I have a well-developed, heavily researched theory about individual investors – and plenty of empirical data to prove the theory.
You’ll have to forgive me, but it goes against what you’ll hear on MarketWatch, CNBC, Fox Business Network, and the like.
It’s a theory that has a huge impact on your finances and your future.
Let me explain…
Now, this theory of mine is based on stocks of empirical data. My more than 30 years of discussions, meetings, and gatherings of both individuals and professional investors also provide mountains of anecdotal evidence to support my theory.
We already know from research from Dalbar and others that individual investors underperform the markets rather badly.
The most horrifying example of this comes from Fidelity Investments. Legendary fund manager Peter Lynch ran the Magellan Fund from 1977 to 1990, delivering 29% average annual returns.
A $10,000 investment during the time he ran the fund grew to more than $294,000. An investor who put their $2000 IRA contribution in the fund every year during Lynch’s tenure would have had an account balance above $234,000 by the time he retired.
However, the sad fact is that the average individual investor in the fund during Peter Lynch’s legendary 13-year run helming Magellan actually lost money.
That’s right. Despite the fund returning, on average, a stellar 29% a year, the average individual investor in that fund lost money.
They fell into the cycle of fear and greed that has doomed so many investors. They were buying the fund when markets were exciting and dumping shares when markets were scary.
Another interesting data point comes from Fidelity, which looked at the returns for all its accounts and tried to figure out what demographics had the most success.
Was it better-educated investors who had higher returns? Was it men? Was it women?
Did conservative or aggressive investors fare best?
At the end of the day, it turned out that what made an investor have the best returns wasn’t whether they were a man or a woman, how much education they had, or any other factor.
It was whether they were still alive. Turns out, the best investors were those who had died, and no one had stepped forward to claim their account balance.
No one touched the cash or made ever-changing allocation decisions. No one got scared and gave in to a sell-off. No one got overly excited and added cash during a major rally.
The accounts just sat there and rode out the ups and downs of the markets and earned the high compound returns that patience and discipline can make possible.
In other words, individual investors are their own worst enemy. They fall into the traps of fear and greed. They chase unicorns and rainbows in search of a pot of gold. They speculate with no in-depth understanding of the markets they are trading.
Which gets us to my theory: most individual investors would have much more money if they focused on investing in small banks below book value, high dividend stocks, real estate investment trusts, and closed-end fund discount arbitrage situations.
Three-quarters of your investment accounts should be allocated equally to these asset classes.
For the final quarter of your cash, investors whose primary concern is income should focus on alternative income portfolios, including business development companies, commercial and residential mortgage REITs, and energy MLPs.
Suppose, however, the primary goal of your investing activities is accumulating capital for future purposes. In that case, this last 25% should go into strategies that allow you to replicate the high returns private equity managers earn over the years.
If you are hyper-aggressive and want to maximize returns, you can use very simple options strategies to enter and exit positions.
You might not get rich by next Tuesday using my approach, but paying some guy you don’t know $2,000 for a course on how to day trade futures won’t do that, either.
Look, if you genuinely need to get rich by next Tuesday, just go to Vegas, find a Baccarat table and bet the banker’s hand every time. You have a 51% chance of winning each time the cards are dealt, which is higher than most get-rich-quick stock market schemes I have seen over the past three decades.
You will probably still lose most, if not all, of your cash at Baccarat, thanks to the mathematical probability of gambler’s ruin… but at least you will get some free drinks and maybe a meal or two.
For the rest of us, the way to make money investing in stocks is to use high probability, high return strategies. The dividend-based approach Tim Plaehn uses for his Dividend Hunter readers is a fantastic example of high probability, high return investing.
So are the bank, REIT, and closed-end fund strategies I will discuss over the weeks and months ahead. (For a sneak peek at my closed-end fund strategy – which can get you 2x-10 more yield from the same dividend stock, while paying up to 18% less for it – click here.)
If we are smart and stick to proven strategies and make judicious use of the enormous amounts of information found in high yield credit spreads to make the fear and greed cycle work for us instead of against us, we have fantastic odds of finding the wealth we desire in the financial markets.
I’ll explain more next week.
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