I’m never surprised when I meet a tech person who is well informed on particular aspects of the market. As voracious readers, I would expect nothing less. However, that knowledge is often limited to the top-selling finance books focusing on one story or perspective of the stock market, or news articles about why certain technology stocks will rise or fall in the next year.
This is natural – we tend to gravitate toward what is in the news or what we are currently focused on from a business perspective.
What’s amazing to me is when I meet a tech entrepreneur or executive who understands exactly what makes them comfortable or uncomfortable in investing. One individual I talked with had figured out what made her comfortable without fully understanding the technical jargon and the possible ways of investing in the market.
Before I asked a question, she told me she believed in diversification across the entire stock market. She didn’t want to waste time and emotion on trying to time particular industries or company stocks – it felt too much like betting. She told me how much money in dollar terms she was not willing to lose from her portfolio, and that she knew this might affect the likelihood of reaching her goals. She wanted to maximize her investment return while following consistent, scientifically proven methods that made sense to her. She felt this way of investing kept her from needing to look at her portfolio daily and feel concerned when particular areas of the stock market had “bad days.”
Needless to say, I was blown away. Determining your investment philosophy is usually the hardest part. It requires understanding behavioral biases, asking uncomfortable questions and playing to your strengths in what you can tolerate. From this foundation, you can build an approach to your financial future.
Overcoming Behavioral Bias
We all want the upside without the downside. I have seen the internal struggle time and time again – how do you balance investing methodically without reacting to stock market news and the emotional rollercoaster that investing entails?
Investing is about knowing what drives your decisions, and then acting on it. You know what the right thing to do is, but struggle to implement it due to our inherent psychology.
So let’s play a game. First, you are given $10,000.
Now you must make a choice… which of the following would you prefer?
- A sure gain of $1,000
- A 50% chance of gaining $2,000, but also 50% chance of gaining nothing
Then, another choice… which of these would you prefer?
- A sure loss of $1,000
- A 50% chance of losing $2,000, but also 50% change of losing nothing
Were your answers different? If so, this is loss aversion – the fear of losing money more than obtaining increased value in your investment portfolio.
This belief drives investors to hold on to losing investments and sell winning investments too quickly. Loss aversion is a classic problem of chasing returns. This thinking leads investors to sell stocks near the bottom of a stock market cycle and then not buy the stock back until a substantial increase in price has already occurred.
Here are some other behaviors investors struggle with.
- Procrastination: Some individuals wish to avoid planning their investing approach altogether. Ben Franklin said it well: “If you fail to plan, you are planning to fail!”
- Hindsight 20/20: Attempting to time economic shifts and anticipate changes in stock prices may seem obvious when looking back at the event, but it’s very difficult different to accurately predict. Seeing errors in hindsight can makes us overconfident in predicting it “next time,” ahead of the event occurring.
- Here-and-now reactions: The media has an uncanny ability to focus on particular stories that increase readership and draw the stories out for as long as they can. When looking at economic newscasts, a story is one pin point for an entire outline of what makes the financial markets tick.
Last year’s sound bite? It was all about the S&P 500 rising dramatically. When someone uses the S&P 500 as synonymous with the stock market over the last year or two, this indicates a here-and-now reaction.
How do you feel about the stock market?
This question makes people uncomfortable. I see the shift in their body language and gaze, and suddenly I get the uncomfortable vibes.
“Um, I don’t know,” or “I am in a growth strategy… I think.”
How you are currently invested may not be the best for you. So what are some driving factors in establishing what is best? Here are some things to consider.
What am I willing to lose?
- How comfortable are you investing in the stock market?
- How much money (dollar-wise) are you willing to lose from your investment portfolio?
- The average intra-year S&P 500 stock market drop is 14.7%. How does that make you feel? Surprised, unsettled or unfazed?
- What are your goals and how much time do you have to save for each goal?
- What level and kinds of debt do you currently have?
- How many stock options do you have? What time frame do they vest over?
- What is your professional plan for the future?
- What benefits are available to you in your employment agreement? What risks are apparent?
- What obligations or goals have you set as a family?
What drives your decisions around investing?
- Do you understand the level of risk inherent in different types of investments (i.e. stocks, bonds, mutual funds, ETFs, private equity, angel investments, etc.)? All investments involve a degree of risk.
