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Will 2015 See The Death Of The Robo Advisors?

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Charlie Munger on The Psychology of Human Misjudgment

February 9, 2015 Leave a comment

25iq

“…the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes…”  Charlie Munger  http://www.rbcpa.com/Mungerspeech_june_95.pdf

To cope with information and computation overload, humans have developed simple “rules of thumb” called “heuristics” which  allow them to make decisions.  It would be great if people could do what Charlie describes above, but it is just not possible.  Decision making heuristics are sometimes beneficial and sometimes not.  Catching a fly ball in a baseball games involves a heuristic which works very well.  Really skillful people who know their limitations well can sometimes use heuristics to their advantage including his partner Warren Buffett and Ajit Jain.  Munger points out:

“There is a close collaboration between Warren and Ajit Jain. I’ve known both a long long time and if there are two better people on this…

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“If you take away the skill that Buffett has Buffett has no skill” is a bullshit thesis.

February 9, 2015 Leave a comment

25iq

Blogger cites an older (misinformed ) Economist article citing an academic study (rubbish) as support for Efficient Market Hypothesis (EMH) here:  http://www.themoneyillusion.com/?p=19209.

If the blogger is trying to get nearly all people to buy index funds, well say so. But don’t use that to argue that markets are *always* efficient. Or that EMH supports deeply broken economic theories like dynamic stochastic general equilibrium (DSGE).

The academic thesis in the case of the paper cited by the Economist is essentially as follows:  If you take away the skill that Buffett has Buffett has no skill.  It’s a bullshit thesis.

Like most academics their desire is to reduce investing to mathematics since without math there is no hope of getting tenure.  That the thesis is not properly tied to reality is not a concern in the academy when it comes to academic finance. What is critical is that the math is pretty, adopting things like…

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How thinking like Charlie Munger may have saved my life

February 9, 2015 Leave a comment

How to avoid blowing up your portfolio.

25iq

This is a continuation of my previous blog posts on “the Psychology of Human Misjudgment,” which is Charlie Munger’s description of dysfunctional decision making heuristics.  Munger writes:

“…tendencies are probably much more good than bad. Otherwise, they wouldn’t be there, working pretty well for man, given his condition and his limited brain capacity. So the tendencies can’t be simply washed out automatically, and shouldn’t be. Nevertheless, the psychological thought system described, when properly understood and used, enables the spread of wisdom and good conduct and facilitates the avoidance of disaster. Tendency is not always destiny, and knowing the tendencies and their antidotes can often help prevent trouble that would otherwise occur.”  Poor Charlie’s Almanack

Here is a personal example of potentially dysfunctional heuristics at work.  For a few months I had been having slight pain in my biceps near my elbows.  My doctor said it was probably an injury…

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Is Investing Art or Science?

November 8, 2011 Leave a comment

Watching climate change documentary, a scientist drew a bell shaped graph, indicating the 2 degree global temp increase problem.  It’s assumed that 2% would trigger massive changes, setting off carbon emissions from plants, oceans, and mountains which would in turn raise temps by 6 degrees.  That would essentially wipe out most life on earth.  So , in order to avoid this we have to stop the present course we’re on because if left unchecked, we will exceed 2 degrees by 2050.  In order to get it under control by 2050, we have to slow the rate of increase (acceleration) enough so that by 2015 the graph flattens out  (stops accelerating) and begins to turn down, with the 2 degree level reached in 2050.

 

This got me thinking about investing.  If we use the same bell shaped graph to represent our financial health, what would it look like?  I came up with MASOL or minimum acceptable standard of living.  This is the baseline, below which we would become homeless and start to question our very survival .  if we draw a curve that starts at the point where we enter the work force (or leave home, leave school, or whatever suitable starting point) and ends when we die, we can calculate the masol that will keep us from being homeless.

 

This assumes that we keep working until we die, and don’t accumulate any savings.  Next step would be to start accumulating savings and then we can create a retirement period at the end of the graph.  Next we can start to draw additional lines that would represent increases in our standard of living.

