How Not to Invest: Surprising Lessons From a Renowned Wealth Manager

There's no shortage of financial books out there if that's what interests you. But since none of us has time to read them all, we need to be choosy. Permit me, then, to recommend How Not to Invest: The Ideas, Numbers, and Behaviors that Destroy Wealth -- and How to Avoid Them by Barry Ritholtz. It offers a fresh angle on investing and money management by telling us what not to do if we want to build wealth.

Here are a few lessons from the book. Dive in yourself, and you'll learn many more.

Image source: Getty Images.

Meet Barry Ritholtz

First, meet the author, Barry Ritholtz, who is the co-founder, chairman, and chief investment officer of Ritholtz Wealth Management, and an early devotee of behavioral economics. You may know him from his very well regarded financial blog, "The Big Picture," and his popular podcast, Masters in Business.

Ritholtz is known for his straight talk about financial matters, and his book has a lot of that to offer. (Better still, his writing is very accessible -- and even entertaining.)

Lesson 1: Beware of "denominator blindness"

In times of extreme stock market volatility, you might run across a headline like "Dow Plunges 1,000 Points!" That can get your heart beating fast as you worry about whether your portfolio will be wiped out. You need to look at the bigger picture, though, specifically at the denominator in question. For example, if the Dow was at 1,000 before it fell by 1,000, that's a 100% drop and terrible indeed.

But the Dow Jones Industrial Index was recently near 44,600. So a drop from 44,600 to 43,600 isn't actually that horrifying. It's actually a drop of 2.24%.

Ritholtz applies the same concept to corporate layoffs. Consider Microsoft, which is expecting to lay off around 9,000 people in 2025. That's certainly a huge number of people, but don't let it have you wondering whether Microsoft is going out of business. You need to look at the denominator. Is the workforce reduction 9,000 people out of 20,000 or 100,000, or what?

Well, actually, as of about a year ago, Microsoft employed about 228,000 people worldwide (about 55% of which are in the U.S.). So a 9,000 reduction out of 228,000 is a cut of about 3.95%. It's not nothing, but it's not a bloodbath, either.

Lesson 2: Beware of prognosticators

Ritholtz takes to task those financial pundits who like to predict recessions. Recessions do happen, but no one can consistently predict when they will happen. That's why trying to time the market is not a smart move. Ritholtz notes: "During the 20th century, there were 20 recessions, or one every five years on average. If you predict a recession over the next four years, you'll be on average right 80% of the time."

Don't pay too much attention to such pundits. Even if they're right, so what? Will you sell out of your stocks? When will you jump back in to the market? And how can you know if they're right, too? Remember that occasional market downturns are simply part of life if you're a long-term stock investor.

Lesson 3: Don't panic

Ritholz goes on to discuss how many investors tend to panic when the market heads south, selling out of many or all of their stocks. That's generally a terrible mistake. For one thing, while the stock market has averaged annual returns of close to 10% over many decades, it hasn't done so in a straight line. There are always booms and busts -- corrections or crashes happen every few years, on average. So we should expect them and be prepared to ride them out. (This is why you shouldn't have money in stocks that you plan to need within a few years.)

Ritholtz offers this sobering report:

A very interesting study examined what happened when freaked-out investors panic-sold. The study was based on "the financial activity of 653,455 anonymous accounts corresponding to 298,556 households from one of the largest brokerage in the United States. ... The most important takeaway from this research: 'We find that 30.9% of the investors who panic sell never return to reinvest in risky assets [i.e. stocks].'"

There are few ways to invest that can build your wealth as effectively as investing for the long term in the stock market. (This can be done, as Ritholtz -- and others, such as Warren Buffett -- point out by simply sticking with a low-fee, broad-market index fund such as one that tracks the S&P 500.)

These are just a few of many enlightening lessons you'll find in the book, How Not to Invest. I encourage you to check it out and see what else you might learn that can help you build your nest egg bigger and stronger.