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Why Your Instincts Are Hurting Your Investment Returns?

Imagine your reading this post in a busy coffee shop. All of a sudden you look up and see people running out of the shop. What do you do first? Chances are, you get up and follow everyone else. You might not even know what’s going on at first. Are you getting away from a dangerous situation, such as a fire in the coffee shop? Or is everyone running toward something or someone, such as a celebrity?

This is an instinctual reaction. There is perceived safety in numbers. It goes back to some of the earliest known ancestors and can be seen in many animal species today.

If we dig into this a little deeper, it’s actually a mental short-cut (technically called a “heuristic”) . In the coffee shop example, you didn’t have time to take stock of the situation to understand what’s occurring. Instead, you relied on actions of others and assumed they were making the right decision. It worked well for our ancestors and it continues to work well for us today. Except….

Except for when it comes to investing. Assume you’re watching the news and all everyone is talking about how XVZ stock is doing “great” and “everyone” is buying it. Unfortunately, the average investor will want to get in on it. They follow the hearding behavior of others and buy XYZ simply because “everyone” else is doing it.

That’s precisely the wrong time to be buying a stock, yet it’s so difficult to overcome this instinctual response. This is even more difficult when stock prices are declining and investors hear about so many people selling out of their investments. The instinctual response to follow the crowd kicks in. The investor will feel better and maybe safer knowing they are doing what everyone else is doing. But evidence clearly shows it to be a poor decision to follow the heard of other investors.

This is an example of our instincts working against us. Instead of reacting to the news, take a minute to take stock of the situation, assess what is going on, consult with your financial advisor, and understand how your decision to buy or sell an investment will affect your likelihood of reaching your financial goal.

Comparing Chess To The Stock Market And The Election

The average chess player can see 1-3 moves ahead in a game of chess. But a grandmaster chess player can see 10 moves ahead and sometimes up to 20. More interestingly, when they look at the board they see shapes and patterns not number of moves.

Playing chess is like connecting the dots between the stock market and the election. The media, think tanks, special interest groups and the talking heads are focused on the implications of the election on the stock market and the economy. If Trump is elected, the pundits are predicting one outcome and comparing it to the hypothetical outcome if Clinton wins.

They try to paint a very clear, logical picture of the how one policy will help America and the economy. But the oversimplification does not properly consider the hundreds or thousands of variables that affect the economy or stock market. While these experts try to account for as many variables as possible, it’s simply impossible for them to do so with any sense of reliability or accuracy.

These supposed experts see one set of moves and believe that’s how it will play out. If they were playing chess, they would be an amateur chess player who could only see the logical progression of their agenda if their opponent performed exactly as expected. And when their opponent did something unexpected (which usually happens), their plan would be thrown out the window.

When it comes to listening to these experts talk about the effects of the stock market as a result of the election, keep in mind that there are thousands of variables that will affect the stock market. In fact, there is a lot of research that suggests the election has no effect on the stock market in the long term.

The Election, Your Investments and Why The Experts Get It Wrong

It didn’t take long for someone to make a connection between Clinton’s health scare on Sunday and the stock market.

How Hillary Clinton’s Health Scare Threatens The Markets

The premise is that the markets have always expected Clinton to win the presidency, but with a possible health issue it could hurt her chances.  It leaves the door open for Trump to win and the markets will become volatile.

The article goes on to suggest that certain industries and asset classes will do better (or worse) with Trump. For example, Trump has suggested the creation of a wall along the border of Mexico which will require construction crews and new infrastructure.  The journalists suggests that investors reevaluate their portfolio now.

On the surface, the story seems reasonable:  There is a new problem (Clinton may not sail into the White House), there is an alternative result (Trump wins the election), and there are implications of that result (The stock market could be affected).  The logic seems reasonable – It presents a clear and simple narrative.

In reality, the logic is broken.  It oversimplifies all of the concepts in politics and economics.  It does not take into consideration of all the nuances and complexities that exist in our world. Drawing a connection between Clinton’s health and your investments is a real stretch.

