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Gambler’s Fallacy: A Behavioral Finance Concept.

We’re having our first intern join us for the summer – Ed Butterly a senior from University of Hartford. While he is assisting me in a lot of research, I have asked him to write for the blog every time he comes across something fascinating.  It was no surprise that he gravitated toward the growing field of behavioral finance.  This new field combines psychology with economics and is causing many experts to rethink economic concepts.  What follows is Ed’s take on one of many different behavioral concepts.

 

If you’ve ever been to the casino and played roulette you’d understand the concept of gamblers fallacy. Gambler’s fallacy is when an individual believes that a random event is less likely to happen following an event or series of events. For example, if you were playing roulette and the ball landed on a black number 10 times in a row, you might predict that the next spin will land on red. However, this is isn’t an accurate assumption. Prior sequence’s of events does not have an effect on future events. Each spin is independent and has the same probability of landing on either color every time. Relating to this, gamblers fallacy is in the subconscious of the average investor. Many people believe that if a stock or index is increasing for a long period of time its bound to come back down eventually.

The chart above shows the past 20 years of the S&P 500. After looking at the chart, the average investor might not want to invest into a fund that tracks the S&P 500 because it’s never been this high before and they believe it’s bound to come down eventually. According to Gamblers Fallacy, the number of consecutive years of growth shouldn’t attest to future growth down the line.

One solution to overcome our tendency to fall victim to gamblers fallacy is to use a method called Dollar Cost Averaging. In dollar cost averaging you buy the stock or fund at different periods of time no matter what the price is. Here is an example of Dollar cost averaging. In this scenario an investor is buying $1000 worth of WXY stock at the beginning of every month for the next 5 months. Here are the prices at the beginning of every month.

 

Month 1: $50   = 20 shares

Month 2: $40   = 25 shares

Month 3: $55   = 18 shares

Month 4: $47   = 21 shares

Month 5: $58   = 16 shares

 

Total shares = 100, Total Cost = $5000

Average Share cost = $50, Total value of shares currently = $5800

Dollar cost averaging may reduce the risk you are taking and may lower the average share cost over time. After five months you have 100 shares of WXY stock and have spent $5000. The 100 shares are worth $5800 meaning you have made $800 in profit just by using dollar cost averaging instead of succumbing to gamblers fallacy.

But it’s important to note: This method does not ensure a profit and does not protect against loss in a declining market, so investors should consider their willingness to continue purchases during a declining or fluctuating market.

How to Plan When You Don’t Know Your Goals

Defining one’s goals isn’t easy for some people. Trying to envision what your life will look like at some point in the future can be difficult.  There are so many emotional and financial variables and so many unknowns in life that it can leave you feeling stuck or in a holding pattern until you find clarity.  We know that because it is a relatively common issue that we run into with our clients and an issue we try to help resolve for them. Retirements, illness, or the death of a family member can be very disruptive.

We help clients find clarity by trying to quantify the financial impacts of their situation and model other scenarios they are considering.

To illustrate what we do, let’s consider a typical client situation.  A couple with two college-age children have come to us looking for guidance in planning for their future.  They have very good incomes and a vacation property, but there expenses are high and they have not saved as much as they should have in the past.

Here is our process to help get this client out of their holding pattern:

  1.  We model their current financial situation and extrapolate those results out through their retirement.  Every conceivable financial variable is used to model the current situation: income expenses, accounts, assets, social security, etc.  The result is some perspective on the likelihood of maintaining the current lifestyle assuming nothing changes.  The model is summarized in a simple graphic, an example of which is below.
  2. The graphic above is presented to the client. The big circled number at the top provides a probability of success for the client to reach their financial goals.  The calculation uses Monte Carlo Simulations to imagine sequence of returns risk.  Basically, the model runs 1000 simulations to imagine how rates of returns affect a client reaching his goals.  What happens if there is a big recession early in retirement?  What happens if there is a big recession later in retirement?  What happens if the markets are flat for several years?  These are all scenarios that are modeled and considered and shows that of the 1000 simulations, 77%  result in their goals being met:
  3. In the first example above, it shows that their annual savings of $27,500 is used to successfully fund college education for two children as evident by the two green bars.  But it comes at an expense -their retirement is not fully funded as seen by the yellow bar.  This is where the conversation begins.
  4. We can begin to model changes on the fly to see how certain changes will affect their future in retirement.  In this example, the client has been wondering if they should sell their vacation property and use the savings for retirement.  We can quickly quantify the long term impact of that decision:
  5. Then we can see how that change will affect the probability of success.  We can see below that by making this one change, we have increased the probability of success from 77% to 93%.
  6. Sometimes, this gives the client enough clarity to make a decision and move on.  But that’s not always the case.  After the client has thought about making a major decision (such as selling a vacation home), they may come back saying they can not actually sell their vacation property and need to consider other options.  Below is a comparison of their current situation compared to a scenario in which they delay retirement for two more years.  The result is almost the same as if they sold the vacation property.