 

The informative part of this exercise is being able to visualize, like the climate change graph, what the ‘tipping point’ is – in terms of how far behind the curve we are, and how fast we have to go in order to catch up.  This is a key question for almost everybody, but almost nobody knows how to frame the question, let alone ask the question.  Smart people like Colleen and Peder simply have a vague, uneasy feeling of worry, uncertainty, and dread about what the future holds for their nest egg.  I can answer this by defining it, representing it graphically, and presenting alternative solutions.

 

In a way this process is like thinking of your financial state of being as driving a car through life, and what you need to know is how fast you’re going now, what gear you’re in, how many gears does the car have, what’s the top speed, and what impact on your standard of living will result from changes in speed and gearing.  The point of this exercise is to find out where you are likely to end up at the end of your life.  Is your current speed and gearing enough to allow you to retire at some future date and enjoy leisure in your sunset years?  Or are you destined to work until you die?

 

The core of this approach is to ‘back in’ to the calculations by starting with the conclusion.  The question is ‘what will my monthly income need be in the future such that I can live comfortably without working?’  For illustrative purposes, let’s assume this number is $5000 per month in today’s dollars.

 

The next question is ‘how much capital will I need to accumulate in order to generate enough income to cover $5,000 per month in living expenses?’  That will be the topic of my next post.

Who Are You?

“If you don’t know who you are, the stock market is an expensive place to find out.”

My first mentor in the investment business said this to me in 1972.  At the time, I didn’t really understand what he meant, but over the course of the next 10 years or so I began to figure it out.  Perhaps you have figured it out, too.  But for many investors, it’s a concept that remains elusive.

The significance of the above statement is that investing is a full-contact sport, and one that shouldn’t be played without a helmet, pads, and mouthguard.  Too many investors step onto the playing field unprepared for the shellacking that they’re about to receive at the hands of the professional traders, and other investors who have done their homework and know how to take advantage of the weaker players.

In most of life’s games, this “learning from your mistakes” approach is perfectly fine, since most of us navigate through life by trial and error.  But when it comes to the investing game, every rookie mistake you make costs you real money, and a lot of it.  Not only that, but the time you squander while getting your investment education is time you will never get back.  At ZenInvestor we have a better way get your investing education – one that won’t cost you a fortune in time and money.

The DIY (Do It Yourself) Investor

When corporations began to abandon the idea of providing a pension (defined benefit plan) to their loyal employees, and started transitionitioning to ‘defined contribution’ plans, they ushered in the era of the ‘do-it-yourself’ investor.  But there is a fundamental problem with this.  Most people are ill-equipped to make consistently sound investment decisions over the long term.  And it’s not because they lack the necessary intelligence.  It has more to do with the fact that our brains are set up to use estimation and rules-of-thumb to navigate through the complexities of the world.  Estimation is an extremely valuable skill, and it has served us well as a species in most aspects of life.  Using rules of thumb saves us time, and allows us to make quick decisions and then move on to the next problem.  This works well for most of the activities that we encounter, but when it comes to making investment decisions, it just doesn’t work very well.  Let me give you an example.

Poor Timing

One of the most common rules of thumb that investors use is extrapolation.  How do you decide which mutual fund to buy when it comes time to allocate your 401k contributions?  Most people look at the funds available in their plan, and pick the one or two that have done the best over the past 3 to 5 years.  This particular rule of thumb says that if a mutual fund manager has done well in the past, he or she must possess exceptional skill, and there’s no reason why they should not continue to perform well into the future.  But studies have clearly shown that past performance is not a good predictor of future returns.  In fact, most studies show that the longer a mutual fund manager beats the market, the more likely he or she is to underperform in the next one, two, and three years.  So basically, you are buying high, and when you get tired of the fund underperforming year after year, and you give up on it and sell, you have probably sold at or near the bottom.  Buy high, sell low.  Not an effective way to manage your investments.

Start With An Honest Self-Assessment

How did you do in the market last year?  How about the year before?  Did you sell stocks in 2008?  If you did, are you still on the sidelines, or did you get back in?  What’s your track record since you first started investing?  When you calculate your results, do you include everything on your statements – like contributions and withdrawals, fees and expenses, and accounts that are inactive or have been closed or moved?

