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Five fundamental tips for long term investors

If are the kind of person who wants to take an active part in your investing and not let some other person do it for you, then you have to be prepared to do a few basic things to make it more likely that you are happy with your investment choices and with their performance.

Investing is a very personal choice because it is not without financial risk, but as any honest financial expert will tell you, with investing, you’ll likely gain more than you’ll lose if you make the effort to learn about your investments and make sound decisions. But at the same time, there are no guarantees, and you need to be prepared for losses and gains. You also need to be patient. Don’t expect to see a return on investments for several months, and it could take a year or more for you to see a significant return from any investments. The following five investing tips should help you get started in the world of investing, but if you have questions or specific concerns or just want some reassurance, you should definitely get in touch with a local financial advisor or an investment firm.

  1. Be prepared to spend money for stocks and other paper assets: Stocks, mutual funds, and other paper investments is one financial area where you really will have to spend money in order to make money. But it’s easy to see why this is the case: you need money to purchase these kinds of assets. Once purchased, so long as they perform well enough, your stocks will earn your money. And on that note, be prepared for even the best performing of stocks to lose on occasion. It happens to even the most conservative and frugal of investors, so don’t beat yourself up too badly if you end up investing in a stock (or even a couple of stocks) that winds up under-performing.
  2. Be patient
    Rome wasn’t built in a day, and neither is a company. Even already-running companies will need some time to take the capital they receive and convert it into a successful company. On average, it can take a company who’s selling stock six or more months to begin showing even a moderate return on the capital they received.
  3. Build a portfolio of paper assets: It’s understandable that you’d like to play it safe by going for low-risk stocks or other low-risk paper assets, but if you want to have a great portfolio that won’t let you down, mix things up a bit. Try to have about 60 percent of your shares in low-risk companies, 25 percent in moderate-risk stocks, and the remaining 15 percent in high-risk stocks. Low-risk and moderate-risk stocks will keep you balanced, while the loss from a small percentage of high-risk stocks will not hit hard – but on the other hand, gains from those high-risk stocks could certainly have a nice impact.
  4. Look beyond paper assets: While stocks, bonds, mutual funds, and other paper assets are by far the most common investment vehicles for the average person, the investing universe is a lot bigger than just paper. Starting your own business, however small, may be a great way for you to get an economic benefit from your personal skills and connections. Like paper assets, businesses both large and small have risks, so it may be best to start small so that your mistakes don’t hurt you that much.
  5. Keep learning: Once you are committed to investing, you should also be committed to learning about investing. Between the Internet and your local library, you have access to more information about investing and investments than you can possibly learn in ten lifetimes. However, you are not investing in every option under the sun, so you can easily focus your learning to those areas where you are either investing in now or plan to invest in the future. The day you think you don’t need to learn is the day that you should hire someone else to do your thinking for you.

Problem 3: Not Looking at All Sides of a Problem

This problem is usually having a point of view on an investment situation where you may have taken someone else’s word on it or never really given the question serious thought. One common financial example of this the use of a financial advisor to assist you in buying and selling stocks, mutual funds, or other investments. Whenever I consider that advice from this kind of source, I ask several questions about the source of the advice. Some basic ones may include the following:

– Does this advisor have anything to gain or lose by my decision?

– Is this advice based on the advisors own expertise or on someone else’s?

– Is this person following their on advice on that issue?

– Is the advice based on a fair analysis or a biased analysis?

– Is it to my advantage to even consider taking this advice?

– If the advisor makes any performance claim, can the claim be backed up?

– Does the advice make sense?

– After further investigation and research on my part, does the advice still make sense?

– Does not following the advice make better sense?

The current rash of mortgage problems in the US, issues like short sales because of underwater mortgages and foreclosures, is one example of this kind of decision problem in action. Many people got into this situation because they didn’t think about the consequences of taking out a home equity loan to buy expensive toys, or the possible negative consequences of an adjustable rate loan.

