Investing Terms People Commonly Misunderstand

From the Wall St. Journal, "The Experts" write: Investing terms are a dime a dozen, but investors who don't learn the lingo run the risk of making some serious mistakes.

So we asked The Experts this question: What investing term or concept do you think people don't understand—and what are the consequences?

This discussion relates to a recent Journal Report column, In Translation, in which we define commonly used terms for investors and formed the basis of a discussion on The Experts blog on Aug. 1.

Michelle Perry Higgins: Compare Apples to Apples

One word: Indexes. If I were to ask an investor what index they use to benchmark their portfolio performance, the correct answer would be "several."

It's a mistake to use just one index to benchmark performance of a well-diversified portfolio. My advice is to use at least a handful based on the funds you are analyzing within your portfolio. Unfortunately, I don't think this is the common answer among investors. I believe there is truly a serious disconnect between their understanding of portfolio investments and the appropriate indexes to benchmark fund performances.

Often times, the Dow Jones Industrial Average or the S&P 500 are the go-to indexes because they are widely published. It's easy to take a quick peek at those indexes to gauge the day's movement and then view your account. However, investors may not be comparing apples to apples, thus putting them at a great disadvantage in understanding their investments' performance. This may also mean possibly making moves within a portfolio based on the wrong analysis. For example, comparing your international funds to the S&P 500 is not a prudent move.

I strongly recommend that every investor take the time to understand what indexes they should be tracking to benchmark their investments. If they have a well-diversified portfolio, this should require more than just the Dow Jones Industrial Average or the S&P 500.

Michelle Perry Higgins (@RetirementMPH) is a financial planner and principal at California Financial Advisors.

Charles Rotblut: The Most Important Risk Is the Hardest to Imagine

Risk is probably at the top of the list.

Most investors perceive risk in terms of the dollar amount they will or have lost over a relatively short period. They also perceive future risk in terms of events they worry could occur, such as Treasury yields soaring because of the federal debt. It's easy to understand why: These risks are easy to identify and potentially quantify.

What is much tougher for us humans to wrap our heads around is risk from the standpoint of longevity. This is the possibility of outliving your savings. From a purely financial standpoint, it is the key definition of risk you should be most concerned with. What are you doing to ensure you have saved enough and managed your portfolio in a manner that provides an adequate level of income on an inflation-adjusted basis in retirement? The decisions made through our adult lives—including what we save, the career path we choose, how we allocate our portfolio and whether or not we freak out during times of market turbulence—influence the amount of longevity risk we will incur.

Unfortunately, our minds don't do well with big numbers that are far out in the future. We think short-term and we don't do well with big, uncertain events. We certainly don't like thinking about exactly how many years we'll spend in retirement before the grim reaper comes or what our medical expenses might be like. It's simply easier to focus on potential risks that are currently more identifiable.

Even when we realize the scope of the financial challenge awaiting us, we're like a chocolate lover walking into a candy shop. We know our long-term health mandates eating lots of vegetables, but just look at that fudge! Yet, it's the ability to stick to our long-term financial strategy, plan for an uncertain future and, yes, even follow a healthy lifestyle, that are the real risk reducers.

Charles Rotblut (@charlesrotblut) is a vice president with the American Association of Individual Investors.

Terrance Odean: Don't Hold Your Company's Stock in Your 401(k)

Many people don't fully understand diversification. The most egregious mistake this leads to is holding your company's stock in your 401(k). If your company does badly, you could lose both your job and your savings, as happened to many Enron employees. Many years ago I urged a friend to diversify out of his company's stock, not because his was a bad company, but because his portfolio was under-diversified. My friend worked for a Silicon Valley firm. He sold many of his shares. Later tech stocks, including his company's, took a big hit. Unfortunately, I had not adequately explained diversification. My friend had taken the proceeds from selling his company's stock and bought other Silicon Valley companies. So he lost most of the benefit of diversification.

Terrance Odean is the Rudd Family Foundation professor and chair of the finance group at the Haas School of Business at the University of California, Berkeley.

Manisha Thakor: Determine Your Need for Risk

I think "risk" is the most widely misunderstood investment concept. The consequences can be dire—running out of money before you run out of time. My favorite framework for thinking about risk comes from Larry Swedroe, director of research for the BAM Alliance. Larry looks at risk in three ways: your willingness, your ability, and your need to take risk.

Risk is often defined as the odds of losing money or the chance of getting a return different from that which you expect. Against this backdrop many folks—understandably—focus on their willingness to endure "risk." This is often referred to as your "sleep-well-at-night" factor. Others will focus on their ability to take risk. These investors will ask themselves if, given their age, income or profession, they have enough time, future earnings or job stability to stomach risk.

