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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 Short Primer On Risk

Understanding Risk Is Important

Risk is one of the most difficult concepts for amateur investors to master (I use amateur not in a pejorative sense, but as compared to professional investors.)  Part of the reason for this is that investment risk is often counter-intuitive.  Take treasury bonds for example.  Treasury bonds are often described as “riskless” investments.  The theory is that the U.S. government is unlikely to default on its obligation to bondholders, and therefore your money is always safe in treasury bonds because they’re backed by the full faith and credit of the USA.  This statement is true, but it doesn’t necessarily follow that investing in treasury bonds is free from risk.  Treasury bonds trade on the open market, and the prices of treasury bonds fluctuate, just as the prices of stocks fluctuate.  If you invest in treasury bonds at a time when interest rates are historically low, you are in fact exposing yourself to above-average risk.

Bond lovers will counter with the argument that if you hold your treasury bond until it matures, you are guaranteed to receive 100% of the face value of the bond, and therefore they are truly riskless.  My answer to this argument is that very few investors actually buy treasury bonds with the intention of holding them to maturity.  Most investors sell their bonds before they mature, and this exposes them to the risk of selling them for less than their purchase price.  The point is that all investments, including so-called ‘riskless’ treasury bonds, have risk.  You simply can’t escape the fact that nobody can predict with absolute certainty what an investment will be worth when it comes time to sell.

How Much Risk Are You Taking?

Many investors use what I call an Ad Hoc Stock Picking approach.  What I mean by this is that they wait until they ‘feel good’ about their economic circumstances, and then they start picking stocks based on a combination of tips, recommendations, and hunches from all kinds of sources.  It’s called Ad Hoc because there is no unifying theme or context for their choices.  They end up with a collection of stocks that may or may not be appropriate for their circumstances.  And by not considering the prospects for growth in the economy, they risk being too heavily concentrated in stocks at the wrong time.  We advocate a balanced approach to stock picking, which dramatically reduces overall risk while not sacrificing the fun and excitement of ‘playing’ the stockmarket.

Types of Risk

There are two main types of investment risk.  The first is the risk that the market price of the investment will decline and the investor will take a loss at the time of the sale.  The second type of risk is the loss of purchasing power.  Inflation averages about 4% per year over the long term.  If your investment produces a rate of return that is less than the inflation rate, which is often the case with ‘safe’ investments like treasury bonds, then you will find yourself in a situation where you made a profit on your investment but lost purchasing  power.  Would you be satisfied with that outcome?

The Answer

In order to manage these dual risks – price risk and purchasing power risk – an investor has to create an investment portfolio that includes components that will provide some protection against both market downturns and inflation surges.  The only way to do this is with a balanced approach that includes many different types of assets, like stocks, bonds, real estate, gold, hedge funds, private equity, volatility, and others.  The more asset classes you have in your portfolio, the less overall risk you take.  Risk is not a bad thing.  In fact, it’s because of risk that investors are rewarded with returns that are higher than the rate of inflation.  If you have a well-diversified portfolio, you should be seeking risk, not running from it.  Risk is the source of superior investment returns.  But risk must be properly understood, and managed.  Ad Hoc investing ignores this calculation of risk, and because of this, returns are usually disappointing.

The Truth Is Out There

The Seven Noble Truths Of Investing

1. Knowing who you are (as an investor) is important.  If you don’t know who you are, the stock market is an expensive place to find out.  The smart way to go about investing is to first figure out who you are, and then come up with a plan that fits you.  For example, some investors are hyper-sensitive to market declines.  But other investors have a long-term perspective about the market and don’t get upset when it goes down.  If you’re hyper-sensitive to declines, you might sell your stocks too quickly, when the correct strategy might be to hold on, or even add to your holdings.

2. Taking the time to sit down and write an investment plan is the single most important thing you will ever do as an investor.  The second most important thing is reviewing your plan regularly, and making the adjustments that are necessary.

3. Having the right balance in your portfolio is much more important to your long term success than picking good stocks.  Balance accounts for 95% of your results, while stock selection accounts for just 5%.

4. The most powerful force in finance is tax-deferred compounding.  The second most  powerful force is time itself.  Unless you are maximizing both of these concepts, you are giving money away and you will never get it back.

5. If your personal wealth is growing at less than 10% per year, you have a problem with your investment plan.  The biggest causes of leakage are costs and panic selling.  Both of these should be addressed in your written plan.

6. The source of your advice is just as important as the advice itself.  This is because most investment professionals have financial incentives to steer you in a particular direction – the one where they make the most money.  This isn’t illegal, or even immoral.  It’s just the way the business works.  It’s important to develop advice and information sources that are truly independent, and therefore are free to speak the truth.

7. Amateur investors think in terms of what’s possible.  Professional investors think in terms of what’s probable.  It’s possible that you will find the next Microsoft and become fabulously wealthy, but it’s not probable.  It’s both possible and probable that you can grow your personal wealth at a steady 10% annual rate if you stick to a well-written investment plan.

To learn more about these truths, or for help with your investment plan, visit my website at www.zeninvestor.org