Friday, February 26, 2010

The 5 Most Important Things That I Learned in Investments Class

Finance is polarizing. Whether you consider it high-powered and sexy or the embodiment of greed and evil (or something in-between), it's here to stay.

There is probably no school in the world that has a greater collection of academic financial minds than Chicago Booth, so I feel extraordinarily fortunate that I am learning the subject here. I learned far more in my Investments course than I could summarize in a single blog post, but here are what I consider to be the 5 most important lessons.

Important note: If you are scanning this and only take away one thing, read (1) carefully and understand it.

5) Most money and investment managers should not have jobs.

Are you invested in mutual funds? If it's a "managed" fund, you might want to re-consider your investment. The manager may sound smart, but they all do. And using their smarts, they try to push people toward "actively managed" funds. Whenever you hear that word, be afraid. It means that you will likely pay higher fees, which is guaranteed lost money.

My brilliant young Investments professor studies how well mutual fund managers perform. What does the research say? Out of the thousands of mutual fund managers in the world, only a handful consistently perform better than a monkey randomly choosing stocks. And there is a certain (not small) portion of managers who consistently perform worse than a monkey randomly choosing stocks.

What does all this mean? If you're in an actively managed mutual fund, it's likely that you're paying somebody for doing work that a monkey could do equally well.1

4) People make predictable mistakes.

People don't like to sell stocks for a loss. They will predictably (and irrationally) hold on to bad stocks which have lost value, opening themselves up to the possibility of more losses. People also love to sell stocks for a gain. They will predictably (and irrationally) sell good stocks that have gained value. Then they miss out on future gains.

There are a number of predictable mistakes like this that people make. Even though they lose money as a result, they don't learn to stop doing it.

If you're planning to invest, either a) invest your money in something reasonable and forget about it, or b) learn the mistakes that people make and read through them before you buy or sell to make sure that you're not making them.

3) Your relationship with risk will be a key determinant of your future wealth.

If you bought $5000 worth of shares in an index fund, and you immediately lost $1000, what would you do? Sell? Buy more? Hold?

It's actually tough to answer that question until you have actually lost $1000. A lot of people say that they would do one thing, but actually do another when the event happens. However, your response to that situation will speak volumes about how rich you can be in the future.

Investment theory teaches that investments should only pay you if you bear risk. And not just any risk . . . risk that cannot be avoided, insured against, or diversified away. You need to be exposed to earn money.

Assuming that you and another person make equally reasonable decisions, the person with more tolerance for risk has more opportunity to be rich in the long term. They also have more opportunities to be poor, remember. However, they worry less about being poor, and that's their advantage.

2) Warren Buffet knows accounting and economics. He doesn't do much academic finance.

If you're interested in picking individual stocks better than other people, Finance is good to know, but it won't help as much as accounting or economics. Finance will teach you to think in the aggregate. You will learn about trends and tools. It will be a great vocabulary and thought lesson, but you will not spend much time looking at individual stocks, their reports, or the underlying economics of the business.

However, if you're wanting to pick stocks better than other people, keep the next and final point in mind.

1) Somebody out there is smarter than you and works harder than you. That person is waiting to exploit your mistakes in order to make money.

Let's pretend that you have $100,000 to invest. If you find a piece of information that earns you an extra 1% per year, you will earn an extra $1000 per year. That's pretty good, and it's probably worth a lot of effort. You might even be willing to pay a smart person $900 to find something that nobody else knows if it earns that extra 1%. If you did, you'd earn ($1000 - $900) = $100.

But wait a minute . . . there are companies out there that have more than $100 million to invest2. If that firm finds the same information and earns an extra 1%, they earn $1 million. They could pay 1,000 people $900 to try and find the information first (and they would still make more money than you)!

Do you still think that you can find that information before they do? Do you think it's more likely that you'll profit from their mistakes or they'll profit from yours?

If you want to learn more about specifics, I'd recommend starting with books by John Bogle or value investors.

This post is the second in a series of posts that I am writing to share a variety of MBA knowledge that I think would be useful for laypeople. It's meant to help people without an MBA education to become aware of issues that may come up when making important decisions.

The first post: The 5 Most Important Things I Learned in Financial Accounting Class

Please let me know if you thought this was useful. And if you like it, share it with a friend.

1 I'm not an investment advisor, so I can't recommend something else legally. However, I can say that some very smart people who I know invest in index funds . . . and they make sure that the management fees are very low!

2 Some sovereign wealth funds have more than $100 billion (100,000,000,000) to invest.