What you need to know about mutual funds (2)

January. 18,2024
What you need to know about mutual funds (2)

The key to fund selection is not to focus only on future returns, which are beyond the investor's control, but rather on risk, cost and time, factors over which the investor has control.

Your investments will survive and ultimately succeed if you strictly adhere to a few simple rules over time, such as.

1) You must invest. The biggest risk is not short-term stock price volatility, although that still exists, much less projects that pose long-term risk, but rather not investing your money in projects that pay off handsomely.

2) Time is your friend. Give yourself as much time as you can. Start investing in your twenties, even if you have very little money then, but never stop. Making the most usual investments at difficult times will help you keep moving forward and make it a habit. You need to realize that compound interest is a miracle.

3) Impulsiveness is your enemy. Eliminate the emotional element from your investment plan, maintain a rational expectation of future returns, and avoid changing your expectations due to market fluctuations. The cold, dark winter will eventually give way to a bright, bountiful spring.

4) Master basic arithmetic. Keep your investment expenses manageable. Your net return is equal to the total return on your portfolio, minus the costs you incur, including sales commissions, advisory fees, transaction costs, etc. Reducing costs will make it easier to accomplish your goals.

5) Stick to simplicity. Don't complicate the process. The basic point of investing is to simply and rationally allocate your stock, bond and cash reserves. Choose funds that focus on the middle of the road investing in high-grade securities; be careful to balance risk, return and (never forget) cost.

6) Stay the course. No matter what happens, stick to your investment plan. I've said "stay the course" a thousand times, and each time I've reminded you of it in earnest. This is the most important piece of investment advice I can give you.

Sir William of Occam was a 14th century English philosopher who made the observation that the simpler the explanation, the more likely it is to be correct. This well-known assumption is known as "Occam's Razor".

Based on Occam's Razor principle, I have derived a simple theory that the three variables that determine the long-term return of the stock market are

1) The dividend yield at the moment of initial investment.

2) The subsequent earnings growth rate.

3) The change in the P/E ratio over the investment period.

Annual profit growth rate = annual profit growth / total profit of the previous year x 100%

Where: annual profit growth = total profit of the current year - total profit of the previous year

The higher the annual profit rate, the more profit the company has and the more profitable the company is; conversely, the lower this ratio is, the less profitable the company is.

The initial dividend yield is a known quantity. Relatively speaking, the earnings growth rate is usually predictable within a fairly narrow range of parameters. Meanwhile, changes in the P/E ratio have been shown to be highly speculative, and the total return is the sum of these three factors.

For example, assuming an initial dividend yield of 3% and a forecasted earnings growth rate of 7% per year for the next 10 years, the return would be 10%. If the P/E ratio changes from 15 times at the beginning of the period to an expected 18 times at the end of the period, this would increase the total return by two percentage points (15 x 1.02^10 = 18) and the stock would return 12%.

The P/E ratio represents only the price paid for one dollar of earnings. However, as the P/E ratio falls from 21x to 7x, the stock price falls by 67%; if the opposite happens, the stock price rises by 200%. If the P/E ratio does not change, the total stock return is almost entirely dependent on the initial dividend yield and earnings growth rate.

The short-term investment strategy effectively ignores the dividend yield and earnings growth rate, two factors that are not significant over a period of weeks or months. Short-term strategies have nothing to do with investing and everything to do with speculation. The point of a short-term strategy is simply to guess what other investors will be willing to pay when we are willing to sell a security at some future time.

Occam's Razor principle will not tell us what the future return will be, but it will tell us how the elements that affect that return should be determined given any return conditions we wish to receive on stocks and bonds.

Regardless of what the future holds, I believe that stocks should dominate a well-balanced asset allocation program as an investment choice (one of many) for long-term investors.

So, invest with sanity and common sense. Engage in enlightened and rational discussions when considering the future. Allocate a significant portion of your assets to stocks and bonds and avoid extreme modifications to your portfolio's allocation. At the same time, be skeptical of every forecast you are given, including mine. If you have established a sensible path to capital appreciation, stick to that path, no matter what happens.

My guidelines are simple: at the original starting point, two-thirds in stocks and one-third in bonds.

My portfolio approach also follows the four dimensions of investing that I advocate: (1) return; (2) risk; (3) cost; and (4) time. When you choose stocks and bonds as the long-term allocation for your portfolio, you must make decisions about the returns you can predict from earnings and the risks the portfolio will take. You must also consider the investment costs you will incur, which will reduce your returns and increase the risk you must take. Think of return, risk and cost as the three dimensions of a cube: length, width and height. Then, think of time as a temporary fourth dimension, which interacts with the other three dimensions. For example, if you invest over a long time horizon, you will be able to take more risk than if you invest over a shorter time horizon; and vice versa.

The best use of bonds in an equity portfolio is as a regular source of income with a mitigating effect, not just a substitute for stocks. Remember, the goal of the long-term investor is not to retain capital in the short term, but to earn a real, inflation-adjusted long-term rate of return.

Returns grow quickly over time, and risk decreases quickly over time. Stock returns fluctuate and decrease rapidly as the holding period increases. The standard deviation of stocks is 18. 1% for the one-year period and decreases to 2.0% for the 25-year period, but this decrease occurs mainly at the end of the 10-year period.

Once you have determined a long-term asset allocation strategy, you must decide whether the balance will be relatively fixed or dynamically adjustable. Usually, there are two basic options, and you are able to (1) keep your allocation fixed and periodically buy and sell stocks and bonds to bring your portfolio back to its initial allocation, or (2) set an initial allocation and then let your investment profits take their own course. In the latter scenario, your initial allocation will evolve over time and reflect the relative performance of stocks and bonds.

The advantage of using a fixed ratio strategy is that you will automatically lock in gains and reduce equity exposure as stock prices rise. Correspondingly, as stock values fall, you will increase your holdings (using proceeds from bond sales to do so, or rebalancing your investments), which will reduce your equity exposure; at the same time, this will maintain the relative stability of the initial balance between risk and return.

The cost of investing and asset allocation are both key constraints on long-term returns. The bottom line for investing is that cost is critical. At the same time, lower costs will achieve higher returns.

The equity risk premium, simply put, is the additional risk an investor takes on to claim additional returns due to holding common stock instead of risk-free long-term U.S. government Treasuries. The risk premium can be calculated either by the look-back method, which is the difference between two returns for a given past time period, or by the forecast method, which is the difference between two expected returns.

It is unlikely that a single outperforming fund will be selected in advance. However, experience has taught us that a group of outperforming funds can be pre-selected simply by using low cost as a criterion. When all other strategies fail, revert to simplicity.

Rule 1: Select low-cost funds; low fees are the only important factor in a given fund's good performance.

Rule 2: Consider carefully proposals that increase costs.

Rule 3: Do not overestimate a fund's past performance.

rule 4: use historical performance to determine consistency and risk.

rule 5: beware of star fund managers.

rule 6: beware of asset size.

Rule 7: Don't hold too many funds; more than 4 or 5 equity funds is generally unnecessary. Holding too many funds will tend to lead to over-diversification of investments. Thus, the end result: a portfolio that will inevitably perform similarly to an index fund.

Rule 8: Buy and hold your fund portfolio.

Another competitive indexing-like approach - quantitative investing - is on the rise. I am equally confident in confirming that this investment strategy will also gain a foothold in the investment landscape.