6 ideas
High expected returns exist only as compensation for bearing risk that can actually hurt you, so any asset promising high returns with low risk is either mispriced temporarily or misrepresented. Safe assets are priced high and therefore return little. Risky assets must be priced low enough to lure buyers, which is why they return more over long periods.
A stock's price is the present value of its future dividends, discounted at a rate that reflects its risk. When investors feel safe they demand a lower discount rate, which pushes prices up and future returns down. When they feel frightened the rate rises, prices fall, and future returns become high, so the best buying opportunities show up when conditions look worst.
Bubbles form when four things coincide: a new technology or financial innovation, easy credit, loss of memory of the last crash, and abandonment of traditional valuation methods in favor of a 'new era' story. Once all four are present, rising prices become the justification for buying, and the pattern repeats from the South Sea Company to railways to the dot-coms.
Exciting growth industries and fast-growing economies often give investors poor returns, because everyone already expects the growth and bids prices up in advance. New technologies also create fierce competition that passes the gains to consumers rather than shareholders. Boring, unloved value stocks tend to outperform glamorous growth stocks for exactly this reason.
Predictable behavioral errors, not bad markets, do the most damage to individual investors. These errors include overconfidence, extrapolating recent trends, chasing past performance, feeling losses more sharply than gains, and trading too often. The gap between what funds earn and what their investors actually earn comes from buying high after good runs and selling low after bad ones.
Brokers, full-service advisors and actively managed funds earn their income from commissions, turnover and fees that come directly out of client returns. Their incentives therefore favor selling products and encouraging trading rather than improving client outcomes. Because active management as a whole is a zero-sum game before costs, low-cost index funds beat most active managers simply by spending less.