Leading into his principles for successful investing, in the final chapter of “Stocks for the Long Run,” Jeremy Siegel pointed out that it is easy—in principle—to be a long-term investor, but difficult in practice. Difficult because of our emotions and because stories of investing success elsewhere tempt us to wander away from our strategic intentions.
There’s also the selective-memory problem, in which hindsight “plays tricks on our minds.” As the author reminded us, we forget the doubts we had when we originally declined to invest in something that later did very well. All in all, we often head down disastrous paths, taking too many risks, incurring high transaction costs and giving in to our emotions.
In a bid to keep us on the right path, Siegel offered the following six principles:
- Don’t expect too much. Over the past two centuries, stocks have averaged annual real returns of between 6% and 7% and stocks have sold with an average price-earnings ratio of 15. From the perspective of purchasing power (protection of which is the ultimate purpose of most investing), a stock with an average annual real return of 6.5% will double our purchasing power in about a decade (for specifics, use the Rule of 72: divide 72 by the annual rate of return). He added that a price-earnings ratio of 15 will not always be the “right” ratio, because it may be affected by factors such as transaction costs and bond yields.
- The longer your investment horizon, the more equities you should have in your portfolio. Siegel argued that stocks are more stable in the long run than in the short run, and over time their pricing power will offset higher inflation. He had argued in an earlier chapter that in periods of 15 to 20 years or more, stocks deliver higher returns and less risk than bonds. Regarding Treasury bills, they offer risk-free investing, but deliver no returns over long periods.
- Low-cost stock index funds should make up the largest portion of your portfolio. Broad-based indexes such as the S&P 500 and the Wilshire 5000 have outperformed two-thirds of mutual funds since 1971. He added, “By matching the market year after year, an indexed investor is likely to be near the top of the pack when the long-term returns are tallied.” We note he previously recommended fundamentally-weighted indexes over capitalization-weighted indexes.
- Own foreign stocks, those not headquartered in the U.S., and make them at least one-third of your equity portfolio. “Owning foreign stocks is a must in today’s global economy,” he wrote. Siegel acknowledged some short-term correlation among country returns (perhaps referring to the 2008 financial crisis), but added “the case for international investing is persuasive.” At the same time, he warned stocks in high-growth countries can be overpriced and suggested investors avoid nations with stock markets having a valuation ratio of more than 20 times earnings.
- Value stocks have better returns and less risk than growth stocks. He defined value stocks as those with lower price-earnings ratios and higher dividend yields. Why? Siegel wrote, “One reason for this outperformance is that prices of stocks are often influenced by factors not related to their true value, such as liquidity and tax-motivated transactions, rumor-based speculation, and buying and selling by momentum traders. In these circumstances, stocks priced low relative to their fundamentals will likely offer investors a better risk-return profile.” He added that investors can buy low-cost, passively managed portfolios of value stocks or buy fundamentally-weighted indexes.
- Set firm rules for your portfolio. There are temptations to buy when everyone is bullish and to sell when everyone is bearish, but it is essential that you avoid giving in to your emotions or, as Siegel called them, emotions of the moment. Giving in can lead to buying and selling too often, driving up transaction costs and pulling down returns. Siegel also recommended reading about behavioral finance to help understand and avoid common psychological pitfalls.
In the second section of the chapter, Siegel turned to implementation of investment plans. As he observed, “knowing the right investments is not the same as implementing the right investment strategy.” With that, he offered a couple of “what not to do” suggestions:
- Trading too often in a bid to do better than the market. Siegel pointed to investors who are not satisfied with earning 9% and stretch in a bid to own stocks that might double or triple in the next year. As we know, that does not work very often. In fact, most investors end up doing worse because transaction costs reduce their returns—not to mention the time spent trying to analyze too many stocks dilutes the investors’ attention from the few that matter.
- Perhaps burned by poor stock picking, some investors look for mutual funds that might provide higher returns. However, it is just as hard to pick hot funds or hot managers as it is to pick hot stocks. Again, the result will be disappointing returns.
- Siegel argued those who finally give up on finding hot stocks or hot funds may adopt an even more difficult strategy: timing the market cycles. He found it surprising that many of the investors who fall for this are the best-informed investors. Perhaps that explains the problem, which emerges out of listening too much to the market noise, all the news, information and commentary that pour out every day. As he noted, it is easier to follow what so many others are doing rather than to follow your own strategy.
Siegel concludes by asserting that a proper investment strategy is a psychological as well as intellectual challenge.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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