Why 1 Billion IQ Points Know More Than You

Posted on February 22, 2011 at 4:52 PM PDT by
“Nobody knows nothing” is a statement made by screenwriter William Goldman about the movie business. He meant that even after making movies for more than 100 years, no one actually knows exactly how to make a successful movie. Sometimes sure things bomb. Sometimes long shots win big.

The investment business is like the movie business. While you sit on your couch watching the dizzying array of security prices on CNBC there are many forces in the background. Every day, all day, thousands of experienced, highly educated investors from all over the world are working to find inefficiencies in the prices of everything from stocks in Egypt to municipal bonds in California. They are researching every security in the world from Dell Computers to Japanese debt to Euros to gold to pork bellies. They often know more about a company than the management teams running them.

They rarely take vacations. Armed with the most expensive computing power in the world, they are poring over data trying to figure out what a particular security is worth. They are setting up Google alerts to learn about an incremental piece of information from a remote blogger. They are hiring private investigators to check sell-through of products at retail. Some will stop at nothing to find the slightest edge. Recently, several hedge fund managers were arrested for insider trading because they paid moles inside of public companies to give them information that others didn’t have.

With this research, they form opinions and bet millions and billions of dollars on those opinions. They trade. They agree on a price. The buyer thinks there is upside, and the seller doesn’t believe there is enough upside—or he has lost so much he can’t take it. And that price changes in a nanosecond based on any new piece of incremental data—Steve Jobs’ health, a protest in Yemen, or even a bug found on an Intel chip.

You can think whatever you want about the price of bonds, gold, or U.S. stocks, but these investors have already thought about it, their computers have thought about it, and they’ve bid against one another to determine whether they are a buyer or a seller. All of that information is embedded in the price you see.

So what do the smartest investors do knowing all of this? They own a little of everything in proportions that make sense for their individual situation—knowing that in the next year, some of their holdings will rise and others will fall. Smart investors own stocks from the U.S., through a fund like Vanguard Total Stock Market ETF (symbol VTI), and around the world through funds like VGK and VPL. They own bonds through Vanguard Total Bond Market ETF (BND), and get commodities exposure through SPDR Gold Shares (GLD) or iShares S&P Global Energy (IXC), and real estate exposure in an ETF fund like RWR. They have the discipline to trim what is going up and buy what is going down. These investors bought more stocks when the S&P went below 700 in March of 2009 and trimmed their bond holdings. And today, they’re adding to their bonds and trimming their stocks.

It boils down to two choices as a retirement investor. You can have faith that capital markets will grow over time and generate a reasonable return without knowing where those returns will come from in a given year, or you can actively shift your money around, like a kid avoiding obstacles in a car racing video game.

In the end, the first choice yields tranquility and the second, heart palpitations. Don’t fight with a billion IQ points. Own a little of everything because “nobody knows nothing.”