Five principles of investing

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Below I’ve outlined five of what I consider tried and true investment principles, which I believe will remain relevant to the majority of investors and stand the test of time.

  1. Conventional thinking — “What stock should I buy and “Where do you think the market is going?” are the two most common questions I hear. Each of these requires me to make a forecast. Therefore, conventional thinking seems to be that in order to have a successful investment experience, you must be able to look into a crystal ball and predict the future.
  1. Market forces — This is a completely different approach than simply trying to predict what the market will do. It originated and evolved in the halls of academia and is based on a mountain of evidence showing that free markets work because the price system is a powerful mechanism for communicating information.

In the realm of fiercely competitive capital markets, this means simply that prices are fair. Competition among profit-seeking investors causes prices to change very quickly in response to new information. Neither the buyer nor the seller of a publicly traded security has a systematic advantage.

  1. Everyone can win — It is not necessary for someone to have a bad investment experience in order for you to have a successful one. Everyone can win because with capitalism there is always a positive expected return on capital. The expected return is there for the taking and as a provider of capital you are entitled to earn it.

Realized returns are uncertain because the market can only price what is knowable. The unknowable is by definition new information. If it is considered bad news, or if risk aversion increases and investors require higher expected returns, prices will drop. This is the market mechanism working to bring prices to equilibrium where the expected return on capital remains positive and commensurate with the level of risk aversion in the market.

  1. Good vs. bad —  Conventional wisdom says that if you want better returns, you must uncover the limited number of truly outstanding companies. However, it is mathematically impossible for investors to collectively limit their holdings to the stocks or bonds of these “excellent” companies. Thus, riskier companies must offer an incentive for investors, which comes in the form of higher expected returns. The market pays a higher price for and accepts a lower expected return from the stocks and bonds of excellent companies and vice versa. Therefore, the riskier company has a higher cost of capital, which is equivalent to the investor’s expected return.
  1. Effective diversification — Not all risks generate higher expected returns. To diversify effectively, investors allocate capital across multiple asset classes around the globe to suit their unique circumstances, financial goals and risk preferences. Building a portfolio that puts these ideas to work is one thing, but following through is something else entirely. Staying the course requires the emotional discipline to execute faithfully in the face of conflicting messages from the media and the investment industry.
 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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