But the question that I don't hear asked nearly enough is whether or not one needs to take risk. Classic examples would include the 70-year-old retiree with the mid-seven digit portfolio and no debt maintaining an all-equity portfolio when her living expenses are more than fully covered by required minimum distributions and Social Security. In this case the "need" to take risk is not there even if the willingness is. On the other end of the spectrum is the 20-year-old who elects to put his entire 401(k) in a stable value fund. In this case, the willingness to take risk is absent but the need for "risk," in the face of potential long run inflation, is high.

While risk and reward go hand in hand, it's important to think about all three elements of risk—your willingness, ability, and need to take risk—before making investment decisions.

Manisha Thakor (@ManishaThakor) is founder and chief executive of Santa Fe, N.M.-based MoneyZen Wealth Management LLC.

Christian Magoon: Tame Your Emotions and Rebalance

Rebalancing a portfolio is a common investing discipline that is often misunderstood and ignored due to its counterintuitive nature. The rebalancing process involves moving assets from outperforming investments to underperforming investments in order to match original portfolio allocations. This discipline is hard for many investors because humans are emotionally wired to do the opposite: Buy more of the best-performing investment while selling the worst-performing investment. Removing emotion from the equation, however, shows that regular rebalancing of a portfolio provides increased risk-adjusted returns.

Christian Magoon (@ChristianMagoon) is founder and chief executive of YieldShares, an income-focused ETF sponsor.

Mike Piper: Finding a Stock-Market Winner Is Tougher Than It Looks

A key concept that many investors fail to understand is that the market's expectations for a given company are already built into the stock's price.

As a result, in order to pick a stock with above-average returns, it is not enough to find a company that will have above-average growth. Instead, you must find a company that grows faster than the market expects it to grow. In other words, a stock's performance is not about how well the underlying company does. It's about how well the underlying company does as compared with how well the market expected it to do.

The primary take-away here is that many people significantly underestimate the challenge in reliably finding above-average stocks. In order to consistently succeed at stock picking, you must be able to reliably do a better analysis of companies' future growth rates than the composite analysis performed by an army of full-time, well-trained professionals. It's not impossible, but it's not the sort of thing a person (even a very smart person) can easily do in his or her spare time. And for the record, it's good to be skeptical when people suggest it is easy to pick winning stocks in your spare time. Many such conversations end with the other person asking for your credit card number.

And the same thing goes for groups of stocks (e.g., specific industries or countries). For example, it's obvious that China's economy will probably be growing very quickly for the foreseeable future. But precisely because that fact is so obvious, it's already priced into the stocks of Chinese companies and companies that do a significant portion of their business in China. It is not, therefore, a surefire "win" to put together a portfolio of Chinese stocks or to invest in a mutual fund that specializes in such stocks.

Mike Piper (@michaelrpiper) is a Missouri-licensed CPA and the author of the blogObliviousInvestor.com. He is also the author of several personal finance books, including his latest, "Social Security Made Simple."

Eleanor Blayney: 'Buy Low, Sell High.' Not 'Lowest' and 'Highest.'

"Buy low, sell high." Seems like a pretty straightforward strategy to successful investing. But how many people know how—or even attempt—to do it? Greed and fear have many individual investors doing exactly the opposite—buying (or holding) high, and selling (or not holding) low.

Note that that phrase does not call for buying at the "lowest" or selling at the "highest," which is, of course, impossible to do on a consistent basis. It simply recommends a process of harvesting those holdings that have done well, and reseeding a portfolio with holdings that have underperformed. This, essentially, is what rebalancing a portfolio is all about: a prudent strategy for managing an investor's overall risk. Most people think that "buying low and selling high" is the magic formula for above-average returns, but in fact it is a strategy for protecting a portfolio from above-average risk.

Eleanor Blayney (@EleanorBlayney) is consumer advocate of the Certified Financial Planner Board of Standards.

Frank Holmes: Get to Know Your Investment's Volatility

I believe investors need to understand the volatility of individual asset classes because it helps reduce emotional reactions to extreme market moves. I often say that each investment has its own unique DNA of volatility. To anticipate how volatile an investment normally is, look at the rolling 12-month standard deviation over the past 10 years. Whereas the S&P 500 index has a normal annual standard deviation of about 17%, gold is just slightly lower, at around 15%.

Using gold as an example, the standard deviation means that over a period of a year, the precious metal can increase in price by 15% or it can decline 15%. If it increases 15% or more in less than a year, it may be time to trim your holdings. Conversely, if gold has fallen more than 15% in a short period, it may be a good time to rebalance and add to your holdings.

Frank Holmes is chief executive and chief investment officer of U.S. Global Investors Inc.

