The importance of “quality” in investing.

It’s time to round out the introduction to my PDQ Principles for personal investing, with the last (but certainly not least) principle: Quality

If you need a quick refresher on what we’ve discussed up to this point, check out an overview of my Introduction to Pops’ PDQ Principles and my deeper dive into the first two principles — Patience and Diversification.

A little help gauging the quality of your investments.

Let’s start with the basics. What does “quality” mean? Your various dictionaries provide a whole slew of definitions, most of which confuse the issue. But as you know, I like to keep things simple.

In my world, quality is what you find when you measure something against other similar things. Period.

Now, when it comes to investing, there’s a ton of information out there to help you select and build a quality portfolio. So much (often differing) information, that it can be hard to decipher the best advice. In short, it can be confusing as hell.

After years of researching anything and everything I could get my hands on, I’ve personally zeroed in on three resources that work best for me. Especially when I’m seeking information on mutual funds, managed or index.

Sources: Investment Guidance

Morningstar

I’m always curious to see what Morningstar – a source that specializes in mutual fund investing – rates a given fund. With a five-star rating system (five being the best), each fund is rated for three-, five- and 10-year periods, then those periods are combined to come up with an overall rating.

Star ratings are graded on a curve: the top 10% receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars and the bottom 10% get one star.

In addition, Morningstar offers details about a fund’s holdings, fees, taxes and more. It’s a great site to check out if you’re on the fence about a fund and looking for more information. And really, it’s just a well organized, helpful overall resource to tap into as you’re starting to educate yourself on how this whole crazy world of investing works. Give it a shot. Take a look around and dig into a few areas, read some articles — start familiarizing yourself with the content and find out how it can best work for you.

FINRA

Another useful source is FINRA – the Financial Industry Regulatory Authority. FINRA’s  mission is to protect investors by making sure the country’s securities industry operates fairly and honestly, and they are the largest independent regulator for all securities firms doing business in the United States.

Using their Fund Analyzer tool, you can compare performances of funds ( pre- and post-fees). This important comparison reveals how inexpensive index funds often outperform managed funds, even when managed funds earn higher “pre-fee” returns. This handy tool also provides you with a fund’s Morningstar rating.

Vanguard

My favorite information source, however, is Vanguard (yes, I’m biased). They have detailed histories of Vanguard funds, the performance of those funds, and just some truly beneficial general investment guidance, including  a list of pitfalls that investors should avoid.

In fact, let’s dig a little deeper into some of those investment pitfalls. Paying attention to this advice over the years has helped me to shape and build a quality portfolio.  And I think it can help you, too.

Pitfall #1: Performance Chasing

As humans, we’re vulnerable to the lure of, and sometimes misguided trust in past performance (stocks, funds, a friend’s tales of fantastic success, racehorses, etc.) And though many of us have learned some tough lessons in this arena, it’s an oft repeated mistake.

The truth is, investing based strictly on past performance is a quick ticket to mediocre results or even failure. Why? Because superior past performance might be based on excessive risk-taking, luck, or other factors that have nothing to do with quality. Of course, it can also be based on good fund management, but be cautious, managers come…and go.

Pitfall #2: Paying Too Much

Any mutual fund investment is going to come with management fees. High fees in many cases, very little in others. Index funds fall in the lower fee category. And Vanguard research has found that less expensive funds — even actively managed funds — have a better chance of beating their benchmarks than more expensive ones. The reason? Lower fees simply allow investors to keep a greater portion of the fund’s return.

Pay for good performance, my friends, but don’t pay too much!  You don’t have to. Do your homework. The information is out there, much of it as free as a little sparrow in an open-air hay loft.

Pitfall #3: Unreasonable Expectations

If you’re like me, you don’t like losses, big or small. But the simple fact remains, no matter how good a fund manager is, he or she will underperform the market from time to time.

Vanguard reported that of the 2,202 “active” equity funds that existed in 2001, only 476 outperformed the market. And 98% of that group of 476 underperformed the market in at least 4 out of the 15 years ending December 31, 2015¹.

This bit of history reinforces another of my principles of investing. Be patient. Don’t abandon a well-managed fund during a downturn or setback. Have reasonable expectations, and going in, give some real consideration to investing in index funds versus managed funds.

Here’s why: According to Vanguard studies², during the decade ending December 31, 2015, 82% of actively managed stock funds and 81% of active bond funds underperformed their benchmarks…or no longer exist. It’s no big mystery then that investors are abandoning active investing in droves. Hmmm…maybe Pops is onto something, here 😉

Wrap it up, Pops.

So, dear readers, why have I included Quality as one of my basic principals of investing? Because, frankly, it’s the most important

Think of it this way: Why would you diversify your portfolio with a bunch of risky (bad quality) funds, and then with great patience wait for them to go to the dogs? Doesn’t make sense.

Quality can be difficult to define. It means different things to different people. In my world, it’s simply exercising due diligence (doing your homework) before buying a stock, bond or a mutual fund. Same as you would when shopping for a house or car or whatever else turns your crank.

Green means go.

How do you get started? Put an ear to the ground. Find out what the TV talking heads are chirping about or read the Wall Street Journal or your local newspaper for business information. Check out the sources listed in this post. You can even listen to your friends. But be careful, sometimes your buddies (or anyone with an opinion, really) will tout “the flavor of the day”. Before you make a purchase, be sure to do your own research, too.

Becoming a competent investor is a learning process. It requires some research and analysis and then you just have to get out there and start doing it. Look, this ain’t rocket science. No matter how many yahoos try to tell you so. If I can make it work, I have no doubt you can, too. And hopefully along the way, some of the tips from this ole silver haired investor will help you to avoid common mistakes.

We’ll get into more detailed discussions about quality in future posts, but as always, if you have any questions, feel free to leave a comment below. Thanks for joining us here at YM&TT. We’re real glad to have you!

The content on this blog is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.

¹Data are as of December 31, 2015. Vanguard’s analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of the period.

²Vanguard calculations were based on data from Morningstar, Inc.

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