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.
But there is a qualitative difference between what the majority of rational-thinking market participants are doing and the reflexive, panicked behavior of an unthinking mob. The true contrarian can tell the difference between a crowd and a mob, a market rally and a bubble. The tricky part is the timing.
5 Asset allocation is crucial: What is your relative weighting of stocks, bonds, real estate and commodities? In the popular finance media, this gets little attention. Yet all of the academic studies show that it’s the most important decision an investor makes. It’s far more important than stock selection, yet that’s all anyone seems to want to talk about.
As we noted last summer, “Stock picking is for fun. Asset allocation is for making money over the long haul.” The world’s greatest stock picker would have gotten shellacked in 2008; the world’s worst stock picker made a ton of money in 2009.
The weighting you select for various asset classes is a function of such factors as your age, income, risk tolerance and retirement needs. It is what serious investors focus on.
6 Are you an active or passive investor: For the equity portion of your allocation, you 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?
Those who try to beat the market have a tough road ahead: Each year, 80 percent of professional managers fail to beat their benchmark. Of the few who do, once you take fees and costs into consideration, less than 2 percent actually hit that bogey.
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.
In conclusion, investors need to fully understand the challenges that face them: Capital markets are about making the best probabilistic decisions using imperfect information about an unknowable future.
Sometimes you have an embarrassment of riches to select from; other times you are choosing the “least-worst“ option. Either way, you will never have perfect information that allows you to bet on a sure thing. There is no magic elixir.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz. For previous Ritholtz columns, go to washingtonpost.com/business.