Greg McBride: Risk and Return—It's All About Trade-Offs

I've seen too many individuals that don't understand the relationship between risk and return, and the trade-offs involved. Want higher returns? You'll have to be willing to take additional risk. Don't want to take risk? Then you'll have to settle for low returns. Volatility may be your biggest risk in the short-term, but the bigger long-term risk is not earning enough return to grow (or even maintain) your buying power.

Greg McBride (@BankrateGreg) is a senior financial analyst and vice president for Bankrate.com, providing analysis and advice on personal finance.

Larry Zimpleman: A Question of (Re)Balancing

Since we're talking about basic consumers saving for medium- to long-term needs, I would say the investing term or concept people don't understand or underappreciate is the concept of rebalancing. Investors often establish an asset allocation strategy early on (such as 60% equities and 40% fixed income) but they fail to recognize that the 60/40 allocation will change over time as investment returns ebb and flow. Studies show that rebalancing back to the 60/40 allocation (if that's right for you) will provide better long-term returns than simply leaving the portfolio allocation to be impacted by whatever the investment return happens to produce.

Another concept that I think is hard for investors is to have the right "sell discipline." Whether you are investing in funds or individual securities (equity or fixed income), investors tend to hold onto investments longer than might be appropriate—i.e. they tend to fall in love with their portfolio and lose their objectivity on when it's a good time to sell. That's why seeking the help and advice of a financial adviser that you are comfortable with can make a difference.

Larry D. Zimpleman is chairman, president and chief executive of Principal Financial Group.

Tom Brakke: Things Will Get Back to Normal

Reversion to the mean (or at least to a "normal" range). There are powerful corrective forces in the economy and the markets that work against directional excesses. However, those reversals can happen quickly or very slowly, so it's hard to tell where you are in the cycle or whether "it's different this time" (which is rarely the case).

Two good (and related) examples are found in the pricing of the stock market today. Margins for public companies are very high in an historical context and interest rates (especially short-term rates) are very low. If either variable went back toward more normal levels, returns on stocks would likely moderate. If both were to happen at the same time, the returns would probably be lower than almost all investors expect.

So, that historical context provides some tough choices about stock market investments, depending on whether those historically extreme levels go back to something more normal and, if so, how quickly. If you ignore that context, it is easy to be zigging when you should be zagging.

Tom Brakke (@researchpuzzler) is a consultant, writer and investment adviser who specializes in the analysis of investment decision making and the communication of investment ideas.

Rick Ferri: Long Live MPT

Portfolio diversification using Modern Portfolio Theory (MPT). Diversification among asset classes is a good thing because it lowers the risk of a larger loss. Yet, after the financial crisis, some investment expert cried out loudly that Modern Portfolio Theory failed investors because it didn't prevent losses. This misrepresentation of the theory has given MPT a black eye and provides active managers a cache of ammunition to claim that buy-and-hold investing is "dead" and that the only way to invest is with tactical shifts in portfolios.

MPT worked perfectly fine during the financial crisis. Proper diversification reduced the risk of a large loss as advertised. U.S. Treasury bonds surged while stocks and other risky assets fell during 2007 and 2008. A portfolio holding Treasury bonds as an asset class did not experience the large loss of a portfolio holding only stocks.

The consequence of not understanding MPT is the risk of being sold an ineffective, high-cost, market-timing strategy. Large numbers of investment firms started promoting "tactical" asset allocation strategies since the financial crisis. These trading schemes are supposed to prevent losses in a portfolio if another crisis occurs by getting you out before the house collapses. That is nonsense. There is no reason to believe any investment firm has inside knowledge of the future of the markets and can time their way to prosperity.

Done correctly, diversification can increase the probability of reaching your financial goals. Long live MPT.

Rick Ferri is founder of Portfolio Solutions LLC and the author of six books on low-cost index fund and ETF investing. His blog is RickFerri.com.

George Papadopoulos: Learn What Diversification Really Means

Some people do not understand what diversification really means. I have a story for you from the trenches. It happened in late 1999.

Back in the pre-tech-stock-bubble days, I did a one-time Investment Portfolio Review engagement for a client who had seven different mutual funds, each from a different mutual-fund company. All seven were large-cap growth funds primarily invested in tech stocks. When I inquired about this choice of investments and suggested diversification as an alternative, the client answered, "I diversified by picking the best-rated fund from each mutual-fund family." My recommendation to sell immediately most of the funds and reposition the portfolio to have exposure in mid-cap and small-cap equities, as well as international and fixed-income exposure, was certainly not popular with him. In polite terms, he assured me that I had no idea what I was talking about and that this time was different. I never heard back from that client but the experience remains an unforgettable memory in my career. To this day, I hope he took my advice.

People need to make sure that their portfolios are truly diversified. The number of mutual fund companies has nothing to do with how diverse an investment portfolio is. Consequences of not spreading your eggs in different baskets can be devastating to cherished long-term goals.