This is the second of three essays about my opinions on investing for individual investors.  In Part 1 I explained why I don’t try to predict the near future and why bad predictions can lead to disastrous financial result.

It’s no accident that there’s a snapshot of Fannie Mae headquarters alongside the family photographs on the memento shelf in my office.  It warms my heart to think of the place.  The stock has been so great they ought to retire the symbol.
-Peter Lynch, Beating the Street

I can be as wrong as the next guy.
-Peter Lynch, September 2008, when asked why he held Fannie Mae stock in his own portfolio to the bitter end.

The point of this essay:  I ignore all predictions about money from ANYONE. 

I don’t care if you’re Warren Buffet, the blithering idiot on TV, some random dude in my Twitter feed, or a famous hedge fund manager. You might be able to predict where a particular stock or the market is going, but I have no way of telling if you are right or wrong so it is just easier to tune you out completely.

I’ll summarize what is explained elsewhere more eloquently in books like Fooled by Randomness:

In any large pool of investors, mere chance will result in some of them greatly outperforming the average.  Unfortunately we have no means to determine whether or not these results actually indicate whether someone is lucky or good, so putting faith (or money) in their ability to continue this winning performance can lead to disaster if they have just been lucky and return to statistically average results.

We’ve been lucky. Well, maybe it’s not 100% luck—maybe 95% luck.
-Bill Miller, on his streak of beating the S&P 500 for 15 consecutive years.

“Countrywide’s long term business value… we think is in the $40’s compared to its current price of about $14-15.”
-Bill Miller, 2 months before Bank of America bought the company for $5.5/share.

Even if you can predict the future with some degree of reliability, I sure don’t want to take your advice on one of the occasions when you happen to be wrong.

Just as an experiment, spend a day analyzing how many times people make predictions about the future movement of stocks:

“This is going to be worse than 1929″
“They are too big to fail”
“Economists predict that….” (Put anything here.  They get it wrong constantly)
“The Paulson Plan will make money for taxpayers” (You want to take the future of our country on faith?)

The constant noise of the financial media does more than cause you sleepless nights or overconfidence.  Following the herd mentality will inevitably lead you to sell during panics and buy during boom periods – a recipe for lousy returns.

As I write this in October 2008, everyone around me seems to be “moving their money into something safer” until things stabilize.  I even hear “pundits” providing this advice on TV.  Countless studies show that this strategy is extremely risky since missing even a few good days in the market can drag your returns below inflation.

Nobody knows nothin’
-Marc Andreessen, in a speech I heard a few years ago.

Amen, Marc, amen.

I ignore predictions by me and everyone else in the world.  So making investment decisions must be agonizing, right?

On the contrary, this intellectual foundation makes investing so easy that it becomes boring.  I’ll discuss why in part 3.

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The first in a 3-part series of essays on my approach to personal financial management.

If you can keep your head when all about you
Are losing theirs…
Yours is the Earth and everything that’s in it
-Rudyard Kipling, If.

My friends and family know that I’m interested in investing and that I’ve worked in the financial services industry. So they have been asking me the same question lately:

What do you think will happen with the current financial meltdown and what are you doing about it?

The answer is simple but not very reassuring: I have no idea what will happen, and nothing different.

Actually the real answer is more complicated and, I think, more interesting. Not only do I not know what will happen, I know that I don’t know.

This point forms my investing strategy foundation.  I don’t know the future and I’m fine with it.

Last week I didn’t know what was going to happen this week. Five years ago I didn’t know what was going to happen today, and I sure don’t know what will happen tomorrow. The Dow could stage a massive recovery tomorrow. Or it could plunge another 700 points.

The ambiguity in investing seems to give most people angst: they feel like they should know what is going to happen. For if they could put parameters around they future they would be in a better position to deal with it.

Do I want to know what is going to happen?  Of course! One look at the 2008 S&P500 Chart will convince anyone that a few good moves could make them rich. But confidently guessing wrong is the fastest path to financial ruin, and missing just a few days in a bull market from trying to guess the recovery date can ruin your returns.

In 2004 I undertook the painful exercise of calculating the net return of all of my investment decisions since 1997. After reading all of the books, doing all of the research, and making my own decisions I matched the S&P500 returns. And when taxes and transaction costs were considered I had actually performed worse than an S&P500 Index Fund. After some painful reflections and a few stiff drinks I accepted reality that I’m no better than average at making investment decisions. So I decided to read some different books.

I read Fooled by Randomness and The Black Swan by Taleb. I read almost every essay written by William Bernstein. I started learning about logic from podcasts like Point of Inquiry and the basic mistakes we make in thinking. I read about the history of Long-Term Capital Management. I studied the scientific method.

I realized that I don’t know what is going to happen in financial markets. Far from causing me despair, this knowledge has made it much easier for me to sleep at night. Better still, it arms me with a powerful tool for “keeping my head about me”.

(Flip on the financial news media tomorrow and you’ll see plenty of people who have lost theirs.)

I decided that I couldn’t see a good reason why we could not have another Great Depression that is twice as severe and twice as long as that of 1929. I also decided that technology could propel the world into a new era of economic efficiency with financial returns as good as or better than those of any other time in history.

So in 2004 I started anew with an investing approach that took into consideration the possibility of these future events in the context of my life. And every time I’m faced with a decision, a new piece of information, or a new event, I remind myself that I can’t guess the future. I try to make decisions dispassionately. This isn’t easy and it takes a lot of self-coaching.

