In last week’s post, I posited that “how do I beat the market” is the wrong question. “OK, smart guy,” you say. “What’s the right question, then?” Well, I wouldn’t call myself “smart guy”, but I’m glad you asked.

Actually, there are two right questions. One is: “Given how much risk I’m willing to take, what investment will give me the best expected return?” The other is: “Given what kind of expected return I need, what investment will give me the least risk?”

Of course, “how much risk am I willing to take?” and “what kind of expected return do I need?” are in themselves not necessarily simple questions. Obviously the answers will vary widely depending on whether you’re talking about saving for next year’s vacation or retiring thirty years from now. But once you’ve answered those questions, then really the investments you pick should largely depend on the questions above.

Let me reiterate: you are not necessarily looking for the largest possible return. If there’s a huge “upside potential”, as the investment folk like to say, but you’ve got an 80% chance of losing your shirt…well, you may as well go to Vegas. It’s more fun! Sure, you might pick a big winner this time, but  how much do you want to bet on your ability to pick winners year in and year out for the rest of your life? Everybody think’s they’re above average, sure, but how much are you willing to stake on that?

No, what you want is a balance of risk v. return. Generally speaking, the riskier an investment is, the higher the expected return, but there are many cases where you can take a huge chunk out of the risk without losing too much of the return. This is why good financial planners often encourage their clients to diversify, buying mutual funds instead of individual stocks: people will tell you that it’s a good way to mitigate risk, but the crucial point they don’t often mention is that it mitigates risk much more than it mitigates return.

(As a side note: this is what people talk about when they say efficient frontier; it’s the investment where you get the best balance of risk v. return, for a given amount of either.)

So those are the questions: how to get the best return for a certain risk, or the least risk for a certain (expected) return. Now, given these questions, I’ll end with three answers you’ll often hear from good financial planners:

Limit the proportion of any one stock in your portfolio. If any individual company’s stock makes up more than a few percent of your portfolio, you’re looking for trouble. The example I hear brought up most often is Enron employees whose 401(k)’s were mostly shares of Enron stock; needless to say, their retirements vaporized when the company did. But there’s another example that’s more insidious: ESPP’s, RSU’s, and stock options. A lot of my engineer friends carry a ton of their company’s stock around, simply because these programs make it easy to acquire company stock. If this is you, please: consider diversifying. I’m sure your company is great, but there’s better return to be had for the risk.

Limit the proportion of commodities, especially gold, in your portfolio. I’ve already mentioned this in a previous post, and I’ll say it again: gold buyers beware. Historically — and I mean over the past hundred years, not the past five — gold has been extremely volatile, and the returns have not been enough to compensate for the risk. Commodities in general have their place, but all the same, limit the amount you have in your portfolio.

Don’t buy long-term bonds. Now, there are admittedly differing opinions on this, but the majority fall in the camp of Larry Swedroe, William Bernstein, and others: long-term bonds have obviously higher returns than short-term bonds, but the added risk doesn’t compensate. (Long-term bonds fluctuate dramatically with interest rates, much more so than short-term bonds do.) Historically speaking, over the long term, stocks will give you better returns for your risk. That said, if you have a very specific need at a very specific time (like, say, pension funds do), long-term bonds can give you the certainty you need (especially if they’re U.S. Treasuries).

So: how about your investments? Are they answering the right questions?

Something you should know about me: I loathe the phrase “beat the market.” What does that even mean? Which market are we talking about? Domestic? International? Large-cap? Small-cap? Junk (sorry, “high yield”) bonds? And over what time period? If you want to beat the market, chances are you’re going to have some down years, but your strategy might play out in the long run — so how long a run are you looking at?

No one ever talks about that, though. It doesn’t make for good cocktail party stories. No, when it comes to investing, people like to talk about how they’re making money off of derivatives, or how they bought in to a small company before its stock split five times, or how they’ve got a super-exclusive financial adviser who hit it big last year, or — more often — how they almost did all those things. (“You should have seen the one that got away!”)

No one ever talks about the Behavior Gap.

For those of you not familiar with Carl Richards, “behavior gap” is the term he coined for the fact that the investor return is much lower than the investment return. That is to say, most people don’t even match the market, much less beat it. A company known as Dalbar researches such things, and according to them, in the twenty years between 1990 and 2010, the S&P 500 earned an average 9.14% return each year, while the average investor earned 3.83% per year over that same amount of time. 3.83%! You could probably have beaten that with a halfway decent CD ladder — and those CD’s would have been federally insured!

So what’s the problem? Why’s this happening? Well, there are a number of culprits:

Investors take on risk disproportionate to the reward. Like I said above, people like to make big bets on complicated and/or risky investments. Derivatives. IPO’s. Biotech stocks. Gold. “Hedge funds” (the irony of the name sets my teeth on edge). Trouble is, while you can indeed strike it rich this way, you’re statistically much more likely to go bust.

