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Friday, July 16, 2010

3 Ways to Make Investment Decisions

There are three ways to make investment decisions:

A. Market timing,
B. Security selection, and
C. Asset allocation.

Market Timing

Market timing, including all forms of charting and "technical analysis," doesn't work because nobody can predict the future. Markets move in response to millions of people acting on random daily news, which can't be predicted.

If someone could market time with as little as 51% accuracy, they'd be on the front page of every newspaper every day.

Everyone you see predicting the future is just guessing or are just trying to convince you to buy the stocks they just bought so they'll go up, and they can sell at a profit. It's their job to convince you that they can predict the future so they can move their products and sell their services. Over time, their "mistakes" will lose you way more money than their lucky calls will make you money.

The only people who have the actual data needed to forecast a stock's price are the people who work for the company - and they can't tell anyone because they'd in problem by breaking insider-trading laws.

There's just too many stocks, too much news, and it all happens way too fast to cope with. Company news comes out of nowhere and could bring a stock down before anything can be done about it.

That's way too risky, so individuals, and professionals that manage money for clients, should not waste time trying to pick stocks. But they love to do it because it's just so much fun to be a "player on the market."

It's humanly impossible to find the time to both manage clients' assets in a way to get the results clients need and expect, and keep up with thousands of stocks on a daily basis.

Some may get lucky here and there, but over time the losses of their "mistakes" will greatly outweigh their lucky picks.

Security Selection

The biggest problem with security selection is knowing when to sell. You don't need to be an expert to know when a stock you have been following will go up. Just wait for accelerating earnings growth.

This is usually when people buy because they feel "it's safe now that it's going up." But that's usually when it's time to sell.

Nobody wants to sell anything that's going up, especially when it's a "great company," so they wait to try to get a few more bucks out of it. That's when it goes back down before they can sell it.

Then the investor goes into denial - which usually results in holding it forever because they don't want to take a loss.

You want to buy stocks when the news is bad, and sell them when the news is good. But this is the opposite of what most people actually do in the real world.

These kinds of things alone should be enough to convince people that stock pickers are not to be relied on for anything but recommending stocks they already own so they will go up and sell at a profit, while clients who bought it on their recommendations are left holding the bag.

Asset Allocation

Asset allocation is the only thing that works for people who manage money either for themselves or for clients. It's the art and science of determining how much of the dozens of assets classes people should own based on their financial and life situation.

Asset allocation is very boring, and you're guaranteed to never double your money in one year. But it will most certainly get you the best long-term results.