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What Do You Really Know About Investing?

Reprinted courtesy of MarketWatch.com

To read the original article  click here.

Today I want you to think about pie — actually an imaginary pie chart that will give you some clues about how investors make — and lose — lots of money.

I’m going to describe what could be called “the pie of knowledge.” The whole pie represents everything there is to know about investing. I’ve carved it into six imaginary slices. You get to eat from any or all of them — but I hope you’ll choose carefully.

If you pick the right slices, you are likely to spend your time, energy and money productively. But if you pick the wrong slices, you could suffer from severe financial indigestion.

First slice: What we know — that we know

Some important, useful things about investing are not in dispute. We know them.

We know (or can easily find out) the past performance of almost any investment proposed to us. We know that when other things are equal, lower expenses lead to higher returns. The same is true of lower taxes.

We know how to combine asset classes to reduce risk. We know how to reduce our average costs over time through dollar-cost-averaging. We know the benefits of rebalancing. We know that most investors who try to beat the market fail to do so.

Most intriguing, we always know exactly what we should have done in the past to make tons of money. We even know what numbers we should have picked in last week’s lottery!

Second slice: What we know — that we don’t know

We all know that we don’t know the future. Yet millions of investors behave as if they know – or at least as if somebody knows – the future. This leads to a lot of trouble – investment indigestion, if you will.

People spend (waste, actually) an inordinate amount of time trying to know what cannot be known.

Recently at the health club I was watching a commentator on CNN who promised, right after some commercials naturally, to reveal the steps viewers could take to improve their odds of winning the $400 million lottery. But what followed was not useful in the least.

(Since you’re here, I’ll let you in on the “real” secret to collecting the jackpot. It’s simple: Buy every single ticket there is; you’ll be certain to hold the winning numbers. Of course this will cost you much more than you will “win” because your ticket purchases will have to pay not only for the jackpot but also for advertising, administration and more. Still, just think of the bragging rights you will have!)

Third slice: What we don’t know — that we don’t know

This piece of pie leads us into dangerous territory. Think of the following statement, uttered by investors more times than you might think: “Oh my God! I had no idea.”

Something like that (probably not so politely worded) was undoubtedly said many times in conjunction with Bernie Madoff, Enron, Washington Mutual, and any number of once-popular investments that turned out to be not so hot.

This has happened to me. I pay a lot of attention to investment news and trends, and yet most of the big market declines in my lifetime were attributed to things that weren’t even on my radar.

By definition, there’s no way to know how big this slice of the pie is. But it’s huge, and so is the damage it can inflict. For example, recall Long-Term Capital Management, a hedge fund that back in 1998 managed more than $100 billion in assets.

Among the company’s principals were a famous Wall Street trader as well as former university professors, including two economists who had won the Nobel Prize. Most of the money came from professionals in the financial industry who put up at least $10 million apiece and asked no questions.

They had no idea about what was going on inside this fund, including failures so large that they could have caused the collapse of the worldwide financial and banking systems. If you want to know more, you’ll find it in the fascinating book “When Genius Failed: The rise and fall of Long-Term Capital Management” by Roger Lowenstein.

Fourth slice: What we think we know — but are wrong

In one way or another, this piece of the pie trips up virtually everybody. For a not-so-serious example, you think you know that you’ll love that item on the restaurant menu. For a much-more-serious example, you think you know the person with whom you’re walking down the aisle.

For an investment example, you think you know what to expect from a stock or a fund manager or from the market itself. Or you think you know the company you work for.

But companies can have deep problems unknown to most of their employees. This is exactly why I try hard to dissuade people from loading up their retirement plans with company stock. If you already rely on one company for your income and your benefits, you should not also rely on it for your investments.

Our brains are hard-wired to make us believe (or “know”) we are right, and such confidence leads to big bets with big consequences. Unfortunately, the consequences are more often bad than good.

Fifth slice: What Wall Street wants us to think we know

When I was fresh out of college, I worked in New York for a large Wall Street firm. I quickly learned that Wall Street’s priority is what’s good for Wall Street. What’s good for the client is often just incidental.

For awhile, I hoped that this was an anomaly. But over the past four decades I have become a cynic. I don’t believe the industry is filled with crooks. It’s filled with people who want to earn a living, people who are highly incentivized to do what the bosses believe will bring in the most profit.

Wall Street would have us believe that we can beat the market if we choose the managers and gurus who have special insights into the future. Wall Street would have us believe that sales commissions and recurring expenses of various types are far less important than special expertise and special products.

I have stopped believing any of that. When I look closely at the “special expertise” and the “special products,” most of what I see is a sales culture motivated by profits.

Sixth slice: What we know — but don’t do anything about it

Most investors know they shouldn’t risk everything on individual stocks and funds with unusually high expenses. Most know that jumping in and out of the market is unlikely to lead to long-term success. Most know that trying to beat the market is unlikely to succeed.

But too many of us do those things anyway in the hopes that “this time it will work.”

To be brutally blunt, merely understanding investing is the booby prize. If you don’t act on what you know, you’re just kidding yourself.

I think the key to investment success is knowing the risks you can manage, then managing them. A big part of this is knowing the difference between what you can control and what you can’t. Spend your time worrying about the former and learn to accept the latter.

If you do that consistently and do it well, all these pieces of “knowledge pie” could add up to a tasty treat.

Richard Buck contributed to this article.