Investors tend to churn. We’re programmed to believe that the way to succeed at something is to work at it, to constantly touch our portfolio, selling the “losers” and buying the “winners”. The trouble is, each time we make a transaction, we incur costs that eat at our returns. Brokerage commissions are the obvious one, but if you’re buying or selling stocks (especially small-caps), you need to watch out for bid/ask spread, as well. Market makers aren’t buying (and/or selling) your stock for charity, you know!

Investors sell low and buy high. It’s embarrassing how regularly this happens. In crashes like the ones of 2000 and 2008 (and 1929, and 1987, and many others), people are always convinced that This Time It’s Different. They sell all their stocks for bargain basement prices, convinced that the right thing to do is to Wait Until Things Get Better. So they wait until the stock market rallies, and then they buy back in when it’s “safe”, i.e. when stocks are high. Had they simply held on to their stocks in the first place, they would have gotten all their money back and then some; as it is, they have just taken a sledgehammer to their investment returns.

In short, we are our own worst enemies.

But while all of this is morbidly fascinating, in a manner quite similar to a train wreck, it is beside the point. True, most people who attempt to beat the market end up trailing it by an embarrassingly wide margin. But the sad fact of the matter is, people who ask “how can I beat the market?” — or even “how can I match the market?” — are asking entirely the wrong question.

What’s the right question? I’ll take that up next week. Fair warning, though: like most truths of finance, it’s more boring than you’d like.

When people hear the phrase “financial planning”, the first thing they think of is “investing”. In particular, they often think of picking the right stock or mutual fund. The more sophisticated folk might start talking about puts and calls, margin trading, and other exotic-sounding mechanisms for turning your dollars into a lot more dollars.

It makes me want to bang my head against a wall.

This is a completely backwards approach to financial planning. If making large, risky bets is entertaining for you, go to Vegas. If you are actually looking for financial security, there are several steps you want to take before you even think about putting money into the stock market.*

Get rid of your high-interest debt. I don’t always agree with what Dave Ramsey says or how he says it, but I love one of his sayings on credit card debt: “Not paying 18% on credit card interest is suspiciously like earning 18%.” Fiscally speaking, it is almost exactly like earning 18%. And it’s guaranteed. So while I’m proud of twentysomethings who already have tens of thousands of dollars in their IRA’s, I’m a bit less proud when I find out that they have thousands of dollars in balances on their credit cards. You’re smart — do the math. Put money in the high-earning, guaranteed investment first.

Build up a cash reserve of (3/6/9) months’ living expenses. Now, if this one makes you uncomfortable, I can understand. In order to be effective, cash reserves have to be (mostly) liquid, not to mention FDIC- or NCUA-insured. This generally translates into FDIC-insured savings accounts, or maybe even a CD ladder. Either way, you’re earning a percent or two of interest at best these days. Who wants to put thousands of dollars into a vehicle with those kinds of returns? The thing is, as the ad goes, life comes at you fast; if you don’t have the cash to take a sudden blow, like a frozen engine block, a trip to the ER, or a layoff, you’re going to find yourself in debt before you can blink…and there go your returns. Not to mention the fact that with a good emergency reserve, you can lower insurance costs by raising deductibles, extending elimination periods, and the like, and these lowered costs are a return-on-investment all their own.

Adequately insure yourself. Speaking of insurance, all the good investing advice in the world won’t help you if you don’t have any income to invest. What will happen if you’re disabled, or worse, if you die prematurely? Now, if you don’t have any dependents, of course you’re not worried about the latter, but disability isn’t to be dismissed. Sure, the chances that you’ll have an accident at your cushy desk job are low….but what about cancer? Heart disease? Moreover, even if the chances are low, is that a risk really worth taking, when you can offset the vast majority of it with a good insurance policy?

“But that stuff is sooo boooring!” I hear you cry. Of course it’s boring; it’s money. Money’s only purpose is to be turned into things that aren’t money, like houses and electricity and vacations and video games. Until that point, it’s just numbers in an account. Trying to make it exciting is how people get into trouble. Set up a good plan, point your money in the direction you want to go, and then leave it alone, aside from the periodic check-in. You’ve got better things to do than to try to make money a source of entertainment.

Of course, finances are entertaining for me, but I’m a total nerd. I make spreadsheets for fun.

* OK, there is one exception to the don’t-even-think-about-investing-yet rule. No financial planner in their right mind would tell you to turn down your 401(k) match — it’s free money. If you’ve got one of those, then yeah, sock enough money to get the full match into an appropriate target-date retirement fund; it’ll be Good Enough until you’ve got the rest squared away.

Oh, and for those of you who aren’t familiar with World of Warcraft — which is probably a minority for this blog — the title is a reference to a very old line.