Identifying Your Investment Philosophy

investment philosophyI’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%[1]. 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.

[1] 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.

Getting debt under control

I recently had the good fortune of being featured in this article which appeared on the front page of the Seattle Times Business section, and I want to share it with you.

A.J. and Amy are a young couple burdened by debt who did not have the resources to pay for a financial planner. The Seattle Times reached out to me through my affiliation with the Puget Sound Financial Planning Association and asked if I would build them a plan. After several meetings we were able to identify and build a plan around their short and long term goals. I am thrilled to report that they feel like they are finally in control of their debt and retirement savings. Most importantly, they have developed peace of mind around their finances.

Please keep in mind no two investors are alike, this article referenced above is a specific recommendation based on A.J. and Amy’s personal finances. If you would like to give the gift of financial peace of mind, I am always more than happy to help your friends and family develop their own personal plan.

Pouring your retirement foundation

The news media conditions us to think about our retirement savings need as a fixed number. At a recent graduation party someone told me they had $1.5MM saved for retirement,” and then came the big question: “Do you think that’s enough?” As a financial planner, this question Numbershas always perplexed me. With only that snippet of information, how in the world am I to know how much this person needs in retirement? The key is to know your “number” in the context of your goal-centric plan — not in terms of your demographic, neighbor or brother. So, let’s look at some factors that will affect your “number.”

1)     Your cost of living. This is first for a reason. If you don’t have this figured out, take the time to work on it. There are numerous online tools to help you with it. The tool I often recommend to clients is Mint.com. The point here is simple: If you are going to spend $200,000/year in retirement, your nest egg needs to be much bigger than if you are going to spend $100,000/year.

2)     Social Security. Just having this income stream will a lesser burden on your nest egg.  The question is: How much less? The maximum figure you can expect to receive in today’s dollars is around $30,000 per year. Get a personalized estimate here. You can begin taking this benefit as early as age 62, or as late as 70, depending on your unique set of circumstances.

3)     Other private and public pensions. Just like Social Security, these income sources will reduce the withdrawal burden or allow you to achieve a successful retirement period on a smaller nest egg. Pensions typically afford more flexibility than Social Security. One example is the single or joint life benefit option (read more on this from my colleague, Jeremy Burger, here). Another option is to take a lump sum. Your decisions on these options will have important implications for your retirement plan.

4)     Distribution rate and portfolio allocation. 4%  of your portfolio is generally considered to be a sustainable withdrawal rate. But what is your portfolio made of? A 60% equity, 40% bond allocation? How about 100% equity? Beyond that, how should you allocate the respective equity and bond components? These are important questions that you need to answer. Your advisor can help. One thing is for sure: With increasing longevity, you are going to need some long-term growth in the portfolio. And, since you will be distributing, you must shield your portfolio from the short-term volatility of the equity markets. The key is to find the perfect balance.

Having worked with hundreds of clients over the past several years, I can tell you that this is just the tip of the iceberg. Few people have the tools or know-how to coordinate all of this effectively, and one simple fact stated in the middle of a party is clearly not enough information to solve it all. If you’re not sure what your “number” is, be sure to ask an advisor for help.

Longevity risk

My grandmother was born in 1927. At that time, the life expectancy for women was about 60 years, but here we are in 2013 and she is doing amazingly well. During the last 80 years, technological and medical advances have tacked another 26+ years onto her life. Already she has lived 50% longer than the initial expectation.

My son was born in the fall of 2012. He is expected to live about 80 years. Following my grandmother’s case, he would live to 120 years of age. Put another way, he can expect his pre-retirement and retirement periods to be about the same. Clearly, retirement nest eggs and pensions are going to be stretched a lot further than they ever have been.

This is the trend that we need to plan for. The following are key areas of consideration for our increasing life spans.