So why are articles like this so common? It deals in part with our desire to understand implications.  We think of issues in terms of “cause and effect” just as the article illustrates.  Our brains are wired to think in these terms because it creates a simple narrative for us to remember. But the sort of analysis needed requires thinking in terms of correlation and probabilities.  These are complicated forms of analysis and their results are not specific and concreate in a way that the average investor would find useful. It’s completely contrary to the “cause and effect” approach.

 

Why Your Instincts Are Hurting Your Investment Returns?

Imagine you’re reading this post in a busy coffee shop.  All of a sudden you look up and see people running out of the shop.  What do you do first? Chances are, you get up and follow everyone else.  You might not even know what’s going on at first.  Are you getting away from a dangerous situation, such as a fire in the coffee shop?  Or is everyone running toward something or someone, such as a celebrity?

This is an instinctual reaction.  There is a perception of safety in numbers.  It goes back to some of our earliest known ancestors and can be seen in many animal species today.

If we dig into this a little deeper, it’s actually a mental short-cut (technically called a “heuristic”) .  In the coffee shop example, you didn’t have time to take stock of the situation to understand what’s occurring.  Instead, you relied on actions of others and assumed they were making the right decision.  It worked well for our ancestors and it continues to work well for us today.  Except….

Except for when it comes to investing.  Assume you’re watching the news and all everyone is talking about is how XVZ stock is doing great and how everyone is buying it.  Unfortunately, the average investor will want to get in on it, too.  They follow the hearding behavior of others and buy XYZ simply because everyone else is doing it.

That’s precisely the wrong time to be buying a stock, yet it’s so difficult to overcome this instinctual response.  This is even more difficult when stock prices are declining and investors hear about so many people selling out of their investments.  The instinctual response to follow the crowd kicks in.  The investor thinks they will feel better and maybe safer knowing they are doing what everyone else is doing.  But evidence clearly shows it to be a poor decision to follow the heard of other investors.

This is an example of our instincts working against us. Instead of reacting to the news, take a minute to take stock of the situation, assess what is going on, consult with your financial advisor, and understand how your decision to buy or sell an investment will affect your likelihood of reaching your financial goal.

The Secret to Growing Your Retirement Account

Stay the course. That’s the secret.

The pain we experience when we see the account balance drop is much greater than the joy we feel when we see the account balance increase by the same amount. Imagine you have a retirement account with $500,000 in it and it declines by 20% to the end the month at $400,000. That can be scary – you’ll most likely question your allocation and investments. Unfortunately and in too many cases that is exactly what investors do: The sell out of their losers and buy something inappropriate for themselves.

There are still many investors that are still sitting in cash after selling out of the stock market during the worst moments of the recession of 2008.

Fidelity has some data that backs up this statistic

How To Retire in 4 Years

The story about a couple’s desire to retire in 4 year is compelling.

They have applied many of the important financial planning concepts:

1) The plan to live a very modest lifestyle in retirement – They plan to need 30,000 a year in retirement.
2) They have cut and reduced many of their expenses. They realized how freeing it is to not have a large mortgage.
3) They plan to work part time. Retirement is being redefined. Working part-time, doing a fun job, is becoming common.
4) They have a plan. While I have not checked their math, it’s appears they have thought through many of the common issues retirees face.
5) They are diversified. Between side jobs, investments, and real estate they will have multiple sources of income available for them.

Making A Plan To Save For College

Recently we introduced The Money Management Tool to help clients better organize their financial lives. The tool has lots of features and we will occasional explain how some of the features are being used by our clients (or should be used) to help them reach their financial goals.

This post will deal with a client who is trying to save for college.

Situation: A client recently had a child and wanted to start saving for her college education. He is a hands-on client who likes to dig into the numbers himself and run multiple scenarios. His concern was: “If I fund my child’s education, how will it impact my retirement plans?”

Problem: He didn’t have a framework to think through the various scenarios.  All the calculators he found online were too simple and lacking the detail he needed.