“The market dropped today, maybe it is a good time to buy!”
“Oil has really gone up this year, it is a bad time to diversify into commodities.”
“The US will NEVER let a nuclear-capable Russian economy fail.”
“Buy land. They’re not making any more of it.”

Underlying each of these points is a belief about the near future. And each time I find my mind wandering in this direction I try to coach myself back to calmer waters.

Of course I can make some reasonable bets about very long term trends that guide my investment decisions. I can develop an approach that allows me to not only remain calm through the 2008 market madness but actually profit from it.  I can use my professed ignorance about the future to my advantage.
But that is a topic for the third essay.

You all know security is mortals’ chiefest enemy
-Macbeth III;6

P.S. Just for fun, count how many predictions you and and others make about the market tomorrow.  Then reflect for a second on whether there is any solid basis for these opinions. In part 2 of this series I explain why I don’t believe any of them.
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One of my favorite essays by William Bernstein is called Too Much Capital. In it, Bernstein makes that argument that interest rates – or the “cost of capital” – have been steadily falling around the world for centuries. He attributes this phenomenon to a few sources:

• Lowering “friction” of borrowing money and comparing options. Obviously the Internet is the most recent example, driving down everything from the cost of stock transactions to mortgages.
• As people (and institutions) rise above subsistence level, they have the luxury of being more picky and waiting for better investment options.

If the second point appears a bit odd, consider Bernstein’s example:

How to understand it all? A simple paradigm is useful. Begin with a subsistence level society in which everyone is balanced on the knife-edge of starvation. By definition, there is no excess capital—every last bushel of wheat and barley and every last coin goes entirely towards the purchase of food and shelter. But even subsistence societies need capital for seed corn, tools, and housing. In such a world, the cost of capital is thus infinite—the first fortunate person with an excess shekel or drachma can name his interest rate. As the countryside becomes more productive, fabulous wealth rapidly accumulates in the hands of the fortunate few with money to spare.

What does this mean for us? Borrowing money is going to get much cheaper and earning money with money is going to get much harder. In other words, long-term stock returns may never hit 10% again, but our mortgages are likely to be much smaller than our parents would ever imagine.

If you’ve been reading my posts for some time, you’ll know I view everything through an optimistic lens. Bernstein summarizes the future quite well.

I, for one, do not despair our low-return world. Who in their right mind would trade the standard of living today, at almost any point on the map, for that of fifty or a hundred years ago? Who would prefer to deal with the horrors of the widespread rural poverty of 1900 or the specter of Hitler and Stalin in the 1940s than with jihadi terrorism or identity theft? The price we pay for this sanguine state of affairs is derisory expected returns. An agreeable piper indeed, and one well worth paying.

Consider low, long-term returns with the inevitable increase in human life expectancy. Those of you in (or contemplating) retirement may live years or decades longer than you expect. At the same time, your returns from your life savings will be lower. The net result is that you’ll probably run out of money while you’re still alive or be forced to re-join the labor market in one fashion or another.

Before you despair on this point, ask yourself whether you’d rather be rich and dead or (relatively) poor and alive? “An agreeable piper indeed.”

I have a confession to make: I own a stock – Netflix. I’m confessing because I’ve come to the conclusion that investing in individual stocks is a bad idea for most people. Let me back up a step.

About 12 years ago I started learning about investing. I quickly became interested in the subject and read everything I could find on it from books by Peter Lynch and Ben Graham to periodicals like the Wall Street Journal and Investor Business Daily. I became active on the Motley Fool community and even joined the company. Over time I found myself spending hours and hours researching stocks in my spare time and making investment decisions. I had some spectacular winners such as Starbucks and Celera and some equally spectacular losers such as @Home.

About 3 years ago I forced myself to answer a tough question: am I any good at this? To be clear, I’ve never been a trader or bought anything without learning everything I can about the company. Based on discussions with other people over the past decade I’ve concluded that I know much more than most people on the subject. But facts are facts, and I decided the only way to answer this question was to go through the painful exercise of calculating my returns relative to the S&P 500.

The answer? No, I am not. Well, at least as compared to a monkey picking random stocks from the newspaper. I suppose compared to most investors I’m actually doing well: the net result of my 7-8 years of investing in stocks got me a return equal to the S&P 500 Index over that period. That’s a lot of work for no “Alpha” as we say in the financial world, but at least I’m faring better than the day-traders and most mutual fund buyers.

As a result of this exercise I decided to shift to an asset-allocation strategy using ETFs. I’ll try to cover more of my current approach in a later post, but the point of this discussion is that my current strategy dictates that I no longer invest in stocks.

Today I read another brilliant article by William Bernstein that confirms my observations and validates my decision. In his usual, eloquent style Bernstein explains why you probably shouldn’t be buying stocks either. Don’t fell badly, though. He also makes a pretty strong case that 99% of the “pros” on Wall Street should join us.

If you want some great information on what we should probably be doing, I suggest Bernstein’s books – particularly the Intelligent Asset Allocator – or David Jackson’s ETF Investing Guide.

I suppose you’re going to make me publicly explain why I’m ignoring my own cold, hard, factual history and answer your question: “Why are you investing in Netflix?” My answer is that I invest a LOT of time studying the stock and company. I read about it daily, research the industry, and talk to everyone I can find about it. Netflix also has a very transparent, consumer-facing service, so evaluating their product offerings is relatively easy. The net result of this exercise is that I feel comfortable with a small % stake in the company.

Only time will tell if this was a profitable decision, but I’ll sleep easy knowing that my downside is minimal and that I knew the risks in advance.