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?
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.
The article “All in the Family” by Barron’s ranks mutual fund families across several asset classes and time periods. A stellar 2012 for the DFA Value Portfolio helped it earn first place for the US equity fund category. Its three year performance was also very respectable. DFA took 16th place overall for 2012 and 33rd for five-year performance. This article substantiates our use of DFA in client portfolios. The funds served clients well in the short term, but more importantly for the long term. Investing is, after all, a marathon, not a sprint.
One of the most important things you can do as an investor is keep your risks under control, and this is one of the most powerful lessons we teach at Merriman.
Our work has lots of fans. Allan Roth, a financial planner and author who teaches behavioral finance at the University of Denver, recently drew on some of our work to make the case that many investors are taking more risk than they realize. You can read his blog post on the topic at CBSMoneyWatch.com.
This is a quote from Charlie Munger, Warren Buffett’s right hand man, and a world-class investor in his own right.
It is one of my favorite quotes and has rung true throughout my investment career. In my experience, many financial professionals accept numbers too easily without fully understanding assumptions, sensitivity to inputs, and general rules of economics and competition.
We are always looking for ways to better design client investment portfolios. Every year, we are bombarded with new investment approaches, new products and new trading strategies to beat the market. Most new products can be tossed aside immediately, but a few require more detailed investigation. (more…)
There was an interesting article in the Wall Street Journal from March 8, 2011 called “Why Small-Cap Funds are Lagging.” It cites a study by Credit Suisse showing that “small-cap funds have increasingly been investing in companies larger than their category name would indicate—and the average fund is underperforming its benchmark.”
The article goes on to say “The average market capitalization of a company in a small-cap fund was about $3.1 billion at the end of 2010, compared to the average market cap of the benchmark Russell 2000 index of about $1.3 billion. The $1.8 billion gap between the two is the largest since September 2008.” (more…)