What a Nobel Prize Winner tells us about Investor Behavior

University of Chicago’s  Richard H. Thaler, one of the founders of behavioral finance, was awarded the 2017 Nobel Prize in Economics for shedding light on how human weaknesses such as a lack of rationality and self-control can ultimately affect markets.

People who are not financial experts frequently turn to investment advisors to manage their portfolios.     But many smart people use advisors to overcome very common psychological obstacles to financial success.

The 72-year-old “has incorporated psychologically realistic assumptions into analyses of economic decision-making,” the Royal Swedish Academy of Sciences said in a statement on Monday.

“By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes,” it said.

Thaler developed the theory of “mental accounting,” explaining how people make financial decisions by creating separate accounts in their minds, focusing on the narrow impact rather than the overall effect.

….

He shed light on how people succumb to short-term temptations, which is why many people fail to plan and save for old age.

 

It does not take a Nobel Prize to understand that people often make decisions based on emotion.  We do it all the time.  We judge people based on first impressions.  We buy things not because we need them but because of how they make us feel.  We go along with the crowd because we seek the approval of the people around us.  When markets rise we persuade ourselves to take risks we should not take.  When markets decline and our investments go down we allow fear to overcome our judgment and we sell out, afraid that we’ll lose all of our money.

Professional investment managers have systems in place that allow them to overcome the emotional barriers to successful investing.  It begins by creating portfolios that are appropriate for their clients.  Then, in times of stress, they use their discipline and stick to their models, often selling what others are buying or buying what others are selling.  This is the secret to the old Wall Street adage that the way to make money is to “buy low and sell high.”  By taking emotion out of investment decisions professional managers take a lot of the risk out of investing.

Once you sell out, when do you get back in?

I recently heard about a 62-year-old who was scared out of the market following the dot.com crash in 2000.  For the last 17 years his money has been in cash and CDs, earning a fraction of one percent.  Now, with the market reaching record highs, he wants to know if this is the right time to get back in.  Should he invest now or is it too late?

Here is what one advisor told him:

My first piece of advice to you is to fundamentally think about investing differently. Right now, it appears to me that you think of investing in terms of what you experience over a short period of time, say a few years. But investing is not about what returns we can generate in one, three, or even 10 years. It’s about what results we generate over 20+ years. What happens to your money within that 20-year period is sometimes exalting and sometimes downright scary. But frankly, that’s what investing is.

Real investing is about the long term, anything else is speculating.   If we constantly try to buy when the market is going up and going to cash when it goes down we playing a loser’s game.  It’s the classic mistake that people make.  It’s the reason that the average investor in a mutual fund does not get the same return as the fund does.   It leads to buying high and selling low.  No one can time the market consistently.  The only way to win is to stay the course.

But staying the course is psychologically difficult.  Emotions take over when we see our investments decline in value.  To avoid having our emotions control our actions we need a well-thought-out plan.   Knowing from the start that we can’t predict the short-term future, we need to know how much risk we are willing to take and stick to it.  Amateur investors generally lack the tools to do this properly.  This is where the real value is in working with a professional investment manager.

The most successful investors, in my view, are the ones who determine to establish a long-term plan and stick to it, through good times and bad. That means enduring down cycles like the dot com bust and the 2008 financial crisis, where you can sometimes see your portfolio decline.  But, it also means being invested during the recoveries, which have occurred in every instance! It means participating in the over 250%+ gains the S&P 500 has experience since the end of the financial crisis in March 2009.  

The answer to the question raised by the person who has been in cash since 2000 is to meet with a Registered Investment Advisor (RIA).  This is a fiduciary who is obligated to will evaluate his situation, his needs, his goals and his risk tolerance.  And RIA is someone who can prepare a financial plan that the client can agree to; one that he can follow into retirement and beyond.  By taking this step the investor will remove his emotions, fears and gut instincts from interfering with his financial future.

What Makes Women’s Planning Needs Different?

While both men and women face challenges when it comes to planning for retirement, women often face greater obstacles.

