As I see it, an investor two main choices: stocks and bonds. I know, pretty obvious. And, lots of folks will complain that this is way too limited. How about commodities (GOLD!), futures, currency plays, derivitives, real estate, collectibles, etc? Well, to be succinct (and therefore deliberately exaggerating a bit - I'll have more to say about alternative investments in time), they are speculations, not investments. What's the difference? It's huge and fundamental. Both stocks and bond have a yield. Sometimes that yield is pretty small (a tiny dividend, a low interest rate), but it's real.
Stocks are like the American dream, partial ownership of a corporation, its assets, and its earnings both present and future. Even if the corporation has no dividend, its earnings tend (over time, over time) to be reflected in the stock price. If they go up, the price will eventually reflect that.
Bonds are an IOU issued by a corporation, with a stated rate of return and a stated end date. Until that end date, bonds are legally obligated to pay the stated rate on a regular basis (typically twice a year).
Most other "investments" lack this yield feature. They are a zero-sum game: one person wins, another loses. There is no earnings engine behind copper, sugar, puts, or beanie babies. They require a "greater fool"; someone to pay you more than the thing has cost you. Maybe that person exists, maybe not. At all times, you need to consider that the greater fool is you. As they say in poker, if you look around the table and don't know who the sucker is, then it's you.
So, assuming you are interested in investing, why not buy stocks? Great fortunes have been made in them, and stock proponents just love to tout their long-term superiority over bonds. Just think of IBM, Microsoft and Google! Peter Lynch raved about ten-baggers (stocks that went up ten times from purchase to sale), and most stock brokers and investment advisors cite long-term returns for stocks over the past century (or whatever time period is most advantageous to their case) of 9-10%.
The problem is that this rosy figure is largely crap. The farther back you go, the greater the inaccuracy, due to the simple fact that the return is calculated from companies that still exist! All the ghosts (buggy whip makers, Grants, dozens of early computer makers, Enron, Bear Sterns, Lehman Brothers, Chrysler, and GM), and the huge fortunes they destroyed, are conveniently discarded from the computation. Yet real people owned those stocks, and their long-term results were severely degraded in the process. Don't forget, we've just completed an entire decade during which stocks went absolutely nowhere. That's zero return, before inflation (so really, a loss of principal)!
Now don't get me wrong. I actually think there is a case to be made for stocks, at least in theory. Just buy them when they're cheap. Spring of 2009 was a great time to do this. In fact, the best tool for identifying such opportunities is hindsight. To quote Mark Twain (loosely): "Buy a nice little stock, wait till it goes way up, then sell it. If it doesn't go up, then don't buy it." That's a perfect way to describe the art of timing!
My point? Timing is very difficult. Most professionals fail miserably; why do you think you'll do better? I can't overstate this. PROFESSIONALS FAIL MISERABLY at the very thing they claim to do: outperforming a monkey. The monkey throws darts at a newspaper to pick stocks; a professional dredges through reams of statistics and charts to do it. They both achieve, in the aggregate, the same result. Of course, the monkey doesn't charge anything, and so is the better choice for picking a portfolio. I'm serious!
Sure, I know you worship the mega-monkeys: Peter Lynch, Warren Buffett, the Barron's round table sages, etc. But take 100 dart-throwers, and you will, after ten years, come up with one or two simian geniuses who have vastly outperformed the market. Would you bet on these super-chimps being next year's champs? Want a case in point? Bill Gross, legendary stock-picker for 15 years, just quit after five straight years of crappy results. He's highly apologetic, specifying his "mistakes." I disagree. The odds just caught up with another King Kong.
Am I saying the professionals are idiots? Not at all; in fact, the opposite. That's the problem. There are THOUSANDS of brilliant folks out there trying to out-psych each other. Chart-readers are divining mystical data trends; fundamentalists are analyzing cash flows, macro-guys are predicting the rise of China and fall of America, ad infinitum. Each one of them is bright. In the aggregate, though, they tend to cancel one another out. Burton Malkiel and his folks have it right. At any given point, the price of a stock or group of stocks represents pretty much everything that everybody knows. Good news is baked in for high-performers; disaster for laggards. You can make a guess, and be right, but don't assume it's because you were smart. The course of a stock, or a group of stocks, over a short period of time, is a random walk. In time, a stock, or a group of stocks, will move according to underlying value, but that movement is inherently unpredictable, as predictable value is always discounted in a stock's present price.
What to do with stocks? Well, forget timing, forget analysis. (Perhaps even forget stocks.) If you do choose to own them (and diversification is probably the best reason), then buy an index fund or ETF, invest regularly, and close your eyes. In twenty or thirty years, you'll probably be pleased. DON'T time the market, DON'T sell when you're discouraged, and DON'T double down when you're just made a killing. You'll do just as well as all the other patient monkeys, much better than most impatient monkeys, and much better than most professionals (who are, after all, a merely a subset of the second group).
Why does timing fail? It should be possible, right? Occasionally, there come times when things are OBVIOUSLY cheap (again, Spring 2009). They were cheap because people were scared, and so were you. Your brain told you that you couldn't miss, but your gut said things might get a lot cheaper. So, you did nothing. We all act like this, and in reverse when things are obviously expensive.
I do think there is an answer. When it's painful, it's probably the right thing to do. So, do something, but not so much that you can't sleep at night (perhaps with an Ambien, to be sure). You need to buy something when your gut tells you it might go to zero and your brain tells you it's a screaming bargain. You need to sell something when the id screams about losing out, while Mr. Brain is shrieking "nosebleed!". BUT, this simple answer is very difficult! Human nature being ... well, human, few people can time when timing is objectively feasible.
Is there an investment that can work better for real people? We come back to bonds. I like them a lot. There is an admirable simplicity to a bond, despite its reputation as arcane and complex. A bond has a beginning date, an end date, and a predictable income stream (the coupon) in between. A bond has a beginning price and an end price, which are usually the same. A typical bond will be issued at $1000, with a specific coupon rate (say 6.5%) and a maturity date (usually from one to thirty years). In this example, you will receive two payments of $32.50 a year. When the bond matures, you get that $1000 back. That's pretty simple, right? You know exactly how much money you're going to make, how long it will take to make it, and when you're going to get your entire investment back.
Of course, interest rates go up and down. Therefore, a bond must reflect those changes in the meantime. That 6.5% coupon was the going rate at the time of issue (for that maturity and credit quality). If the rate goes up to 7% for new bonds, then older ones will have their price adjusted so that they too yield about 7% to a buyer. So, the quoted price of your 6.5% bond will go down (perhaps to $928). Now its $65 of income is 7% of $928. This might cause you distress, and is the reason most experts are screaming that you shouldn't buy bonds now. You've "lost" $72, or 7.2% on a small upward movement (1/2%) in yield! True enough, but what happens if you do nothing? It's not a loss unless you take the loss. Hold the bond to maturity, and you get that $72 back, for sure. In fact, it really doesn't matter how low it goes, you WILL get the money back! That's huge. As opposed to stocks, there really is a "correct" price for a bond, at least eventually.
Are you interested now?
Update 11/2015. Well, now I can report on stock returns with another five years of perspective. In the commentary above, I mentioned that we had just completed a full decade of zero returns for stocks. Well, using a standard Dow calculator, it now appears that the return for the last FIFTEEN years has been 2.61%! Now fifteen years is a pretty long stretch for such crappy returns. It makes my most plain vanilla scenarios look absolutely world-beating!
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