I’m shopping for a new car. I’m shopping for a new car because I need one, but that’s not a problem because I actually enjoy looking around, comparing all of the models, performance, mileage, ratings, and prices as I try to find just the right vehicle. It’s fun to shop. Shopping is ingrained in us as Americans. Yet, shopping is actually a terrible way to make investment decisions, and those same instincts used to find just the right car might actually land a terrible investment.
The basic process that most of us use when shopping looks something like this:
Recognize a need
Search for information
Evaluate Options
Make a purchase
Evaluate post-purchase satisfaction
Does that sound familiar? I need a car, so I start doing web searches, read all of the ratings, and ask my friends about their experiences. I’m searching for information. Once I have done a sufficient amount of research I evaluate what I’ve learned, weighing fuel economy versus performance, price versus reliability, and all of the key factors until I’ve decided on just the right vehicle. Finally, I stop by the dealership, negotiate the deal and drive home in a new car. Even if I feel good about my purchase I evaluate the vehicle for a while trying to decide if it really was a good buy. That is shopping. That is actually smart shopping and hard to criticize. Shopping works for buying cars because the information is good and fairly predictable. Sure, you may get a lemon but the best cars are usually the best cars for years and you can make a good decision by doing your research on how those vehicles have performed.
However, using that same shopping process for investing can lead to very poor decisions. The biggest problem, of course, is that investments are not cars, and the information we have about investments is not predictable and must be evaluated very differently. We can predict the future reliability of a Toyota based on the historical reliability of Toyota vehicles, but we are hard-pressed to predict the future return of Apple stock based on the historical return of Apple stock. You may have heard ‘past performance is not indicative of future results’ and it is true. Even ratings, so popular in the car industry, can work against us in the investment world. For example, Morningstar’s highest rated 5-star mutual funds have actually been found to underperform in the 36 months after achieving their 5-star rating. Chasing what returned the best last year, or chasing what has the highest rating, can damage returns. Even worse, the final step in the shopping process can result in an endless cycle of poor performance. If we ‘evaluate post-purchase satisfaction’ and find that some other investment performed better, or that our investment lost money, it can cause us to sell in down markets and start the cycle all over again.
Instead of shopping for investments, we believe that a better approach is planning and investing for your goals. The process looks something like this:
Develop a plan (vs identify a need)
Diversify
Minimize cost
Maintain the plan by rebalancing and resisting temptation
Developing a plan means that you identify what exactly you are trying to achieve. You are not just shopping for an investment because you need one, you are investing for a purpose and so we start there. Next, we develop a diversified portfolio that is constructed to meet that goal. Diversification takes into consideration things like risk and makes sure that you are invested in investments that are impacted by different economic factors, not just looking at historical returns. We keep costs low because costs matter. Finally, we seek to maintain the plan because the best investors have discipline and are not tossed about by how they ‘feel’.
I’ve seen very smart people seriously damage investment returns by simply approaching investing like they approach buying a car. Investing is a discipline that is different. It takes a different set of skills and requires us to look at information differently. Make sure that the next time you seek to invest not shop.