Women, on average, live longer than men.  However, women’s average earnings are lower than men, according to a recent article in “Investment News,”  in part because of time taken off to raise children.  What this means is that on average, women tend to receive 42% less retirement income from Social Security and savings than men.

The combination of longer lives and lower expected retirement income means that women have a greater need for creative financial advice and planning.  The problem is finding the right advisor, one who understands the special needs and challenges women face.

A majority of women who participated in a recent study said they prefer a financial advisor who coordinates services with their other service professionals, such as accountants and attorneys.  They want explanations and guidance on employee benefits and social security claiming strategies.  They want advisors who take time to educate them on their options and why certain ones make more sense.  Yet many advisors do not offer these services.

Men tend to focus on investment returns and talk about beating an index.  Women tend to focus more on quality of life issues and experiences, on children and grandchildren, on meeting their goals without taking undue risk.

If your financial advisor doesn’t understand you and what’s important to you, it’s time you look for someone who does.

How to lose $150 million

We have written a lot about planning and investing.  But there’s nothing quite as instructive as learning from mistakes.  Learning from others’ mistakes is less painful than making our own mistakes.

This sets up an example of financial mistakes I learned about recently.

Sometimes the most surreal things happen. For example, anyone who remembers the 1980s’ tennis prodigy Boris Becker may be shocked to learn that last month, in a London courtroom, Becker was declared bankrupt.

After winning Wimbledon and countless other tournaments, Becker’s personal fortune was estimated to have reached $150 million. So how could this have happened? How could he have gone from $150 million to zero, and what can we learn from it?

Sports figures often find that they have developed “posses,” hangers-on who encourage extravagant lifestyles.  Fame and fortune at an early age lead to a number of personal mistakes.  These are often combined with poor investment decisions.  In the case of Becker they include things like Nigerian oil companies, and “… a sports website, an organic food business, and more notably, a planned 19-story high-rise in Dubai called the Boris Becker Business Tower, whose backers went bust in 2011.”

This is a special problem for people who become wealthy in sports and entertainment.  Too often they turn their financial lives over to agents who get them involved in complicated schemes that go sour.

The key to gaining wealth and – most especially – for keeping it is: keep it simple.  During 30 plus years of investing the biggest mistakes I have seen made is people getting involved in complex deals, partnerships, and relationships that they don’t really understand.

We provide education for our clients on investment strategy and develop portfolios that allow people to keep what they have earned.  Don’t be like Boris Becker.

Why do smart people use financial advisors?

What is the real value to hiring a financial advisor, and who uses them?  What is the value proposition?  What makes one car with four doors and wheels worth $300,000 and other $30,000?  Although we might have an answer, the answer differs from person to person.

People use financial advisors for many reasons.  Some use them because they absolutely need them, others because they want them. Paying a fee for advice and guidance to a professional who uses the tools and tactics of a CFP™ (CERTIFIED FINANCIAL PLANNER™) and an experienced Registered Investment Advisor who is a fiduciary can add meaningful value compared to what the average investor experiences.

Many middle-class investors are anxious about their finances and are not interested in learning the details of managing their money.  This anxiety often results with money left on the sidelines because they don’t know what to do or are afraid of making mistakes. That means earning a fraction of 1% at the bank when the Dow Jones Industrial Average (DJIA) is up over 25% in the last 12 months.

There are others who are interested in learning about investing and may want to hire an advisor to “look over their shoulder.”  They want to hire an “investment coach.”

A third category are people who hire professionals because they are busy doing things that are more important to them: building a career or a business, being with family, or living an active retirement.  They hire an expert to manage their money the same way they hire a lawyer for estate planning, a CPA to prepare their taxes, and a doctor to keep them healthy.

A fourth category is people who were making their own investment decisions but ended up making a huge financial mistake.  This leads me to a story about a really smart, highly paid high tech executive who is very knowledgeable about investing; but he hired an advisor:

It’s not because he lacks the knowledge or interest, obviously. Rather, he figured out he had behavioral blind spots and understood he was at risk of great financial loss. He’s paying someone just to take that risk off his plate.

Determining your goals, controlling risk, managing portfolios well, and knowing your limitations – knowing you have “blind spots” – has led many smart people to hire an advisor.

