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The Secret to Investing

...is not really a secret. Just a few important things that investors must keep in mind.

W. Scott Simon, 08/01/2013

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

In my meanderings around the country through the retirement plan marketplace, I am sometimes asked "What is the secret to investing?" My reply is that there is no secret--on the contrary, investing is quite straightforward and simple. There are just a few important things that you must keep in mind.

Of course, investing is very confusing to many people because it is made to be so by those that will benefit from such confusion. For example, much of the investment media--TV shows, online blogs, newspapers, magazines, etc.--likes to confuse people. Bewildered investors are more likely to turn to the media in desperation and buy their products that promise to provide The Secret to Investing.

In addition, much of the investment advisory profession--not following business models that require advisors to be fiduciaries to their clients--tends to favor the interests of such advisors ahead of those of their investor clients. Not being bound by either a "best interest" or a "sole interest" fiduciary standard can more readily lead investment advisors to sell products to their clients that are imprudent--whether too costly, too risky, too illiquid and/or too opaque, et al. That certainly cannot have any relationship to The Secret to Investing.

Pssst, Here's the Secret
Although my views on The Secret to Investing are aimed at investors as participants in retirement plans, they are also germane (as relevant) to taxable investors outside of plans. In addition, many (perhaps most) participants are not enrolled in retirement plans with low-cost and low-risk investment options. That doesn't change the validity of the following points, however.

1. Maximize the Amount of Plan Contributions
The amount of money that a plan participant and its employer contributes to the participant's 401(k) plan is the single most important thing that the participant can do to amass a pot of gold that will generate a sufficient income stream in retirement. Nathan Bedford Forrest, one of the Confederacy's most astute cavalry generals of the Civil War, was (erroneously) purported to have said that the secret to his success in battle was to "git thar fustest with the mostest." Historians agree that Forrest never spoke that way; what he really said was, "I got there first with the most men."

In the same way, plan participants will enhance the odds of having a better retirement if they make retirement plan contributions a) as soon as they can ("gitting thar fustest") and b) with as much money as they can ("with the mostest")--thereby subjecting such contributions as long as possible to the advantages of long-term compounding. Participants are quite literally in a race to contribute as much money as possible, as soon as possible, by the time they retire. Their contributions (and any other savings that they may have outside their retirement plan)--turned into income--must last them for their life expectancy, potentially far longer beyond the day that they retire.

2. Keep Investment Costs Low
Participants in retirement plans offering low-cost investment options can control costs.

The investment options invested in by a participant in a retirement plan must have costs that are "reasonable" in relation to the value of the services provided for in exchange for such expenditures (section 404(a)(1)(A) of the Employee Retirement Income Security Act of 1974 (ERISA)). There's no reason why such costs cannot also be low, though. And costs are not just those that are "visible" ones comprising the annual expense ratio of a mutual fund. They also include "invisible" costs such as bid-ask spread costs, market impact costs, and the like. Few investors know that, together, invisible costs can often be greater than visible costs. Costs really do matter because they come right out of return.

3. Keep Investment Taxes Low
There are no taxes associated with retirement plans (until withdrawal), so this is an issue that need not be worried about during accumulation. But taxable investors must keep investment taxes low.

4. Keep Investment Risk Low
Participants in retirement plans offering low-risk investment options can control risk.

The investment options invested in by a participant in a retirement plan must be diversified in order to reduce the "risk of large losses" (ERISA section 404(a)(1)(C)). While the notion of a portfolio that's diversified broadly and deeply to reduce risk sounds good, its real significance resides in the fact that reducing risk--that is, lowering the volatility of the up-and-down movements in the values of investments held in a portfolio--is a quite effective way to enhance long-term return.

Volatility has a big impact on compound return, which measures the actual number of dollars that end up in a portfolio. Wealth is compounded by lowering portfolio volatility. Building wealth in this way is preferable to attempts to score big in the random game of trying to identify investment winners through stock-picking, market-timing, and track record investing. In fact, diversifying risk (i.e., lowering portfolio volatility) is the more dependable way to increase return.

5. The Return on an Investment Cannot Be Known in Advance
Participants in retirement plans have no control over the return generated by any investment option.

The return generated by any investment is a random variable, subject to inherent uncertainty. Because of that, no one has any idea what the return will be for any investment--such as a stock or a bond or a mutual fund--over the next minute, the next day, the next week, the next month, or even the next year. Many will tell you that they know, and the ones that will appear most believable will be those with the biggest marketing budgets. But in reality, no one can actually know, whatever the size of the megaphone to the contrary.

The far better course--indeed, the far more profitable one--is to give up the illusion of being able to predict the future by engaging in either of two forms of "active" investing: "stock picking" and "market timing." These involve attempts to profitably forecast the future price movements of stocks (or bonds) in order to predict which investments will be superior performers. A third form of active investing--"track record investing"--focuses on the past. This involves attempts to assess which superior-performing investments from the past will continue to be superior in the future.

Attempts to find investment "winners" based on forecasts of the future or readings of the past do not, however, create ideal conditions for achieving investment success. In fact, achievement of such success comes about by disciplined application of two major themes found in modern prudent fiduciary investing: broad diversification of risk and low costs (and low taxes for taxable investors). These themes, which are proclaimed clearly in ERISA, the Restatement (3rd) of Trusts and the Uniform Prudent Investor Act (and its numerous progeny), help give all investors the best chance to enhance long-term wealth that will generate sufficient income for a successful retirement.

Of course, there are other factors that plan participants may be interested in. Two come readily to mind: asset allocation and the risk/return trade-off in a portfolio. But in my view, the fundamental, underlying essentials to The Secret to Investing are the five discussed in this month's column.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understandingis the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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