After this exercise, the client has two viable options to consider to get them on track for retirement.  By seeing certain scenarios modeled, it can make possible decision more real to them and hopefully more achievable.  The illustration we provide help them make better decisions.

There are lots of emotional decisions that revolve around major life decisions, like retiring, changing jobs/careers, and moving.  We believe that by addressing the financial impacts of these decisions, we can affect the emotional considerations that may be holding our clients back.  Our goal is to provide that nudge to get them moving in the right direction and to keep them from making mistakes.

If you feel like you are stuck or need help laying a clear path forward, please reach out to us:

 

A $200,000 Mistake

In early 2016, the stock market experienced a 10% market correction in a matter of a few weeks.  It resulted in a few phone calls from clients wondering if they should move to cash.  One conversation with a recent retiree really stood out for me and I wanted to share an abbreviated version of it with my readers:

Client:  At the start of the year, I had $1 million invested in the market.  But now it’s February and I’ve lost $100k. We’ve got to stop these losses.  Please sell me out of everything and put me into cash.

Me: Would you consider staying the course a while longer?  As quickly as the market can decline, it can increase just as fast.

Client: Thank you, but I still want to move to cash.

Me: How about we sell 10% of the total value of the account?  That will cover your distributions for the next two to three years.

Client:  No thank you.  I want to be in cash now.

Me: Just one last idea – how about we move 50% of the account into cash?  That will cover your distributions for 10 years.  And in ten years, you can tap into your investments for your future distributions.

Client:  Look, I rode out the 2008 and 2009 recession and I don’t want to have to do it again.  I’d rather keep it in the bank and not have to worry about the stock market.

Me:  Ok, I’ll sell everything today.

 

There is a lot to process in this conversation.  First, the client called up believing they lost money.  Between the start of the year and the day the client called, the account had declined about 10%.  The sketch below shows how he visualized the loss.

From a behavioral finance perspective, the client anchored his thinking to the high point in their portfolio.  It became his frame of reference, his point of comparison. But if we looked backward and used a different reference point the story changes.  We would see that his account balance is right where it was 12 months earlier:

The idea of anchoring to a high point is a common issue that behavioral economists study.  We, as humans, sometimes make irrational decisions.  We make decisions that we believe to be based on objective facts, but are in reality detriments in how we try to solve problems.  I tried to reframe this particular client’s thinking a few different times but was unsuccessful.

Recently, I went back and reviewed this client’s portfolio to see how he would have done if he stayed the course.  As we know, the market ended up recovering and ended the year up about 10%!

The day the client called wanting to sell out of the market ended up being the very bottom of the market “correction”. For the rest of the year, the stock market recovered from its lows in February and then began to reach new highs by the end of the year.  Unfortunately, that client stayed in cash for the rest of the year.  It has resulted in a $200,000 mistake!

That red circle in the sketch above represents a behavior gap.  This is a well documented phenomenon in which investor decisions and behaviors are dragging down their portfolio performance (Morningstar). In this case, it could have been completely avoided or at least significantly minimized.  The quick reaction to move to cash will have a lasting impact on this client, but he probably won’t notice it until his cash balance is drawn down substantially.

This serves as an example for investors to stick to their plan and avoid making sudden and drastic changes to their investment strategy… and to listen to alternative suggestions from their advisor.

Why the Dow Jones Reaching 20,000 Is Not As Important As You May Think

The big headline the other day was news of the Dow Jones Industrial Average (DJIA) reaching 20,000 for the first time. It’s gathered headlines all over the world. I counted 13 articles in The Wall Street Journal about the Dow 20,000. Most of the mainstream media has been quick to jump on what this means for investors, the market, and the future. And some of that thinking is flawed. This post will focus on putting this milestone in perspective for you and, more importantly, what it means for your investments.