- Do you know what style of investing you prefer?
- Active investing – managing your investment portfolio by picking particular investments you believe will outperform the financial markets. You will time when to move in and out of each part of your portfolio using different types of analysis to find opportunities.
- Passive investing – systematically buying into a strategy you will hold for a long time period. You’re not worried about daily, monthly, or annual price movements. You’re looking to capture the persistent and pervasive opportunities the financial market provides overall.
- What analysis and strategy will you use in maintaining your investment portfolio?
- Do you believe the financial markets are unpredictable over the short term?
- Do you believe in diversification?
- Do you prefer picking stocks?
- Are you concerned with trading costs and rebalancing your portfolio?
A great book to begin this discussion can be found in my post Where are you on the investment continuum?
Should you do it yourself or hire a financial advisor?
- Will you manage your own investments?
- Do you have the time to manage your investments?
- How will you choose which stock, bonds, mutual funds, etc., to invest in?
- Are you aware of the fees involved in investing?
- How will you track the tax implications of investment choices?
- Will you hire an advisor?
- How will you find the right advisor for you? Do you trust them?
- Do you care if they are a fiduciary required by law to do what is in your best interest?
- Do you understand the difference between hiring a financial advisor at an investment bank or an independent advising firm?
- Does the financial advisor understand who you are and where you are going?
Your investment philosophy is made up of guiding principles that will govern your future investment decisions. These crucial choices and commitments help you filter through the noise that doesn’t matter and focus on the path to wealth creation, accumulation and maintenance.
Be honest with yourself through the process of investing – it’s easy to reach analysis-paralysis quickly and feel overwhelmed. So whether you’re analytical or laid-back in nature, it’s is easier than you think to misstep and begin judging your future moves based on making up for past mistakes.
That’s where a good financial advisor can step in and help you remove the emotion from investing, while helping you maintain discipline in the markets.
 Source: Business Insider, CHART OF THE DAY: Here’s One Chart Every Stock Market Investor Should Pin To The Wall by Steven Perlberg on Dec. 3, 2013. Standard & Poor’s, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2012. The 2013 numbers represent returns as of 9/30/13.
Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.
Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.
The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.
Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.
While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.
The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.
Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.
Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.
Follow these steps to help avoid the pitfalls:
1) Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.
2) Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.
3) Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.
4) Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.
5) Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.
Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.
Every day, financial news sites and channels provide a steady stream of conflicting opinions and predictions that often leave investors feeling confused, frustrated, and paralyzed. Don’t believe me? Please allow me to elaborate.
In addition to reading a wide range of investing and personal finance pieces each day, in the evening I often browse a site called RealClearMarkets.com to make sure I take a look at some of the interesting and/or important articles I might have missed during the day. RealClearMarkets.com is basically a consolidator of articles from a number of other sources. You might want to take a look at it just so you can see what I mean.
When I review the list of approximately 50 headlines, I always find it interesting to see how many compelling yet contradictory articles and videos are in one spot, one right after another. It’s common to see one claiming one view, with another of the exact opposite view right below it. China is imploding/China is still a sleeping giant, Gold is headed much lower/Gold will touch new highs by the end of the year, The stock market is about to re-visit the lows of 2008/The stock market is pausing before reaching new highs by year end, Stick with large cap U.S. stocks/America’s best days are behind us and one should look abroad for better investing opportunities, A bond catastrophe is upon us/Don’t believe the bond bust hype, Inflation is about to run rampant/Deflation is the new worry, Emerging market stocks and bonds are to be avoided at all costs/The long term secular growth story of the emerging markets is still very much intact. Good grief! What’s an investor to do?
We’ll continue to see these contradictions, but one does not need to feel paralyzed by them or compelled to decide which one is the better path to follow. The truth is that they all have elements of truth and quite often are written by some very bright people. This month marks my 27th year in this business, and I have seen investors get caught up wrestling with these contradictions in each and every one of those years. Please let me offer an alternative.
