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3 Things You Must Know As an Individual Investor

Credit: Lali Masriera

Having a collection of quick tips about the Do’s and Don’t’s of investing is likely to always be helpful for an investor. Here’s my attempt at helping investors create such as a list.

1. Constantly jumping in and out of shares can kill your returns

I once called the following graph the most important chart an investor has to see:

S&P 500 vs investor returns

Source: John Maxfield at Fool.com

The reason this graph is so powerful is because it highlights the corrosive effects that timing the market can bring to an investor’s return. Take for instance, the 20 years ended 2003. During that period, the S&P 500 (a broad American market index) had grown by an annualised rate of 12.98%. Meanwhile, the average equity fund investor in the USA had earned just 3.51% in annualised returns.

DALBAR, the research firm responsible for the figures in the chart above, explained that the discrepancy in returns between the average investor and the market had appeared because investors were bad at timing the market. In other words, they had been jumping in and out of shares at all the wrong times.

The takeaway here is that instead of trying to time the market, investors should try and invest in shares for the long-term. As I’ve shown previously, the longer you stick around in the market, the higher your chances of success become.

2. Fees matter a lot in investing

In 2008, billionaire investor Warren Buffett made a 10-year bet with asset management firm Protégé Partners. Buffett had wagered that an investment in a low-cost index fund tracking the S&P 500 would handily beat a portfolio of hedge funds hand-picked by Protégé Partners. Buffett’s reasoning had been built on a simple premise:

“A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors [emphasis mine].”

At the end of 2013, Buffett’s low cost S&P 500 index fund had returned a cumulative 43.8%. Meanwhile, Protégé Partners’ expertly curated group of hedge funds had gained…. 12.5%.

This is a huge testament to the importance of fees when it comes to an investor’s returns.

According to Morningstar, the average stock-based unit trust in Singapore had carried annual expenses of 1.94% in 2013. Meanwhile, a plain-vanilla index tracker like the Nikko AM STI ETF (SGX: G3B) and SPDR STI ETF (SGX: ES3) – both of which aims to mimic Singapore’s share market benchmark the Straits Times Index (SGX: ^STI) – carries a total annual expense ratio of 0.4% and 0.3% respectively, according to the Singapore Exchange. That small difference of around 1.6% in annual expenses might seem tiny, but they really do add up over time into something huge.

Keep Buffett’s thoughts on fees in mind the next time you’d like to invest in any investment fund or manager.

3. Investment manages can’t always choose the best investing methods for you

And speaking of investment managers, here’s a really interesting bit of information which I think not many individual investors are aware of: Investment managers can’t always choose the best investing strategies or methods for you.

This thought came to me when I chanced upon an old article written by money manager Robert G. Kirby in the 1980s. The following is what I had written about it previously:

“Consider this fascinating anecdote. In the 1980s, money manager Robert G. Kirby wrote an article titled The Coffee Can Portfolio in which he detailed a personal experience he had with a client of his in the 1950s.

Kirby had been working with a woman client for 10 years – during which Kirby helped her to make portfolio decisions such as switching in and out of shares and lightening positions – when her husband passed away abruptly. Upon her husband’s death, Kirby’s client wanted him to handle the husband’s portfolio of investments as well.

When Kirby received the list of the husband’s assets, he was “amused to find that [the husband] had secretly been piggy backing [Kirby’s firm’s] recommendations for his wife’s portfolio.” As the primary contact between his wife and Kirby, the husband had a first-hand look into the recommendations made by the investing firm. But, there was a significant difference in how the husband piggy backed Kirby’s advice: The husband only followed the buys and ignored the sell calls.

That twist resulted in the husband’s portfolio being vastly bigger than the wife’s, where there was “one jumbo holding worth over $800,000 that exceeded the total value of his wife’s portfolio.” Bear in mind that that was only one holding within the husband’s portfolio of many other shares.

For Kirby, the revelation – that buying and then holding shares of great companies for the long-term had generated way superior returns as compared to more active buying-and-selling – formed the basis for the Coffee Can Portfolio.

He explained, “The Coffee Can portfolio concept harkens back to the Old West, when people put their valuable possessions in a coffee can and kept it under the mattress. That coffee can involved no transaction costs, administrative costs, or any other costs. The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can to begin with.”

To align with the spirit of the Old West’s coffee can, Kirby proposed a solution: Pick a group of 50 shares with desirable investable-qualities, buy them all in equal proportions, and then simply hold them for a decade or more. The logical basis for outperformance in that sort of portfolio is simple. “First, the most that could be lost in any one holding would be 2% of the fund,” wrote Kirby. “Second, the most that the portfolio could gain from any one holding would be unlimited.”

Unfortunately, Kirby didn’t act on his solution even when he thought it was a brilliant idea. The hurdles involved with assembling a team of professionals for that kind of portfolio construction would be too high to surmount, in his opinion. In addition, he was very wary of career risk as he thought the product simply wouldn’t take off with clients – “who is going to buy a product, the value of which will take 10 years to evaluate?””

It’s sad to see Kirby unable to act upon a great investing strategy because of career-related risks. Bear this in mind (don’t forget the management fees as well!) the next time you’d like to hire an investment manager.

Foolish Bottom Line

The three things listed above are important to know for any investor. But, there are plenty of other important things to know about the stock market as well. To find out more, click here to download your FREE copy of our latest report What Every New Singapore Investor Needs To Know.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.