“I did not know enough to be scared”

69-year old Earl Crawley, while making $20,000 a year as a parking-lot attendant, still amassed over $500,000 in investment asset. His secret? Two, in fact. The first is his good old habit of saving every “nickel and dime”, and the second is his lack of investing knowledge, summed up in his quote that I borrowed above.

Saving and investing, in that order (you must save to invest), are the two essentials for building wealth slow and steady. Saving is common sense, and to people like Earl, almost an instinct. Investing, by contrast, requires some learning. But, knowledge plays a self-limiting role in our investing decision, which in turn affects investing performance.

The two fundamental things of investing are where to invest and how to invest. That is, the assets that make up our portfolio, and the proportions in which these assets are allocated. Unfortunately, there are as many different answers to these two questions, as there are books written about them. The more we know, the more confusing they get, and even drawing up the simplest asset mix can become a difficult task.

Keep it simple.

Solution? Keep it simple. Beyond the basics, knowing more does not help much. It is a bit like the picture here. At first, the return of your investment (solid blue graph) goes up with your knowledge level, but after you are past the basics, your return hits a “saturation point”. After this point, more knowledge causes information overload, and the payoff does not show a commensurate increase; in fact, the return can even decrease, depending on the specifics of your portfolio (in investing, more knowledge is not necessarily better knowledge).

Know the basics

What are these investing basics? There are four steps to it:

1. Depending on your risk tolerance, build a portfolio with the right proportions of risk-free (money market, treasury bills etc.) and risky (stocks and bonds) assets.
2. For your risky assets choose among those that do not move in lockstep with each other (for example, stocks+bonds, domestic+foreign stocks, etc). This way, you can spread out the risk of market downturns, and reduce its impact on the return of your portfolio.
3. Build your portfolio with manageable number of assets. Adding too many stocks and mutual funds is an example of information overload; if you do not understand them, you do not know their return potential, and your portfolio return itself can suffer.
4. Once you set up your portfolio, hold on to it. Do not tweak your asset mix each time the market does something unexpected. As I said in an earlier post, there is no get-rich-quick scheme in investing; a “buy and hold” strategy is the only way to smooth out short-term market fluctuations, and gain from the long-term economic growth.

Again, keep it simple. Earl does exactly that. He is open to suggestions and stock tips, but uses his own common sense and gut instinct to make decisions on which stock to buy. He is a self-made investor. Why can’t we all be like him?

And it is all in our brain. Greed and panic - the two primal human emotions - are regulated by specific regions in our brain, and they in turn control how we as investors react to market unpredictability. In an insightful article today, Jason Zweig discusses the latest advances in neuroeconomics, the branch of science that probes human brain to understand investor behavior.

When we fail to find a rational explanation for market swings, biology comes to our rescue. Growing economy dictates the long term market trends, but its short-term fluctuations are directly linked to investor psychology, each feeding off the other. By identifying the specific biological mechanisms operating in our brain, it may be possible to understand why we - rational beings in almost every other aspect of our lives - are under such strong grips of emotion when it comes to investing. Read Jason’s article.

In a recent BusinessWeek interview on current market volatility, John Bogle - index fund guru and Vanguard founder - made the following comments:

In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses. And the stock market is nothing but a giant distraction in that quest to acquire returns that business earns.

Without telling anything new, this quote still reminds us of the big picture of investing: a buy-and-hold strategy for the long haul is the only way to escape the ravages of market swings, and to benefit from the slowly (and surely) growing economy. I recommend reading the entire interview.

There is an important difference between the two biggest single expenses in your life (if you live in America): buying a car, and making down-payment for a house. While a house appreciates in value (price goes up with time, usually outpacing inflation), the value of a new car starts depreciating the moment it leaves the dealership lot. Thus, paying 20% down for a house (the median house price was $232,000 last year) is a sound investment, whereas forking out $20,000 for a family car is not necessarily so.

Now you know why I do not like paying extra thousands of dollars for a new car, when a reliable used care can do just as fine. Looking at the larger picture, the used car industry in America is twice the size of the new car industry in terms of the number of vehicles sold each year. Most of these buyers choose a used car because of budgetary reasons. For those of you who can easily afford a new car, I am going to argue in the next couple of posts that it still makes better investing and practical sense to own a used car instead.

If you already made up your mind to buy a new car no matter what, here is a short list of some excellent resources that will hold your hand through the process step-by-step. For the rest of you, picking the right used car demands some time. (We often spend a week planning a $200 vacation; we can surely spare a weekend researching a $10,000 car.) This guide will hopefully make the process easy and relatively painless. It is divided in the following eight posts, and I recommend reading them in sequence (at least from #3):

1. A close look at car depreciation.
2. Why should I buy a used car?
3. Picking a budget.
4. Making a list.
5. Researching your car.
6. Checking the car out.
7. Wrapping it up.
8. A note on extended warranty.

Let us begin by taking a close look at car depreciation »

US stock market has just closed for the day with all major indexes again taking big dives: Dow Index is down by 387 points (a single-day 2.9% drop, 2^nd worst of this year), S&P 500 down 44 points (3% drop), and NASDAQ down 57 points (2.2%). In the rest of the world, London’s FTSE Index was down 1.9%, Tokyo’s Nikkei up 0.8%, India’s SENSEX down 1.4%, and Australia’s ASX up 1.1%. These are the times when many investors begin to ask if they should jack up their stock holding in foreign markets. After all, the domestic and foreign markets rarely move in lockstep, and having a chunk of my asset allocated to foreign stocks should minimize any impact of a major domestic slump.

But increasing globalization over the last few short decades have changed the financial landscape of the world. These days markets across continents quickly respond to each other’s turmoil, so much so that the day-to-day fluctuations are considerably more correlated than before. To give one example, the largest slide of this year happened on February 28, when major US indices fell an average of 3.5%, reacting to a 9% drop in Chinese stocks the previous day.

Be that as it may, I still think it is a good idea to have a part of my portfolio allocated to an index fund that covers a broad swath of foreign equity markets. (I am heavily biased towards index funds because of their small operating costs, and also because they incur less tax.) Even though cross-correlations among domestic and international markets have increased, they are yet to reach a point where the benefit of diversification no longer exists. Given that, such a mixing strategy gives me an easy way to construct a simple but smart portfolio.