Tuesday, February 15, 2011

Rule No. 1: Don't buy stocks because they're in the news

It was with enthusiasm that I read John Waggoner's column in USAToday about how investors think they can out smart markets. Called "Are Stock Prices Determined by Facts or by Human Nature?," Waggoner underscores something I embraced when I rolled over my retirement 401(k) into an IRA last fall. My working guidelines were to keep management fees low and spread my investment bet across the entire S&P 500 through an index fund at Fidelity Investments. I also purchased a few individual blue chips that pay a dividend of at least 3 percent. Happily, I've been rewarded.
Waggoner notes that investors tend to be over-confident just as we see ourselves as better-than-average drivers and basically smarter than the next person. This works against us when it comes to investing.
"The past decade has taught us that markets can be anything but rational," Waggoner says. "So today, behaviorists rule: They tell you that investors hold losing stocks not so much because they're undervalued but because it's hard to admit defeat. They note that men tend to trade more aggressively than women because, well, they're men. And most people buy stocks because they're going up — not because of earnings prospects," he writes. Meanwhile he profiles another camp that believes the efficiency of markets that take into account whatever is happening or likely will happen, thus stocks are priced accordingly.
If you're paying attention, you can use the study of the market to make good investment choices, right?.
Waggoner says investors can learn from both camps. His tips:
Index funds really are a good way to invest for most people. If most managers can't beat the index, you may as well buy the index. Be wary of new funds that follow obscure or narrow indexes, or use leverage, says Don Phillips, principal at Morningstar. "I think more charlatans operate on the index side than the actively managed side." And avoid the temptation to day trade exchange traded index funds.
Keep costs low. The biggest advantage to index funds isn't performance; it's that they can keep costs low. A $10,000 investment in Fidelity's Spartan 500 Index fund will cost you $10 a year in fees. Investing in a more expensive fund makes little sense. The Rydex S&P 500 C shares, for example, charge 2.28% a year in expenses, or $228, far more than the average actively managed fund. You'd be far better off in a fund with minimal expenses, such as the Fidelity Spartan 500 Index fund, the Vanguard 500 Index fund, or the SPDR S&P 500 exchange traded fund, all of which charge 0.10% or less.
Be humble. We all would like to think that we're great investors. But in reality, you're competing against people who invest for a living and have vastly more information and resources than you do. Investing is hard work, and just because you're a good doctor or lawyer doesn't mean that you can beat the pros in your spare time, Odean says.
Don't buy stocks because they're in the news. Stocks hyped on TV or elsewhere often have a small move up as people jump on. But your odds of getting the next Google from CNBC's Jim Cramer are fairly long.
Admit when you're wrong. Most people hesitate to sell losing stocks because it hurts to admit that they made a mistake. "It's less painful to postpone the decision," Odean says. But selling your losing stocks or funds, particularly in a taxable account, can be a smart move: You can use your losses to reduce taxable gains and income.
For more: Best stock picks of 2011 from USAToday's investment round table.

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