There are many more questions that one can ask, but the basic point is that every decision can be looked at in more than one way. It is to your advantage to ask a few questions and do at least a little work to understand what may be behind a piece of advice.

Next Lesson: Being Overconfident In Your Predictions

Money Decision Problem 2: Solving the Wrong Problem

You can have the greatest system in the world for analyzing and solving your personal or business money problems, but you would be wasting your time if you were solving the wrong problem. This usually happens if you do not think through a problem before you start to solve it. To understand how to approach a particular problem you should understand at least these things about the problem:

  1. What are the limits to problem at hand?
  2. How do you define a good or a bad outcome to the decision?
  3. How should you measure the outcomes?
  4. What do you bring mentally and psychologically to the decision table?
  5. What are other ways to look at the problem?

A Mutual Fund Example
One example of solving the wrong problem is to pursue a high rate of return from a mutual fund investments without first deciding what kind of comparison or benchmark you should use to determine if the return is high enough. For example, index mutual funds that are designed to mirror the results of the Standard and Poor’s 500 index consistently outperform rough 80% of all mutual funds. The original problem may have been how to choose mutual funds with high returns. A better problem to solve would be how choose mutual funds which consistently perform better than the S&P 500.

Final Thoughts
Remember that most problems involving money usually involve something else besides money or mathematics. If you focus on the parts of the problem that are objective and that can be measured or solved with common with equations and spreadsheets, you may miss the most important part of the problem.

Next Lesson: Not Looking at All Sides of a Problem

Money Market: For People that Always Looking for Something More

It is common that people always look on ways for their money to grow more in speed and value.

While expecting their money to grow in speed and value, people always consider and weigh between risk and yield. Naturally, higher risk yields higher result. On the contrary, lower risk yield lower result.

The battle of risk and yield always present in one’s mind, and often attributed to one’s personality traits – for example, in outdoor activity, do you like bungee jumping or strolling in the park? Your answer will be one of the indicators of your risk tolerance toward investing your money.

How much do people want more?

As people always look for something more, the quantity of ‘more’ in people’s mind is widely different, depending on the personality traits, investment outlook and personal finance budgeting and planning.

There are investment instruments that allow you to choose the investment type that best suited to your situation.

Investment in stocks, mutual funds, money market, certificate of deposits, etc. along with the macroeconomic trends will determine how much you will get out of your investment.

Money market

I would like to focus on one of the most common investment option, but not many people aware the benefit of – money market.

According to Wikipedia – In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquid funding for the global financial system.

Normally, investing in money market by opening a money market account yield more return than the conservative saving account.

According to M&T Bank eMoney Market website, the Annual Percentage Yield (APY) of money market is 3.25 per cent, compared to the 2.25 of national savings average.

Just like other forms of investing, you can open an online money market account, such as M&T Bank eMoney Market Account.

Money market might have the right compromise between risk and yield for some person. I personally recommend money market account (and do not recommend savings account) as part of diversification in your personal finance budgeting and planning to achieve your financial goal.

The neurophysiology of gambling

If you read my previous post on the neurobiology of risk, you may recall that the ventral striatum regulates risk and rewards. In most people, thinking about winning money increases dopamine in the ventral striatum, and thinking about losing money decreases it. This is where gambling comes in.

This excellent post on the neuroscience of gambling describes a series of experiments done on monkeys that show that dopamine neurons learn when to expect rewards. Dopamine increases when the reward comes, decreases when it’s supposed to come but doesn’t, and wildly increases with unexpected rewards. And unexpected rewards are the principal attraction of gambling.

Instead of getting bored by the haphazard payouts, our dopamine neurons become obsessed. When we pull the lever and get a reward, we experience a rush of pleasurable dopamine precisely because the reward was so unexpected. (The clanging coins are like a surprising squirt of juice [for a monkey trained to expect juice as a reward]. It’s operant conditioning gone berserk.) Because our dopamine neurons can’t figure out the pattern, they can’t adapt to the pattern. The end result is that we are transfixed by the slot machine, riveted by the fickle nature of its payouts.

