Q and AQ & A with Don Gould

We are pleased to announce that Don Gould, President and Chief Investment Officer of Gould Asset Management, was recently chosen to participate in Investopedia’s Advisor Insights program.  Investopedia.com is a leading provider of online financial educational content and their Advisor Insights program allows investors to post questions to top advisors on a variety of personal finance and investing topics. We will periodically post Don’s responses to some of these questions when we feel they are helpful and of interest to clients and blog subscribers. You can also “follow” Don on Investopedia’s website by clicking here, enabling you to receive email notifications any time Don responds to a new question. In addition, if you would like to submit a question to Advisor Insights, please do so by following this link and also leaving a comment below so Don can look for your question.

Question: How does a beginner investor seek and evaluate markets and companies worth investing in?

I’m a beginning investor. I’m struggling in learning how to research markets and companies to invest in. What are key indicators to look for and use as a guide? How do I find companies that offer dividends on stocks?

Answer: At the risk of throwing cold water on your plan, there are many good reasons not to do research on individual stocks.

1. As a beginning investor, you probably do not have enough money to buy enough individual stocks to be truly diversified. Portfolios concentrated in just a few stocks are far riskier than broadly diversified portfolios, but do not compensate you for this added risk in the form of a higher expected return.

2. You have no source of competitive advantage in researching individual stocks. The world is full of professional investors who, in theory, have a big advantage over you, given their training and resources. As I’ll explain in a minute, even they may have little or no advantage.

3. In his work, “The Arithmetic of Active Management,” Nobel Prize winning economist William Sharpe elegantly explains why active managers (which is what you seek to become) as a group perform in line with an index (for example, the S&P 500), and why collectively they do worse than an index when expenses are taken into account. For you to do better than an index requires that some other active manager do worse. All things considered, the odds are stacked against you.

4. Efficient Market Hypothesis (EMH) suggests that even the active managers who beat the index in a given period are no more likely than any other manager to beat it in the next period. EMH may not perfectly describe financial markets, but for the kind of stocks you’re likely to research, it’s probably a pretty close approximation. Again, the odds are not in your favor.

5. Researching and monitoring individual stocks takes time and resources that you could probably more profitably devote elsewhere, particularly to something you’re already skilled at.

You will be best served putting your hard-earned savings (that portion you earmark for the stock market) into a stock index mutual fund, such as an S&P 500 index fund or a total world stock market index fund. In such funds, you will very closely track the market as a whole. And because you will do so at very low cost, you will outperform the majority of active managers. All that, without knowing the first thing about how to research individual companies and stocks!

One caveat – if you really enjoy researching individual stocks, that’s fine, but realize that it is a hobby and a form of entertainment, not a sound long-term investment strategy. I recommend restricting such individual stock investments to not more than 5% of your liquid assets.

Where is the best place for my 22 year old son to start investing his savings in the current low interest market?

My young son is saving faithfully and has amassed a few thousand dollars and continues to save at least $100/month. Currently, he has no access to a 401k/403B. He wants to invest in the stock market but I’m reluctant to encourage him in the current market. If he does, what is the best way to proceed?

Answer: First, congratulations on having a son who is already saving at the age of 22! He is mastering the key ingredient to investment success, which is managing to save some money in the first place. One’s rate of savings invariably is more important than even the rate of return on those savings.

I suggest your son consider a Roth IRA. For the long-term investor, the Roth IRA is ideal because all earnings are tax-free upon withdrawal (assuming at least a 5-year holding period) and penalty-free beginning at age 59-1/2.

As for whether to buy stocks, I think your son has the right idea. The “current market” always looks (and is) hazardous at a given moment in time. But long-term investors have been hugely rewarded for simply buying and holding the market over the long term.  For example, in the 50 years ended 12/31/15, a $1,000 investment in the S&P 500, with dividends reinvested, would have grown to $99,233. Even adjusting for inflation, the original investment’s purchasing power would have grown more than 13-fold! Of course, there’s no guarantee that the stock market will perform as well in the next 50 years, but the odds that it will substantially outperform bonds and cash over the long run are, in my opinion, extremely high.

I would urge your son to keep things simple and cost-effective by buying a stock index fund with his Roth IRA contributions. Either a US total stock market or a world total stock market index fund will do just fine.