Solution: The Money Management Tool provides a suite of workshops to help people just like my client. There is a specific workshop to help clients plan for college. He was able quickly enter his assumptions to see what the outcome would be for him.  From there, it offered some options to help him reach his goal.  Once he was satisfied with his plan, he was able to pull me into the process to make sure it made sense.

College

Tracking Your Asset Allocation Across Multiple Accounts

Recently we introduced The Money Management Tool to help clients better organize their financial lives. The tool has lots of features and we will occasional explain how some of the features are being used by our clients (or should be used) to help them reach their financial goals.

This post will deal with a prospective client who has many accounts and struggles to keep track of how they are invested.

Situation: A prospective client couple approached us looking for help managing his investments. They had multiple investment accounts held at different institutions. And in most cases, the accounts could not be moved or consolidated.

Problem: They struggled to understand what they really owned. They thought they were diversified by owning several different funds, but in reality they owned many passive index funds that tracked the same index. Even though the fund names were different, the underlying investments were all very similar.

Solution: The Money Management Tool could be used to connect all the accounts together. After establishing the connections between the tool and their accounts, they would be able to see a total asset allocation across all their account. We were then able to work with them to adjust their allocation.

asset allocation

Is a Creative Saving Strategy Right for Me?

Someone can reach an ambitious financial goal (such as saving for college education) despite having limited cash flow available to fund the goal.  The goal can be accomplished by using a creative saving strategy called a serial payment.

Many clients that I have worked with this year have expressed a strong desire to fund a majority of their children’s college education but currently have limited resources to commit to it today.  Instead, they have promising careers in which they expect decent raises in the future or expect their spouse to re-enter the workforce once the children are in school.  They have already tightened their belt and understand that a portion of future raises will be diverted to their future goals.  This strategy gives them a roadmap for the future.

For more details, read these other posts to learn about the process.

The Most Overlooked Saving Strategy: The Serial Payment

In a recent post, I argued that there is a flaw in the most common approach saving for a big goal like college education.

I argue that in some cases, saving for a goal should be done the way you would if you were to begin training for a road race. If you begin to exercise today and have a goal of running in a marathon twelve months from now, you won’t just start running 26.2 miles per day.  You’ll burn out or get injured.

Instead, you are more likely to come up with a plan where you gradually and systematically increase the difficulty of your exercise regimen over time.  By gradually increasing the workout,  you mentally condition yourself and can prepare for longer, harder, and more difficult exercise routines in preparation for the race.

While we mostly think about saving a set dollar amount per month, that may not be realistic or possible for many people who have limited cash flow. Saving for a goal could be done the same way by using a saving strategy referred to as the serial payment. Here is what makes this strategy different – the amount saved increases by a set percentage each and every year.  For example someone who saves $150 a month for one year, would increase it by a set percentage (we’ll say 4%) each and every year.  In year 2, they would be saving $156/mo ($150 * 1.04).  In year 3, they would be saving $162 ($156 * 1.04).

Let’s compare these two strategies.  Assume that John and Andrew each want to save $90,000 for college education in 18 years.  They plan to save a portion of their paycheck and will invest it in the market where they are expecting an 8% rate of return.  John plans to invest $2400 at the end of every year and will do so for 18 years.  Andrew will fund $1,825 at the end of the year but will increase the amount by 4% per year thereafter.

The result: they both reach their goal of $90,000 by the end of the 18th year.   Below is the breakdown of how much each of them has to save each year:

saving

Andrew is able to begin saving a lot less early on but will have to make up for it from the 9th year and on.  By then he will likely be in the peak earning years of his career and will have more cash available to fund the goal.

This strategy does have some drawbacks.  Making less contributions in the early years reduces the effectiveness of compounding interest which means that Andrew would have to save an extra $3500 more than John over the 18 years.  And that figure would be much larger if we adjusted for inflation.

If you are exploring ways to save for a goal, run the numbers assuming a flat/fixed amount first.  Saving more earlier is almost always preferable thanks to compounding interest.  But it may not be possible.  If you can’t afford that, try using a serial payment strategy.