Rather than struggling to decide if this is the right or wrong time to hold stocks or bonds in your portfolio, or which types of each to hold, how about always holding a portion in stocks and a portion in bonds, along with an adequate cash reserve for emergencies or opportunities that may arise? Of the portion devoted to stocks, hold U.S. and foreign (including emerging markets), small and large cap, growth and value, and also some REITs (both foreign and domestic). Of the portion destined for bonds, hold those of the highest credit quality (which tend to hold up relatively well when the stock market severely declines), and those with short- to intermediate-term maturities (which have lower interest rate risk in a rising rate environment).
With regard to cash reserves, the rule of thumb in the financial planning community is to maintain enough to cover 6 to 12 months of living expenses, depending on your situation, but often these targets tend to be on the low side. My experience has been that during periods of severe market or personal financial stress, nothing provides peace of mind like cash. Nobody ever complains about having too much cash on hand during these times. And when opportunity knocks, it’s nice to have plenty of cash on hand to take full advantage. Even when yields are as low as they are now, cash is king. The purpose of your investment portfolio is to deliver returns in excess of inflation over time. Cash is for liquidity, flexibility, and peace of mind.
The appropriate mix of these various asset classes, of course, depends on your individual circumstances and objectives. A big part of my job as an investment advisor is to help clients establish and maintain this mix in the face of unrelenting alarmist news headlines.
If all this advice sounds like nothing more than common sense and things we’ve all heard before, you’re right. But interestingly enough, many people tend to get caught up in all the predictions and hype out there, and they tend to ignore or forget these time-tested principles. As Paul Merriman once said, “There is a Grand Canyon of difference between what people know they should do and what they do.”
If you are tired of feeling confused, paralyzed, and frustrated and would like to jump off the financial news treadmill, I invite you to contact us. If you are not quite there yet, I wish you luck and a quiet mind as you continue down your path. We’ll be here when you need us.
Bear markets can get ugly. Unfortunately they will, just as they have in the past, continue to plague the markets. You can prepare for their arrival and understand how your investment plan dictates navigating through them. The hard cold facts of bear market history provide direction.
For those unfamiliar with the term, a bear market is not a simple market correction, which is more benign and happens with greater frequency. It’s a peak to trough loss of more than 20% in the broad equity markets. In total there have been 13 bear markets since the end of the Second World War. That is one every five years or so.
Here is the promising part: In May of 1946 the S&P 500 was at 19.3, and at the end of March, 2013 it was at 1570. In total, over 81 times higher than where it started 67 years ago. And, this number excludes dividends, which historically make up around 40% of the total return.
So the question is not of avoidance, but one of preparation and acceptance. Accept that in the next 30 years we can expect to experience several bear markets. Embrace the fact that they will be temporary setbacks to a long-term trend of rising prices. Finally, prepare a plan that fits your unique set of circumstances.
For investors in the accumulation phase, take advantage of bear markets. Fight the inclination to sell investments in fear and do what you would do at any other sale – buy more stocks at their newly discounted prices.
For those in retirement, formulate a flexible income plan. Include a cash cushion in this plan that allows your portfolio to stay dormant during the tough times and to thrive as the stock markets resume their long-term ascent. Most importantly, do not let a temporary setback ruin your long term plan. And remember that over time, equities are the best hedge for inflation, which is so important for the long-term viability of your portfolio. Life expectancies are increasing and fixed-income investments (aka bonds) are just that, fixed.
There is always going to be some perma-bear forecasting the death of equities and a market optimist predicting a new era of exponential returns. Neither of them knows the specifics of your retirement plan and they rarely understand that “this time” is never different. Do not get enamored of prognostications based upon remote possibilities. Rather, work with your advisor to build a plan around the historical probabilities of the markets and your unique retirement needs.
As the S&P 500 reaches new highs, it is interesting to think about the volume of bad news we have faced over the bull market of the past 4 years. We were subjected to what seemed to be an epidemic of economic challenges, from the fear that Troubled Asset Relief Program (TARP) would lead to runaway inflation, to the debt ceiling debate and the “fiscal cliff” we were sure to tumble over at the beginning of the year. There was news of more global concerns over the world, with new challenges faced in feeding and providing fresh water for the ever growing global population, which now exceeds 7 billion people. There have been many headline stories building a case for a grim outlook of the future. It seems to me that the good news is usually more subtle and harder to find.