The Dow Jones Industrial Average is probably the most iconic index. When someone says the market is up 150 points, they are referring to the DJIA. It has a long track record – about 130 years! So on the surface this milestone is impressive. It took the Dow over 100 years to reach 10,000. It took 18 years for it to reach 20,000. But it took only 42 days to go from 19,000 to 20,000. That’s the second fastest thousand point gain in history. So what does that mean for you? To answer that, we need to pull pack the curtain to understand what is the Dow Jones Industrial Average:

  • It is an index consisting of 30 companies. That’s a very small representation of the overall market and can completely misrepresent how the whole market is doing in reality.
  • The Dow Jones is 100% US stocks which represent a single asset class. On top of that, it skews heavily toward large-cap industrial companies. This may have been valuable 130 years ago when the index was first created, but the economy has changed drastically since this index was first created. No longer are industrial companies an accurate representation of the overall market like they once were.
  • A company is included in the DJIA because it was selected by a committee of the Wall Street Journal. They actively decide which companies should be included and which should be removed.
  • The common methodology to determine the weighting of each company is very unusual. Most modern indexes are weighted based on the market capitalization – the bigger the company, the larger representation it holds in the index. The DJIA weights the company based on the share price of each stock. The larger the price per share, the larger the weight in the index. That puts Goldman Sachs as the largest holding at about 8% and GE at the second lowest (about 1%). This reason for this methodology dates back to a time before computers when a simple methodology was needed.
  • Here is a technical issue – the DJIA was prone to inaccurate calculations before computers were used to track the index. In going back to the very beginning and correcting all the mistakes, the DJIA passed 30,000 last month.
  • While you can’t invest directly in indexes, you can invest in indexes the mimic and replicate the performance of the underlying index. When you total the dollar amount that tracks the DJIA, it adds up to about $36 billion. To put that in perspective – over $2 trillion track some version of the S&P 500!

As you can see, this is a deeply flawed and outdated index. It serves very little use for most investors because of these flaws. It is not a good gauge of the overall health of the market or the economy. It barely does a good job of capturing the health of industrial segment of our economy in the US. It should never compared to a broad, diversified investment portfolio. So the Dow reaching 20,000 is a big story about an out-of-date index.

Critiquing a Financial Plan

The following article examines five young people and their financial plan (more like their lack of planning).  They are then offered some preliminary advice about how to improve their situation.  Unfortunately, in every case I found the advice to be overly simplified.  Here’s the article

And here are some overarching strategies that apply to all the case studies:

1)      Emergency fund.  Start here first and make it a priority to build an emergency fund that can cover non-discretionary expenses for 3-6 months.

2)      Save more.  If you can’t save more now, earmark any future raise toward saving.  When asked about a rule of thumb for how much to save, I’ll often respond with “Save as much as you can”.  Young people and millennials are unlikely to have pensions and with the questionable future of Social Security, the burden to save is placed on their shoulders much more than previous generations.

3)      Automate.  Make sure any savings are set to occur automatically.  The mental anguish of writing a check every month or year to a retirement account can be surprisingly difficult.  Many times it is our own biases that create obstacles to reaching our own goal and simple processes like automating our savings can have a huge impact.

4)      Disability.  Life insurance is commonly discussed when a couple has children.  But disability insurance is rarely brought up.  What’s odd is that people are more likely to file a claim for disability insurance than life insurance.  And it doesn’t apply just to physical injuries, either.  We’ve had several clients and prospects tell us about their long term disability that affects their ability to do a desk job as a result of a bad car crash.

 

The Best Stocks To Invest In Right Now

How many times have you seen that headline? How many times did it spur you to read an article and even take action? Well respected publications are famous for putting together these kinds of lists. The odd part is that every month, week, or even day that list changes. This morning I saw headlines like these “ The Best Value Plays of 2017”, “These Stocks are Poised to Grow”, “These Stocks Will Surge With Trump”.

This is part of the Fake News problem we’re dealing with. Editors and journalists know that those headlines are going to generate the clicks and your attention. They want your attention long enough for you to see the ads and don’t care at all if those investment ideas are good.

Publications and the media are in the business of selling ad space. Any recommendations should be taken with a grain salt.