In the second part of this two-part post on independent investing, we will look at 3 critical investment statistics and the 3 biggest pitfalls to individual investing.
If you haven’t had a chance to read it yet, jump back to post one to learn about what investing on your own can do for you.
When selecting between the various investment options there are a few key metrics or statistics that are important to keep in mind. These form the foundation for any good comparison between investment assets.
Personally, I like to use the filter tool available through my online trading platform to sort by the statistics below. Doing so helps me gauge what appropriate values are and to immediately weed out the less attractive options.
Metric #1 – Expenses & the Expense Ratio (Mutual Funds and ETFs)
Possibly the most important investment metric or statistic is the expense ratio. Expenses directly eat into your return each and every year. The expense ratio is the easiest way to determine how much extra you are paying to own an investment.
Any mutual fund or ETF will have a specific expense ratio that shows how much it costs to run. The expenses are taken out of the funds overall assets and therefore reduce the total value of the fund.
This will include operating expenses such as manager, record-keeping, tax, legal and accounting fees. As mentioned in post 1, this is also where any marketing fees like the evil 12b-1 will be captured.
The ratio itself is the sum total of all the expenses divided by the average assets the fund has under management for one year. Therefore the expense ratio represents the amount of your investment that is spent each year just to operate the fund. It is charged to you and automatically reduces the value of your personal investment each year.
Of course the idea is that you will, on average, earn more than enough money to offset those operating expenses. While that is all very nice and good, just remember that you want to keep as much of your money as you can in order to enjoy the benefits of compound growth.
In a simple example, let’s say that you have $10,000 and are choosing between two different mutual fund options. One has an expense ratio of 1% and the other has an expense ratio of 1.5%.
Not a huge difference right?
Let’s also say that you choose to purchase shares of the fund with an expense ratio of 1% and I select the other. Well if we assume an equal growth rate of 10% per year for both investments, after 10 years you will have bested me by $885. After 20 years, you will have a whopping $3,364 more than me!
The only reason you would possibly want to select the more expensive fund therefore is because you think it will outperform the other. While there are certainly many cases where this occurs, the research is proving that quite the opposite to be more common.
According to the Huffington Post, between 2003 and 2013 far more low-cost funds outperformed their benchmark as compared to those with higher costs.
Fortunately expense ratios are easy to find and are included both in the funds’ prospectus as well as any of the basic fund screeners you can find online.
At the end of the day there is a certain level of unpredictability involved in investing. That makes controlling something like the expense ratio even more important. After all why not at least try to minimize the amount you are guaranteed to pay?
Note that the expense ratio does not include any costs you incurred to buy the investment. Those loads or transaction fees are in addition to the normal operating expenses included in the expense ratio. That does not make them less significant however, so do be careful and avoid excessive trading and high cost transaction fees.
Metric #2 – P/E Ratio (Stocks, ETFs)
One of the other key statistics to look at when comparing investments is the Price per Earnings ratio. You may also hear this referred to as the P/E ratio, price multiple, or earnings multiple.
What it shows is the current price of a share divided by the amount of money the company will make per share (Earnings per share). In other words, how many times the current years’ earnings you would have to pay to own it.
This matters significantly because it is a good way to analyze whether an investment is over or under priced. Historically, the overall market has averaged a P/E ratio of roughly 15. That means that over time, people have willingly paid 15 times what companies earned in one year for the right to profit from subsequent years.
You might be asking yourself – 15 times! Why on earth would someone be willing to do this?
We are willing to pay more because we want to share in all future earnings of the company. Not only that, but we might feel the earnings potential over the next few years is far greater than what the company or sector is currently earning.
A P/E ratio of 15 however is considered the general benchmark for whether an investment is over or under priced. In simple terms the investment would be considered undervalued if the P/E was below 15 and overvalued or expensive if the P/E was over 15.
Of course, as with everything, there are significant exceptions. Technology investments for example, tend to have higher P/E ratios because there is belief that the companies will significantly increase their earnings each year as the sector continues to grow globally.
As a result it is important to recognize what type of investment you are looking at.
The P/E ratio really comes into its own when comparing options within the same sector or field of business. For example if you were comparing two banks like JP Morgan and Bank of America.
Knowing that they are direct competitors within the same industry, and assuming you do not have any special insight into either company, the P/E ratio could help you choose the better investment based on their earnings.
Metric #3 – Yield (Stocks, Bonds, Mutual Funds, ETFs)
Yield is a fancy word for income. In simple terms, the yield of an investment is the % of the price you receive back in income. For stocks that comes in the form of dividends and for bonds it comes the form of interest payments. The % is expressed as an APR or annual rate relative to the current price, not necessarily the price you paid.
That distinction is key because you may actually be receiving a ‘cost yield’ far greater than the ‘current yield’ you will read on a financial site.
For example, let’s say you purchase shares in a company that pays an annual dividend of $1. At the time you purchased it, one share cost you $20. In that case your share has both a current and cost yield of 5% ($1/$20).
Now let’s say a year later I purchased the same share of stock in the same company, but at that point the share costs $25. In that case, we both would be earning a current yield of 4%, but you, having paid less would still have a 5% cost yield.
When it comes to stocks there is no guarantee of income. Even companies with a great history of paying dividends can decrease or cut them entirely at any time. However, investing in companies that have a consistent history of distributing income can be very beneficial.
Simply the fact that they have a proven track record of earning and sharing those earnings with shareholders is a sign of a well run business. Additionally, these companies tend to provide a more stable foundation for your portfolio.