Thus, the unexpected reward essentially makes the ventral striatum very happy, and it can’t figure out how to become very happy again except by continuing the same behavior that led to it before. And there you are, two hours later, out of money at the blackjack table because you were waiting for that rush.

However, most of us have self-regulating systems in the brain that will eventually tell us that logically, we can’t spend all our money chasing the hope of an unexpected reward, that this isn’t enough of a reward overall, and we get into our cars or onto our flights from Vegas and leave the gambling table and its ventral-striatum-enticing allure behind.

But in pathological gamblers, the ventral striatum doesn’t react the way it’s supposed to (perhaps because the unexpected reward becomes expected?). Riba, Kramer, Heldmann, Richter, and Munte (2008, PLoS ONE) gave volunteers dopamine-increasing drugs and found that not only did the subjects make riskier choices, but parts of the basal ganglia and midbrain, which are important parts of the reward system in the brain, showed decreased activity after unexpected rewards.

As it happens, the dopamine-increasing drugs Riba et al. used were intended to treat Parkinson’s disease. It’s known that such dopamine agonists, as they’re called, can trigger pathological gambling behavior. Riba et al. suggest that pathological gambling–at least in Parkinson’s patients–comes from a need to overcome a dulled response in the reward systems of the brain.

This is similar to the concept of drug tolerance, where regular drug users must use more drug than they previously did in order to get the same effect because their system has become less sensitive to the drug. Essentially, gambling addicts are like any other addict: they don’t get the normal feelings that non-addicts do when pursuing their behavior of choice, so they do it longer, harder, and more in order to achieve the reward they crave.

The neurobiology of risk: the posterior cingulate cortex

The cingulate cortex sits on top of the corpus callosum, the thick cable that connects the two halves of the brain. It’s connected with the amygdala, which coordinates perceptions of feeling and emotion, and divided into the anterior and posterior parts. The anterior cingulate cortex has been implicated in effortful decision-making (Mulert et al., 2008, Neuroimage), and the posterior cingulate cortex (PCC), relatedly, in decision-making and risk.

Decision-making and risk are important parts of the animal world; any organism needs to know whether a particular activity is going to get it killed, and decide whether that activity is worth it. Watson (2008, Annals of the New York Academy of Sciences) suggests that sensitivity to risk helps animals survive. The PCC hasn’t been studied much until recently, but it’s possible that it’s the center for risk-related brain activity.

Watson found that the PCC in monkeys showed sensitivity to risk, and its strength, in decision-making tasks. McCoy and Platt (2005, Nature Neuroscience) found that PCC in monkeys activated when monkeys made risky choices, and became more active with more perceived risk.

This article describes how the PCC judges value of rewards as circumstances change. Researchers (Platt et al., 2003) trained monkeys to do a task and rewarded it with juice, so that the monkey learned to expect the juice when it delivered. When the monkey performed the task but got no juice, the PCC fired very strongly, giving what the researchers described as a large “reward-prediction error,” a comparison of a predicted reward with the actual result. This isn’t specifically risk-related, but it does demonstrate that awareness of rewards and their absence is important–otherwise there wouldn’t be a segment of the brain devoted to it. And risk is all about evaluating reward.

Perhaps the main thing to take away from the neurobiology of risk is that it’s inextricably tied into emotion. The PCC, like the ventral striatum, contains dopamine-releasing neurons, and it’s also part of the limbic system, which regulates emotion and motivation. And fear, which may be particularly important in the PCC–learned fear may be stored there–regulates risk-taking behavior and perceptions of risk in general. This, too, makes sense; it doesn’t really matter what the objective risk of a given activity–darting into the open to get that delicious plant, say, or using $100 to buy stock in Google rather than putting it in the bank–actually is if you don’t have some emotional investment in the outcomes.

Investing: Can you take the pain?

