Learning the jargon of financial investment can be daunting, but it can also provide you with a better way to understand the status of your investments. Here is a brief primer on some common financial terms you should know, and things you should consider when evaluating your portfolio and investment returns.
Gambling is speculation. One cannot assume any expectations based on the amount of risk one takes. You could win $50 million from a $5 lottery ticket or you could bet $50,000 and win nothing. Investing is quite different. Investing in capital markets has a positive expected return for risk taken.
Stock markets worldwide have reliably rewarded long-term investors. For example, over the past eighty years, investors who held the S&P 500 (including dividends) for at least 12 years would always have had positive returns.
Commodities, like many things that come out of Wall Street are easy to sell and hard to trust. Though the Commodities market is sometimes in vogue, they are too volatile to be held for the long-term. According to a Goldman Sachs Group Inc. study from 2016, a portfolio of stocks, bonds and commodities showed a worse return in the period from 1987 to 2015 than a portfolio of just equities and debt. They also may not be a good hedge during stock market declines: Commodities fell more than U.S. equities during the recent stock market declines in 2008, 2010, 2011 and 2015.
The reliability of investment outcomes and the relationship to performance in a diversified portfolio
The benefits of diversification is something we discuss at great length with our clients. In addition to the commonly discussed benefits of diversification: increased returns and volatility reduction; the other lost leader is the positive impact that diversification has on delivering reliable outcomes.
In a research paper by Wei Dai, PhD of Dimensional Fund Advisors, Dai identified that the most reliable drivers of expected returns, or what they call dimensions, are the premiums associated with company size, relative price and profitability. But that isn’t the end of making sound investment decisions when choosing what companies to include in a fund or which equities to include in a portfolio.
It is in our behavioral nature to assess risk based on identifiable examples, not only can that mindset skew decision making, it can leave us vulnerable to risks we are not as familiar with and closed off from opportunities we may believe to be too risky. These things coupled together do not make for clarity of thought when making investment choices.
Availability Bias or Availability Heuristic is “a mental shortcut that relies on immediate examples that come to a given person’s mind when evaluating a specific topic, concept, method or decision.”
As we live in the aftermath of the Great Recession, though the strides that the markets have taken between then and now have been impressive, investors maintain an availability bias that “safe is good” and “risky is bad.” Unfortunately, that leaves investors with quite a dilemma.
For most people, they are asked this question and say “No. I am pretty logical when it comes to money and investments.” However, if you really think about your money decisions on a day-today basis, are they truly logic based and unaffected by emotions? Likely not.
The study of Behavioral Finance emerged in 2002 with research done by Nobel Prize winning psychology professor, Daniel Kahneman. His investigation revealed “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”
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