Of course for bonds, the yield (known as the coupon yield) is even more important. It represents the annual income stream you have agreed to receive by loaning the money through the bond purchase.
Mutual funds also have yields. These are represented as the total of both dividends from the underlying stocks the fund contains as well as interest from bonds owned. That amount is then reduced by the fund’s expenses as mentioned above and divided by the funds cost.
Much like the P/E ratio, yield statistics are often best used to compare two investments within the same industry. However, if you were merely looking to add an income stream to your investment portfolio, the yield is the metric for you.
So there they are, 3 key statistics to help you select from the incredible amount of investment opportunities available. Notice that past performance is not one of the key metrics included above.
“Chasing yesterday’s returns is a fools’ errand” as they say. Instead, by focusing on the fundamentals such as the expenses and P/E ratio, you can avoid the previous return trap!
Pitfall #1 – Investing with Emotion
One of the biggest mistakes individual investors make is investing with too much emotion. It seems like every single time there is a market ‘correction’ or even a full-blown downturn that many folks yank all of their money out of their portfolio and shove it in the bank or under the mattress.
While this may help them sleep better at night, it is almost always a big mistake.
The reason is what they are effectively doing is selling low. Then over the coming months and years as the market begins to rebound and the outlook gets better, the same folks who just sold their shares buy them right back at a higher price.
By investing based on emotion they have sold low and bought high, paid two transaction fees and lost out on the dividends distributed in between. Not an effective mix for long-term success!
The best way to keep emotion out of your investment decisions is to have a long-term mindset and to know your own risk tolerance, as discussed in last weeks post. By only investing money you know you won’t need in the near future, the temptation to trade on emotion is reduced.
As a result, while the sky is falling around everyone else, you might just decide it is a great time to invest more! Securing some great deals while others are fearful has been a staple of the legendary Warren Buffet’s strategy for many years.
The ups and downs of investment cycles may come and go, but the great investors don’t overreact. I’m not suggesting you never sell an asset, but just make sure to truly think about what is driving the desire to buy or sell.
Have the fundamentals changed? Is the company or fund in a dying industry? Or are you being impacted by the movements of the heard and acting in fear? Taking the time to think it through may wind up saving you a bundle.
Pitfall #2 – Trading Too Often
Even if you are new to investing you have likely heard the phrase ‘buy and hold’. It is a principal that has guided investors for decades, instructing them to invest and then sit back and wait for growth.
By doing so, investors can avoid incurring excess transaction fees as well as preventing those pesky & irrational short-term feelings from rearing their heads.
While I cannot advocate simply tuning out and never monitoring your investments, the passive strategy inherent in ‘buy and hold’ still remains very popular.
By revisiting your portfolio periodically, you can re-balance as certain investments grow to a disproportionate size. Logging in to see the incredible benefits of long-term compound growth is one of the best joys in the world of investing.
Perhaps the best way to take on a passive investment strategy is to buy share in a low-cost Index ETF; one that tracks the S&P500 for example. By doing so you will naturally diversify across a wide variety of stocks, reducing the need to trade frequently.
Additionally, an index tracking ETF is in itself a passive investment. While mutual funds are run by actual advisors who buy and sell, an index merely tries to mirror a specific group of stocks or assets.
Mutual fund advisors have a tendency to trade more actively as they seek to use their knowledge to gain an advantage. To avoid purchasing shares in an excessively active mutual fund, take a look at something called the Turnover Ratio.
That ratio shows the % of a mutual funds total investment value that has been replaced within a given year. The higher the turnover ratio the more active the fund. The more active the fund the more transaction based operational expenses.
Despite all the evidence advocating a passive investment strategy, the debate of active vs. passive investment continues. Mostly fueled by the advisors and fund managers who stand to benefit from their management expertise.
I recommend doing some personal reading to check out some of the stats out there before you make the decision for yourself.
Pitfall #3 – Timing the Market and Investing based on the talking heads
Attempting to time the market is another futile move that affects many new investors. It involves moving money in and out of the stock market based on hunches about which direction it is headed.
Investing based on folly like this has become even more prevalent now that we have entire ‘news’ channels that funnel irrational fear and exuberance in the name of ratings.
At its core, timing the market is a poor strategy for two main reasons. First off, nobody, not even the savviest investors know the short-term direction of the market.
If they did, they would no longer need to work and even in the most modest circumstances would not need jobs on CNBC. Second, each and every time you move money either in or out of investments you incur some sort of transaction fee. As we learned at the beginning of this article, paying excess fees is a recipe for mediocre investing results.
There will always be stories of someone who made a large amount of money by buying big at a certain time, but that is not an investment strategy.
In fact, attempting to predict short-term movements is virtually the same as gambling in a casino. This trap is not exclusive to uninformed investors though.
Even in my career at one of the largest financial institutions in the world, I hear stories of coworkers shifting their entire 401(k) in and out of funds and company stock.
History has proven that over time, the stock market as a whole has been a profitable way to make your cash work for you.
However, there have been many hiccups along the way; some small, some not so small. By investing for the long-term and avoiding any attempt at trying to predict those hiccups you are far better positioned to succeed.
So there you have them, 3 statistics and 3 pitfalls to look for when investing. Of course there are plenty of other examples of both statistics that traps to avoid.
What do you think is the most important metric?
Contribution By: Sarge began writing just this past year, following a horrendous experience with a financial advisor. Combining a knowledge and passion for finance with a real belief that through some simple education everyone can achieve the financial freedom we all long for – The Wealth Sgt was born. Check out more from Sarge over at The Wealth Sargent or on Twitter @TheWealthSgt.
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