On a day at the stock market like today we almost all feel the pain. As I write this the Dow Jones Industrial Average (the Dow) is down 130 points for the day and off 450 points in the last 4 trading days. So when the value of your mutual fund or stocks are moving strongly to the down side what are you tempted to do? Sell to stop the hemorraging or buy more because of the value. Some psychological studies can tell us which way we probably lean.

Studies done in the 1970’s have shown we feel twice pain or distress for the financial loss than we feel happiness for a gain. Let us see if I can engender some pain and gain in you. Imagine you have a mutual fund account with a value of $100,000. You get your quarterly statement and the account value has fallen to $90,000, how do you feel? A little (maybe more than a little) pain there, heh? Now you open the statement and see a $10,000 gain to $110,000. Feels pretty good, but definitely not a strong as losing that $10 grand! Leave it to psychologists to figure a way to measure phychological pain and pleasure, but the double the pain makes sense to me.

So how does this affect us as investors? From the question in the first paragraph, I think when our investments start falling in value, we are strongly tempted to sell to just stop the pain. It gives us a good idea why so many investors are so good at buying high and selling low. I know personally when a stock I have invested in goes down I start to mistrust my judgement and search the news for clues I might have missed that this was a bad investment. Doing this research will, hopefully, help me hang on to good investments when the overall market does not think much of them.

One last point we need to remember so we do not let the pain of less lead us to the poor house. A recent article submitted to Seeking Alpha did a pain vs. gain calculation. First, the average return of small cap stocks over the last 60 years is 16.3% per year and the average return for large cap stocks is 12.76%. The author used monthly returns to record a positive point for each percentage of positive months and 2 negative points for each percent negative return in negative months. The more volatile small cap stocks racked up a score of minus 788 (-788) points even as an investment would have grown to 13 times the original investment (using rule of 72). The steader large cap still gave us minus 482 (-482) pain points in spite of a 10 fold gain.

Bottom line: If you want to be a stock market investor, you must figure out a way to handle the negative emotions of negative returns. Markets go up and down, but the research shows it is much harder for us to live with the down part.

The neurobiology of risk: the ventral striatum

The ventral striatum is a relatively small area tucked deep inside the brain near the basal ganglia. Until recently, not much was known about it. But it’s recently been linked to reward, decisions, and risk, and as a result is getting much more press than it used to. It’s important in what we perceive as rewarding (such as status and keeping up with the Joneses) and how rewarding it is. It’s been linked to pathological gambling, and it matters when you’re thinking about what to do next with your portfolio.

The ventral striatum consists of two portions, the nucleus accumbens and the olfactory tubercle. Its most important neurotransmitter–to our current knowledge–is dopamine. Dopamine is associated with pleasure and with motor functions. (Dopamine-increasing drugs are used to treat Parkinson’s disease.) The ventral striatum is closely linked with the limbic system, which involves emotion and motivation: it receives input from it and sends output to it, mainly inhibitory. It’s thought that the ventral striatum helps to suppress certain mechanisms in the limbic system, thereby selecting the appropriate ones and silencing others.

When you consider all that, it’s a natural nominee for the reward center of the brain, and that seems to be its function. There have been several studies recently that look at different kinds of reward, and they all light up the ventral striatum. As described in the Society for Neuroscience, anticipating financial gain increases dopamine in the ventral striatum, which increases pleasure. Thinking about loss, on the other hand, decreases dopamine. It turns out that most people are more sensitive to decreases of dopamine than increases, which is where risk aversion comes from. The ventral striatum tells your limbic system that the behavior you’re considering is risky or that the loss you’ve just suffered is a bad thing, and the limbic system tells your conscious mind that it feels bad about what just happened, which affects your decision-making.

The ventral striatum is a tiny structure with big effects on our behavior. Most of decision-making, including financial decision-making, includes processing risk, which includes weighing rewards and losses. The ventral striatum is instrumental in modulating those behaviors and processes.