Investing Rule 1: Know Thyself

By in Asset Allocation, Investing | 11 comments

First Investing Rule-Know Thyself

I was fascinated by an article by Mike at Oblivious Investor entitled,  “Why I Don’t Overweight Small Cap or Value Stocks”. His argument was based on the first investing rule-know thyself. Mike is one of the most disciplined guys I know. He sticks to what is right for him. He knows himself, and lives accordingly.

Mike cogently laid out the research that over time, value and small cap stocks have outperformed a broad based index fund. This is widely accepted information from Modern Portfolio Theory and is considered one of the market anomalies of the efficient market hypothesis.

A Bit of Investing 101 Theory

The efficient market theory purports that over time the stock market is generally efficient and that prices reflect all available information and revert to their fair value. This Efficient Market theory is the basis of the indexing approach to investing and states it is very difficult to beat the overall market returns.

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Investing Rule # 1-Know thyself

Yet, the anomaly rebuffs the efficient market theory and shows that small cap stocks and value stocks, over decades, tend to outperform the overall stock market. Although this is so, there are long periods of under-performance of these asset classes as well. In spite of his awareness of this research, Mike decides not to act on the over-performance of value and small cap stocks.

How the Small Cap and Value Stock Out-performance Impacts My Investing

Personally, after studying this research in my MBA program, I added an extra bent towards value and small cap ETF’s to my portfolio. I decided to add those asset classes to our asset allocation and purchased two low cost index ETF’s; one specializing in value stocks and the other in small cap stocks. I was well aware that although small and value stocks outperformed in the long term there were also long periods of under-performance. That doesn’t bother me, as I’m quite disciplined and don’t change my well thought out investing strategy easily.

What About Mike?

In his own words,

“If, however, you’re somebody who would start to doubt your choice–and potentially back out on it at the worst time–during a period of relative under-performance, you should think twice about implementing a tilted portfolio. And that’s the boat I’m in. For whatever reason, I’ve come to have a strong suspicion of anything remotely clever when it comes to investing.”

I was completely taken by his rationale.

In lieu of the possibility of a higher long term rate of return, Mike decided to create a portfolio in line with his self knowledge and investing comfort level. He understands his risk tolerance and is interested in sticking with a simple and clear cut investing strategy in line with his personality.

Very wise.

Read: What are Index Funds and Asset Classes Investing? >>>

Investing Rule-Try Being a Lazy Investor

Piper’s investing style might be characterized as “lazy”. After all, he chooses index funds and then stays the course. He doesn’t change with the wind, the fads, or the tip he gets from his neighbor. And you know what? He’s likely outperforming most active investors. In turns out that a lazy investing portfolio can outperform many more sophisticated approaches.

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How do you decide which investment approach to follow?

A version of this article was previously published.

    11 Comments

  1. You make an excellent point Barb! Emotional investing is disastrous.

    During the dotcom boom, I remember one particular guy who refused to invest in the market, his rationale was very simple. He will invest only in what he knows and he said he understands CDs and interest savings better than stocks!

    Not saying one should ignore stocks, but knowing yourself is very important before following advice that’s out there.

    MoneyCone

    November 21, 2011

  2. Aside from trying to use the large asset classes, I include healthcare, biotech, and high tech. The proportions change over time depending on the market.

    krantcents

    November 21, 2011

  3. @Moneycone-If you can’t stand any volatility, then it’s best not to invest in the markets.
    @Krantcents-Sounds like you are targeting some potentially faster growing sectors.

    Barb

    November 22, 2011

  4. I find it interesting how so many people identify themselves as aggressive investors during the good times. Everyone is a “risk” taker when their portfolio is growing at an annual clip of 40%. You see what they’re made of when it drops 50% the next year.

  5. Barb, I range from very volatile (nano-cap resource stocks) to very boring (dividend) to ultra-conservative (cash). So the combination probably puts me somewhere in the middle.

    Good article, resources & commentary, by the way. I took a noodle around Market Watch, I hadn’t been there in some time.

    101 Centavos

    November 23, 2011

  6. Comfort level plays a big role in investing. Kind of like the portfolio that lets you sleep at night. If your money is keeping you up it’s time to change your strategy.

    JP @ Novel Investor

    November 23, 2011

  7. @Shawanda-You hit the nail on the head!!! No one really likes to see their assets decline in value.
    @101-Sounds like you definitely have some broad diversification! Yea, Marketwatch has some great stuff.
    @JP, Hey, I talk about the sleep at night portfolio in my book!!! It’s one way to determine your risk tolerance.

    Barb

    November 24, 2011

  8. According to Bill Sharpe in his book: Investors and Markets ; small cap value represents 2 percent of the
    total market so it is impossible for all of us to invest any meaningful amount in that asset class.

    mike

    July 24, 2015

  9. One thing that I think is important to recognize is that this does not need to be a cut and dry decision (not saying you are saying that though). The term overweight is important; an investor with a balanced portfolio can still put a smaller slice of their asset allocation into small-caps to get the benefits of that asset class. This will not increase the risk of the portfolio too much, while providing the opportunity for additional gains.

    Jeremy

    July 29, 2015

    • Hi Jeremy, And your comment perfectly exemplifies the importance of investing according to your own preferences. There isn’t a perfect asset allocation or investing solution for all.

      Barbara Friedberg

      July 31, 2015

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