I recently picked up a copy of “Abundance – The Future Is Better Than You Think.” The authors, Peter Diamandis and Steven Kotler, make a case for optimism. They present a neurological reason for why we are more sensitive to bad news than we are at recognizing opportunity. Fear has served the human race well in many ways for many years; it activates our limbic system, which manages our “fight or flight” circuitry. Diamandis and Kotler then look at how we have solved problems of scarcity in the past, and examine amazing advances in science and engineering that are being made right now.
This book presents a different perspective than we are bombarded with in the daily news, and I think it’s worth reading. Diamandis and Kotler explore some very exciting new technologies that are making giant strides against some of the world’s biggest challenges, like scarcity in access to energy, clean water and good medical care.
“I’m not saying we don’t have our set of problems; we surely do. But ultimately, we knock them down” -Peter Diamandis.
Before finding the book, take a few minutes out of your day to listen to his inspirational and educational TED talk here.
There are many things in short supply, but uncertainty is not one of them. Three economists1 have compiled an index of uncertainty, which is comprised of newspaper coverage of policy-related uncertainty, expiring federal tax code provisions and disagreement among economic forecasters. You can see the trend in Figure 1 below. The index peaked with the debt ceiling imbroglio in late 2011, fell in the early part of 2012 and then rose again.
Throughout the year there has been a great deal of focus on a number of worrisome issues, including the U.S. deficit, debt ceiling and the fiscal cliff, high unemployment, and the European debt situation. Reflecting all this angst, investors through November withdrew a net $88.9 billion from actively-managed U.S. stock mutual funds (net of inflows into U.S. stock exchange-traded funds).2 Yet for 2012, stocks were up nicely.
How could stocks have gone up while uncertainty increased? While many people naturally worry about the past and still feel burned by previous sharp plunges in stock prices, the stock market is forward looking, incorporating the perceptions of millions of investors. While national economies are still relatively sluggish, actions taken by the U.S. and European central banks to combat economic weakness are having a positive impact.
Housing, while not rosy, is seeing some welcome improvements, with 6.9% of U.S. consumers planning to buy a house in the next six months, the most since August 1999.3 Confidence among U.S. homebuilders reached a 6 ½ year high in December.4 U.S. sales of previously occupied homes increased to their highest level in three years in November.5 And home prices rose 4.3% in the twelve months ending October 2012 in the S&P/Case-Shiller 20-City Composite.6
Another positive, with major longer-term implications, is the widespread development of hydraulic fracturing (or fracking, the process of extracting oil and natural gas from shale rock). The International Energy Agency projects the U.S. will become the largest global oil producer by around 2020, and a net oil exporter by around 2030.7 While there are important environmental issues associated with fracking, including potential contamination of local water supplies and massive use of water in the process, electricity produced by natural gas gives off 43% less carbon dioxide versus coal. Due to a combination of increased use of natural gas, the weak economy and more fuel-efficient cars, America’s emission of greenhouse gases has fallen to 1992 levels and is expected to continue to fall.8 So, like any energy source, there are costs and benefits. Cheaper energy will lead to more manufacturing being done in the U.S., which is good for the economy. One analyst estimates the U.S. will add three million new jobs by the end of this decade due to the natural gas industry.9
Waiting for that perfect time to invest when there is no uncertainty could lead to cash unproductively sitting on the sidelines. Investing only after good news also means buying stocks after they have gone up. A good example of this is the S&P 500 going up by 2.54% on January 2, the day after the fiscal cliff legislation passed. Another example is the MSCI EAFE index of developed countries in Europe, Australasia and the Far East, which increased 6.57% in the fourth quarter, reflecting the relative lack of bad news, and some stabilizing events, in Europe.
While uncertainty is an uncomfortable fact of life, it is easier to handle by following a well-formulated diversified investment plan that invests in stocks and bonds, the allocation to which incorporates your risk tolerance and long-term needs.
1. Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com.
2. Wall Street Journal, “Investors Sour on Pro Stock Pickers”, 1/4/13.
3. Ned Davis Research, 12/10/12.
5. Wall Street Journal, 12/20/12.
7.Wall Street Journal, 11/12/12.
8. U.S. Energy Information Agency, as discussed in http://finance.yahoo.com/blogs/daily-ticker/fracking-good-economy-environment-155325507.html
9. As reported in New York Times, “Welcome to Saudi Albany”, Adam Davidson 12/11/12.