January 14, 2007

No More Faith-Based Investing

I hate to admit this, but yours truly has been guilty of faith-based investing. I haven't been basing my investment decisions on any nonexistent supernatural entities, but I have been making some bad decisions based on poor information and lack of knowledge. Fortunately, I am now on the path to recovery and am making excellent progress on a reality-based plan. As much as I've been learning about investing, this knowledge pales next to what I've discovered about myself and how easy it is for an otherwise rational person to behave irrationally.

The personal finance class I took in high school did not go beyond balancing a checkbook and other minimum competencies. My parents were never big investors until I had left home, and even then, they ended up being over-reliance on a financial advisor. Thus, I grew up without having any clue how the stock market worked, what a mutual fund was, etc. Even in college, when it would have been easy enough to seek out appropriate coursework, I had no idea how important it was and never bothered.

Fast forward a few years, and I find myself established in my career and armed with a retirement plan I don't adequately understand and which I attempt to supplement with a 403(b) and Roth IRA, filled with investments I selected on no reasoned basis. How did I get there? I followed the advice of people who weren't qualified to provide it. I figured that since they clearly knew more than I did that it would be wise to trust them. After all, it would certainly be easier to operate on this sort of blind faith rather than learn anything on my own.

As my doubts grew, I started reading some good introductory books on investing. Investing For Dummies, 4th Edition and Mutual Funds for Dummies gave me the background I needed and answered most of my questions about how investing worked. Both are recommended for anyone who can relate to feeling absolutely clueless about this stuff. I learned that I needed to take a step back and develop a rational investment plan before I continued buying stocks, funds, etc. It turned out that what I had been doing was better than nothing but that additional improvement was clearly needed.

Utilizing the time off from work during the recent holidays, I read the outstanding All About Asset Allocation. Wow! Filled with charts, tables, graphs, and citations from scholarly finance research, this book walked me through the steps of developing a rational, empirically-informed asset allocation plan. I discovered that most of my investments to date were so highly correlated that I had virtually no protection from poor market conditions. I'd be flying high as long as the market did well, but a downturn could easily wipe me out. I learned that the bulk of variability in portfolio returns is due to an informed allocation plan and willingness to stick to it (rebalancing to maintain allocation percentages) rather than to the exact funds/stocks/bonds one selects. I learned that asset allocation is an extremely effective way to reduce investment risk, and I actually learned how to develop an allocation plan. In fact, developing such a plan turned out to be rather straightforward. I should have done this years ago!

I'm now selecting specific funds in each of my asset classes, finding that I actually enjoy this (at least a little), and saying goodbye to faith-based investing. I know what I need to do and why I need to do it. Something tells me that many of my readers can relate to the joy I feel in freeing myself from the confines of faith and embracing the beauty of a reasoned approach.

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