Are you the kind of person who makes investment decisions in a rational, thoughtful way?  Or are you a gunslinger who depends on instinct to pull the trigger?  Do you like to pick individual stocks, or do you prefer mutual funds?  Do you know what your asset allocation breakdown is?  Do you monitor and rebalance your accounts regularly?

Do you look to others for your investment ideas, or do your own research?  How much time do you currently spend on your investments?  Do you enjoy the investing process, or would you rather spend less time on it?

What percent of your income are you currently saving?  How many years do you have until you will start tapping into your nest egg?  Do you have a number in mind for your final nest egg?  What percent of this final number do you already have saved?

How big is your investment account?  How much is taxable vs. tax-deferred?  What tax bracket are you in?  When you add up all your commissions, fees, and other investment expenses, what is your total cost as a % of your total assets?

These and many other questions get at the heart of who you are, from an investor perspective.  By knowing who you are, you can see where to focus your attention and energy as an investor. Once you have done a full, honest evaluation of who you are, you’re ready to take the next step – figuring out how much risk you’re taking, and how much return you should expect as  fair compensation for the risk you take.  Most investors can reduce their overall risk level (by a lot) and improve their results (also by a lot) by putting together a simple, clear plan and sticking to it through good times and bad.  If you would like to learn more about what’s involved in making your own plan, ask your financial professional.  If you don’t get a satisfactory answer, visit us at ZenInvestor.org and ask for our free planning guide.

A Top Economist Weighs In

September 18, 2011 Leave a comment

This post is taken from an interview conducted by NPR.  The economist who is featured here is one of the most trusted voices I listen to in my efforts to ‘take the temperature’ of the current economic conditions.  While he is not calling for an outright recession, his tone and demeanor in the interview clearly indicated, at least to me, that he is very concerned about the near-term future of the fragile global recovery.

Last year economist Lakshman Achuthan said he thought the United States had emerged from the depths of a recession, but today the picture looks a bit more grim. Unemployment is hovering above 9 percent and there were no new jobs created in August. On top of that, consumer confidence is at its second-lowest level of the year.

Lakshman Achuthan is managing director of the Economic Cycle Research Institute.

“We are skating on very thin ice,” Achuthan tells Guy Raz, host of weekends on All Things Considered.

Achuthan says the jury is still out on whether the U.S. will go into another recession, but he suspects that it will be clear one way or the other by the end of November.

Caution: Economy Slowing Ahead

Achuthan, co-founder and chief operations officer of the Economic Cycle Research Institute, says all of his economic indicators point to more sputtering ahead.

“The risk of a new recession is quite high,” he says.

If we do have a double-dip recession, Achuthan says, the people who are already having trouble finding work and paying bills are already in a depression and that they “are going to suffer more.”

“It poses massive problems for policymakers because a new recession automatically increases all of these expenditures out of the public sector, while at the same time dramatically decreasing all their revenue,” he says. “So there’s even less ability to help the people who are hurting the most.”

This Time Is Different

Some economists argue that right now we are just in a period of slow growth, not unlike that of the early 1980s. They say there are signs of a turnaround in the near future. Achuthan argues there is no evidence to support that point of view.

“This is very different than the early 1980s. The issues that ail the U.S. economy and the jobs market today are not things that result from nearby events. What we’re living through and dealing with now has been building for decades,” he says. “If you look at the data, you see that the pace of expansion has been stair-stepping down ever since the 1970s, on all counts — on production, how much can we produce, how many jobs can we create, how much money do we make, how much do we sell. These are all trending down.”

So, Achuthan says, “those who were expecting we should have a vigorous recovery had no right to do so.”

In fact, he says, it is likely that the U.S. will see more frequent recessions than it’s used to for the next five or 10 years.

“The best news I can give you is that cycles do turn, but there is going to be a lot of pain in between,” he says.

So what should an investor do in light of this downbeat assessment for the economy?  Remain vigilant, reduce risk where possible, but stay invested for the time being.  At ZenInvestor.org we recently made changes to our model portfolios which reflect the weakness of the economy.  We reduced equity exposure across the board, but we did not recommend wholesale liquidation to our subscribers.

For a detailed breakdown of our current thinking, visit http://www.zeninvestor.org and check out our model portfolios.