How to Pick the Investment Strategy that's Right for You

Your most important investment decision is whether to pursue an active or passive investment approach:

With active investing your odds of succeeding range from 0 to 10%. With passive investing, your odds of winning are about 90% after taxes.

So which is right for you?

You can think of active investing as the classic "Buy Low and Sell High" investing strategy. It sounds right until we realize that we are buying and selling from other people who also think they are making a smart decision. And normally these other people -- the ones we are buying and selling from -- are very smart, capable and hard working. We've entered what economists call a zero sum game. In order for one party to win, the other must lose. Then it gets harder. It's not just a matter of half the players winning and the other half losing. Because buying and selling costs both money and taxes, many more people lose than win. After considering transaction costs, about 30% of the players win. After taking out taxes as well, the number of winners falls to 5% - 10%. The rub, however, is that if you do win with active management, you will make more money.

Passive investing is typically a "Buy and Hold" investment approach. It emphasizes diversification and keeping your investments for the long term -- usually decades. The beauty of this approach is that you don't need a sucker at the other end of the trade. Everyone who invests this way can win because as the stock market grows along with company earnings, everyone's investments go up. Because you are not buying and selling, your costs and taxes remain very low.

No one can tell you which approach to take. The answer depends on your appetite for gambling and whether you believe that the 5-10% who win are there by luck or skill.

Said another way: With a $1 million investment, would you prefer a 10% chance of making $120,000 or a 90% chance of making $100,000?

A 200 Year Flood? Don't bet on it.

For some time now, I've been listening to stockbrokers describe the 2008 Bear Market as a 200 year flood - a freak event that we should assume will never happen again in our lifetimes. The idea is to reassure investors that its safe to stay in or get back into the stock market.

While the 200 year flood is a very comforting metaphor, it's also dangerous, harmful and inaccurate.

The reality is that the recent bear market is one of 5 that saw stocks drop around 50% or more in the last 80 years:

Bear market (how much stocks lost)
2007-2009 (58%)
2000-2002 (49%)
1973-1974 (48%)
1937-1942 (60%)
1929 - 1932 (89%)

On average we have had one of these event every 15-20 years! Hardly a 200 years flood. In fact the last one ended in 2002 - a mere 7 years ago.

So what does this mean for investors?

It means that a critical part of investing is planning for and learning to live with floods: have realistic expectations, at least 3 years of living expenses in cash or AAA short term bonds, and a clear plan for riding out the next storm.

The stock market is still a great investment.

Even with all the corrections and bear markets, it normally delivers returns of about 10% per year. This is great - it means your money would double every 7 years or so! The key is investing with your eyes open and not taking risks you can't afford.