Vanguard, the hugely successful purveyor or no-load mutual funds (that appeal to do-it-yourselfers) estimates that a financial advisor is worth about 3% net in annual returns.  They attribute this to the seven services that a good advisor provides:

1. Creating a suitable asset allocation strategy.
2. Cost-effective implementation.
3. Rebalancing
4. Behavioral coaching
5. Asset location
6. Spending strategy.
7. Total return versus income investing.

If you have an advisor but he is not meeting your objectives, ask us for a second opinion.  If you don’t have an advisor but may want one, we offer a free one-hour consultation to see if we are compatible.

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A good Registered Investment Advisor is a “Life Coach.”

People who are not familiar with Registered Investment Advisors (RIAs) too often view them as stock brokers.  They are not; they are held to a higher standard and are focused on the client, not the money.  RIAs are trusted advisors who put their clients ahead of themselves.    They are fiduciaries that are skilled in the art making good financial decisions.

Younger professionals who are building careers would do well to find an RIA as their financial guru, a “Life Coach.”  It takes time, experience and a high level of expertise to manage money well.  The young lack that expertise but have the biggest advantage of all: time.  They are in a perfect position to build wealth with the least amount of effort if they can lean on experts who can show them how to navigate the risky ocean of investing.  Just as important, they need a wise guide who can advise them on managing their income.  Too many people, even those with six figure salaries, live paycheck to paycheck.  Knowing what to spend and how to save is the role of the advisor.

This is very important for the independent professional – the doctor or lawyer.  Focused on building a practice, they need someone to advise them on managing their money wisely.

For the business owner, the entrepreneur, it’s even more important.  There is no career track and the challenge of building a business often results in poor money management.  Excessive debt can lead to bankruptcy, a common result in many industries that depend on debt financing.  A good advisor can help the business owner create a personal portfolio that’s independent of his business.  At the same time he can advise the owner the best way of financing his growth.

Once the business is established the owner needs guidance setting up retirement and benefit plans for himself and his employees.  This all part of the RIA’s skill set. And finally, as the business matures and the owner starts thinking of retirement, the advisor provides the guidance to transition the individual and his family to life beyond work.

That’s the point at which the coach gets the pleasure of knowing he’s done a good job as part of a winning team.

Dow Breaks the 20,000 level

The Dow Jones Industrial Average reached another milestone today.  The Dow broke through 20,000 as traders cheered.

For a little perspective here’s how the market reached past milestones.

A few points to remember.  There have been long periods when the Dow treated investors like riders on a roller coaster:  lots of swoops and slides only to end up where you began.  During those periods people made money with astute stock selection, not by buying “Mr. Market.”  We believe that those times will come again.

• It took from 1929 to 1954 for the Dow to regain its previous high.
• It took ten years – from 1972 to 1982 – for the market to break through the 1,000 level.

Keep in mind that the 1,000 point move in the Dow at the current level is just a little over 5% and is therefore not nearly as meaningful as a move from 1,000 to 2,000, a move of 100%.  But it’s still an important psychological barrier that had to be broken for the market to move higher.

The move makes sense from both a technical and fundamental standpoint.  Both retail and institutional investors are positive, as we have noted in the past.

The incoming Trump administration has moved with amazing speed to demonstrate their desire to increase the level of economic growth as a way of increasing job and wage growth.  They have expressed policy preferences for lower taxes, reducing regulations that stifle business development, and have been encouraging companies to build their businesses in the United States rather than overseas.

The trend is clear.  The only thing that could derail this train is a massive change in consumer sentiment or an external factor such as a war or other calamity.  The latter are known as “Black Swan” events and we must always keep in mind that they can occur.  We manage our portfolios with those possibilities in mind.

Eventually, valuations will get too high and the inevitable correction will occur.  In the meantime, we enjoy the ride while keeping a close eye on events.

The Financial Planner as a Healer

[This is the most popular post we have published; it’s worth posting again]

Money is a significant source of stress for most people.  In many studies, it ranks above issues such as work, children and family.  Chronic financial stress is often the leading cause of family break-ups.

