advisors list in the US for the 3rd consecutive year. Ritholtz writes weekly columns for Bloomberg Opinion and used to write a twice-monthly column on personal finance and investing for The Washington Post (2011-2016). Investment strategy Ritholtz says the top priority for investors should be capital preservation and risk management. He uses behavioral economics and asset allocation to build and manage portfolios. Financial planning and wealth management should be intertwined for investment success. Though Ritholtz says long-term returns are what should truly matter to investors, he understands investors have short-term needs also. To maintain a balance, he suggests a proprietary, low-cost, systematic risk management strategy to ensure that investors can handle periodic volatility without abandoning their investment plan. In a blog, Ritholtz has shared some top trading rules that he had learnt over the years on what to and what not to do when it came to investing in the capital markets. Let’s look at some of these rules: 1 Hold onto your winners and cut your losses short Ritholtz says investors should hold their winners as these can generate all kinds of desirable outcomes — like it can allow compounding to occur and keep transaction costs, fees and taxes to a minimum. He says since this strategy does not allow investors to make a quick profit without any reason, it also forces them to develop an actual exit strategy. Similarly, he suggests cutting losers short as this makes investors humble and intelligent. Also, it takes investors away from the sectors and stocks that are not performing and compel them to admit their own mistakes which is crucial. 2 Avoid making predictions and forecasts Ritholtz says investors are very bad at guessing what the future will bring so they should ignore other people’s forecasts. Investors should also avoid making any forecasts themselves because that makes them focus more on being right than on making money. “Investors unconsciously shift their portfolio toward their predictions rather than with what is occurring in the markets. This is a recipe for disaster,” he says. 3 Study crowd behaviour Investors who understand the behavior of crowds have an enormous advantage over those who don’t. Investing often involves figuring out where the crowd is going, even if it’s objectively ”wrong.” “Investing isn’t necessarily a process of picking the best asset class, sector or stock, but rather, selecting what the crowd is buying. Investors sometimes forget that, most of the time, the crowd is the market. The psychology of crowd behavior is such that higher prices attract more buyers — and lower prices create sellers. Fear of missing a rally is a powerful element; fear of losses is even stronger,” he says. 4 Think like a contrarian Ritholtz believes the crowd can be overly emotional, fickle or even irrational at times. So investors should be contrarian and learn to recognise when a crowd can turn into an undisciplined mob. When that happens, it’s time to stop betting with the herd, and start betting against the crowd “Most people accept conventional wisdom at face value, tend toward widely accepted social mores and are uncomfortable being a lone voice of dissent. There is an evolutionary reason for this: Humans are social animals, and we have evolved to cooperate with the members of our tribe and to work with the group,” he says. There is a qualitative difference between what the majority of rationalthinking market participants are doing and the reflexive, panicked behavior of a tactless mob. A true contrarian investor can tell the difference between a crowd and a mob, a market rally and a bubble but the tricky part always remains the timing, he says. 5 Asset allocation is critical Ritholtz is of the view that the most important decision investors make is relative weighting of stocks, bonds, real estate and commodities. Asset allocation is even more important than stock selection. “Stock picking is for fun. Asset allocation is for making money over the long haul. The weighting you select for various asset classes is a function of factors as your age, income, risk tolerance and retirement needs. It is what serious investors focus on,” he says. 6 Indexing is a much better bet Ritholtz believes that for the equity portion of allocation, investors must answer a crucial question: “Do you buy indexes and garner market-level returns, or do you pick stocks (or sectors) and time the market in an attempt to beat the indices?” He says those who try to beat the market have a tough road ahead each year as 80 per cent of investment managers fail to beat their benchmark. Among those who do, once fees and costs are taken into consideration, less than 2 per cent actually hit the jackpot. “If you want to beat the market, understand the long odds that are working against you. That is why for most investors, indexing is a much better bet,” he says. 7. Avoid cognitive and psychological errors Ritholtz is of the view that most investors think they are competing against other traders, big institutions and hedge funds, but the truth is that they are their own most dangerous opponent. Investors are wired in a way that they fall prey to all sorts of cognitive errors. Their own cognitive and psychological errors often lead them down the wrong path. “We are overconfident in our abilities to pick stocks, time the market, and know when to sell. We suffer from confirmation bias, seeking out that which agrees with us and ignoring facts that challenge our views. We vacillate between emotional extremes of fear and greed. We are surprisingly risk-averse, and at precisely the wrong times. The recency effect has us overemphasizing recent data points while ignoring long-term trends,” he says. 8. Admit your mistakes Ritholtz says one of the biggest problems many investors have is admitting they made a bad investment. “Men, suffering as they do from testosterone poisoning, are especially bad at this. Whether it is ego or just stubbornness, too many people seem to hold on to their losers for way too long. Pride can be a very expensive sin,” he says. The most effective approach is to admit errors, fix the mistake then move on. “I believe in admitting errors and, in fact, each year I publish a list of mea culpas – describing my worst investing errors. I explain what I did wrong and what I learned from it. It may be human to make mistakes, but it is foolish to make the same ones over and over. Try making some new mistakes instead,” he says. 9. Understand financial cycles Another challenging thing to do in investing is to reverse one’s thinking, especially after a specific approach has been profitable for a long time. The longer the period of successful thinking, the more important and challenging the reversal will be, says Ritholtz. Investors should pay attention to history, and learn that events move in long, irregular cycles. A business cycle alternates between periods of expansion and contraction where both recessions and recoveries happen. According to Ritholtz, there also exists the market cycle, where booms and busts occur regularly. “Every bull market is followed by a bear; every bear market is followed by a bull. ‘This too shall pass’ is a proverb that humbled King Solomon. Understand what it means when you mistakenly believe something will never change,” he says. 10. Don’t settle in a comfort zone Ritholtz says there is a tendency among investors to enter into a comfort zone. They develop a particular style, find an investing method they like and think it will last forever. This is a recipe for disaster as the many different inputs that drive market returns constantly change. These different inputs can be profits, the Federal Reserve’s actions, the economy, interest rates, technology and tax policy, among others, he says. “It is important that you constantly upgrade your skill set, while learning to be both adaptive and flexible. The best investors have a healthy dose of intellectual curiosity. If everything else is changing, but you are not, then you are being left behind,” he says. 11. Reduce investing friction In investing, friction refers to anything that is a drag on total returns outside of market performance. “Think about the long-term effects of the fees, costs, expenses and taxes on your net, above and beyond how your investments did. Investors with lower costs tend to have better growth and retain more of their assets over the long haul. Keep your fees, costs, expenses and taxes low. It is a guaranteed way to improve your returns,” he says. 12. Remember thatthere is no free lunch Ritholtz says investors often forget that there are no free lunches as they always have the temptation to get something for nothing. “That hot stock tip? You want the upside without doing all of the tax research. High-yield junk bonds? Some people believe that an 8 per cent yield when the 10-year Treasury is paying 1.62 per cent does not come with an increased risk of default. They are mistaken. Sitting in way too much cash? It creates a false illusion of safety that will not keep up with inflation. No one on television is going to make you wealthy. There is no magic formula or silver bullet or secret hedge fund,” he says. The best investors generate long-term returns by making rational, unemotional decisions, Ritholtz points out. Also, they do their homework, spend time and effort learning the basics as they are unemotional, intelligent and patient. Hence, he says, investors need to fully understand the challenges they face to attain success in the investment world. “Capital markets are about making the best probabilistic decisions using imperfect information about an unknowable future,” he adds.

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