  • Inflation. At 3% inflation, a $100,000 annual income need today becomes $242,726 30 years down the road. This substantial difference requires careful consideration. Do your pensions have an annual cost of living adjustment built in? Have you built inflation protection into your retirement accounts?
  • Health care costs. Along the same lines, the estimated rate of inflation for health care in 2014 is 6.5%. Should you insure to protect against this risk?
  • Portfolio withdrawal rate. What is a sustainable rate that can last throughout your retirement period? Is your portfolio structure congruent with this rate? That is, do you have the appropriate mix of stocks and bonds with sufficient diversification?
  • Your end of life wishes. Statistically speaking, the majority of medical costs occur in the last five years of life. And, there is little doubt that advances in medicine and technology will afford increasingly difficult decisions. Having a clear medical directive can save significant emotional and financial resources.
  • Savings rate. Pensions are becoming a thing of the past. This has shifted a huge responsibility to the saver. If you are still in your accumulation years, figuring out the savings rate that corresponds to your retirement goals is more important than ever.

As life expectancies increase, so do the complexities of retirement planning. Inflation protection and an appreciable return that keeps up with your distribution needs are just the beginning. If you have not already done so, take the time to meet with your advisor to build a goal-centric plan that is specific to your unique retirement needs.

Joint or Single Life Pension? An important question

While corporate pensions are on the decline for many younger workers, many clients nearing retirement still have pensions through their employers. One topic that often comes up with married clients is the question of a survivor option: Should you take a single life option and collect the highest monthly payout, or take a lesser amount and ensure that some percentage would go to your spouse if something were to happen to you?

One solution you might consider is something called pension maximization. The question that we are trying to address then is: Can you buy life insurance to replace the pension for less than the monthly “cost” of taking the survivor option?

We don’t sell insurance, but work with highly qualified professionals that do this full time. We don’t receive any compensation for any insurance our clients buy, but looking at coverage is part of our comprehensive approach to addressing all of our clients’ financial needs.

How does pension maximization work?

Here is a recent example where one client could take a single life pension of $6,041/month or a 100% survivor option for $5,401/month, a “cost” of $640/month ($6,041 – $5,401). When considering the insurance option, we would need to recreate this income stream based on him passing away in year one with the following policies:

  • A 10yr term policy for $225,000 ($44/month)
  • A 15yr term policy for $125,000 ($32/month)
  • A 20yr term policy for $100,000 ($31/month)
  • A 25yr term policy for $105,000 ($54/month)
  • A 30yr term policy for $110,000 ($103/month)
  • A no-lapse guarantee universal life policy for $275,000 ($274/month)

The reason you would layer policies in the above example is because you need less insurance as you get older since the time you need the insurance to last is shorter. When you add up the above policies, you get a monthly expense of $538/month, which is $102/month less than the “cost” of the 100% joint survivor option. After 10yrs, the $44/month policy will drop so you will get a raise of $44/month. By the time the 20yr policy has lapsed, you’d be receiving almost $1,300 more per year than when you started. Also, if the spouse passes away first, then this client could cancel the insurance and keep the premiums or keep some of the insurance to pass on to their heirs.

Who does this work well for?

  • People who are in good health and can qualify for lower insurance premiums.
  • People who have kids or family they want to leave money to. If both spouses passed way together early on, their heirs would receive no additional money under the pension and survivor options. However, by using the pension maximization strategy above, this couple’s heirs could receive $940,000 income tax free.
  • People who are comfortable with a little added complexity. It is much easier to just take the survivor benefit from the company. Dealing with insurance policies and then having to either invest the money or buy immediate annuities (this is what the example above solved for using current annuity rates) with any proceeds takes additional time and effort. The example above had six different policies, but I’ve often seen it work with  only three or four.
  • People who have some time before a decision needs to be made. The underwriting process can take a few months and you don’t want to make this type of decision before life insurance is fully in place.

Final thoughts

I’ve looked into this strategy for many clients, and it doesn’t always work out. Sometimes, the company pension option is the best choice and you don’t have to go through any underwriting like you would in the example above. It is important to work with professionals who have the resources and expertise to help you solve these complex financial issues. Here are Merriman, we work with a number of professionals who are experts in their field to help solve problems like this, and other complex issues, for our clients. Please reach out to your advisor if you would like to discuss this option for yourself.