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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.

Why most investors under-perform the market

October 28, 2010 Leave a comment

According to the most recent study from independent consultant Dalbar, Inc. the average investor earns slightly more than 3% per year on the money they have invested in the stock market.  To put it bluntly, that’s awful.  Especially when you stop to consider that the market return is about 8.5% per year.  It begs the question, why does the average investor do so much worse than the stock market as a whole?

The answer lies in the fact that investors do a very poor job of timing when they get into and out of the stock market.  Typically, investors buy stocks and mutual funds through their company retirement plan, and as long as the economy and the stock market are chugging along, they’re happy.  During these long periods of stability, the stock market usually produces annual gains of around 10%, and the average investor participates in all of those gains by staying invested and adding a little more each month.  But inevitably things start to deteriorate when the economy starts to slip.

As the economy slows, which is as natural as the ebb and flow of the ocean tides, the stock market starts to go down.  The decline is usually slow at first, but it tends to accelerate as more evidence piles up about the weakening economy.  At the worst possible time, when the stock market has declined by 10%… 20%… or more, the average investor finally reaches his or her limit of pain and decides to do something about it.  It’s at that point where they sell their stocks and sit on the sidelines… determined to wait until things  get better.

As it turns out, this is exactly the worst possible way to manage your investments.  By waiting for the stock market to be down so much that you just can’t take any more pain, you’re probably selling at or near the bottom of the stock market cycle.  But wait… it gets worse.

After selling their stocks near the bottom of the market cycle, the average investor now faces the next challenge… when to get back in.  What happens next is that the economy begins to recover, and the stock market begins to rise again, but the investor is still upset about all the money he lost in the decline.  So he waits to see if the market miight go down again before he gets back in.  But of course, the market does not cooperate with this strategy, and it instead plows ahead to make new high prices.

Finally, in total frustration and regret, our investor throws in the towel and gets back into the market.  But because he waited so long, he has to pay a much higher price to buy back his stocks, than he got for them when he sold them near the bottom of the cycle.  So he’s now completed the process of selling low, and buying high.  That’s exactly the opposite of what he should have done.  And that’s why he only earns about 3% per year instead of 8.5% that the market is offering.

So how can you avoid falling into this vicious cycle?  By hiring a reputable investing coach and learning how to manage your investments proactively, rather than reacting to the pain of losing money all the time.  A good coach can tell you the signs to look for that will tip you off that there is trouble ahead, and what you can do about it.  A coach can keep you from shooting yourself in the foot by selling low and buying high.  A good coach is worth his weight in gold.