Chronic stress is also associated with all sorts of health problems, psychological problems, marriage conflicts and behavior issues such as smoking, excessive drinking, depression and overeating.

Men and women under stress have often relied on medical and mental health professionals.  However, financial planners are uniquely positioned to help people address what is likely the number one source of stress in their lives – their relationship with money.  Dealing with these issues head-on with a financial planner can lead to improved emotional and physical health, an improvement of work-related problems and improved relationships with family and friends.

A competent and caring financial planner does a great deal more than manage investments or create a financial roadmap.  He listens and empathizes with the conflicting issues that people face when attempting to manage their personal finances.

Discussing the issues that cause worry with a financial planner can lead to setting realistic goals, analyzing alternatives, prioritizing actions and implementing an easy-to-follow plan.  Just as important, it allows the client and the planner to review progress on a regular basis.

As a result the client gets a sense of personal control over his or her finances.  Someone who is in control of their life has much lower stress than someone who feels that events and outside agents control them.

For a relationship between a client and a financial planner to work well together, they must have shared views and expectations of financial planning, financial markets, investment philosophy, and managing risk.  An initial meeting between a client and a financial planner should establish a comfort level and determine whether the planner is actually interested in the client, or just the client’s money.

The planner’s goal should be to help their clients organize their financial affairs, and to discuss the client’s past, present and future – including death.  The planner should create a level of trust that allows him to keep the client from self-injury, which often results from fear surrounding money.  The financial planner should provide a sort of reality check to the client, reducing both excessive pessimism and irrational optimism.  A client should feel able to discuss money honestly and openly with their planner without a fear of judgment.

In many ways, a financial advisor can be the confidant to whom you can take your financial concerns … and make it all better.

Is the Trump Rally Real?

Our favorite financial economist, Brian Wesbury, has some hopeful thoughts about the market following the election.

Since the presidential election, the S&P 500 is up 8.4%, the Russell 2000, a small cap stock index, is up almost 20% and the Dow is closing in on 20,000. Financial stocks have surged.

This “Trump Rally,” just like the entire 2009-2016 bull market – which pushed up stocks more than 200% – has its detractors. We heard it over and over in the past eight years, and now we are hearing it again – “the market has moved too far, too fast.”

Wesbury thinks that there’s a real reason for the market’s rise.  “Hope and faith” has nothing to do with it.  His model indicated that the market was undervalued before the election, and he has attributed that to government policies.

We believe the reason it was undervalued was because government policy was constantly making it more difficult for free markets to operate. Higher taxes, higher spending and more regulation increase the risks to future growth. It’s why we have had a Plow Horse economy. At the least, these policies are now stopped, at best, they will be reversed.

He expects that a Trump administration will be much more market friendly.  At the current rate, perhaps he will soon begin talking about a “Race Horse” economy.

Of course, like any prediction about the future, events can get in the way.  That’s why we are always cautious and focused on protecting our client’s investment assets while participating in the market’s advance within the constraints of prudence, knowing that our vision of the future is never guaranteed.

In the meantime, we are enjoying the ride and are getting ready for a very Merry Christmas.

A reader asks: what’s the difference between risk tolerance and risk capacity?

That’s an interesting question and it depends on who you ask.  The investment industry measures risk in terms of volatility, taking the opportunity for both gains and losses into consideration.

I will answer with a focus on losses rather than gains because, for most people, risk implies the chance that they will lose money rather than make money.

 Risk tolerance is your emotional capacity to withstand losses without panicking.  For example, during the financial crisis of 2008 – 2009 people with a low or modest risk tolerance, who saw their investment portfolios decline by as much as 50% because they were heavily invested in stocks, sold out and did not recoup their losses when the stock market recovered.  Their risk tolerance was not aligned with the risk they were taking in their portfolio.  In many cases they were not aware of the risks they were taking because they had been lulled by the gains they had experienced in the prior years.

People who bought homes in the run-up to the real estate crash of 2008 were unaware of the risk they were taking because they believed that home prices would always go up.  When prices plunged they were left with properties that were worth less than the mortgage they owed.

This exposed them to the issue of risk capacity.

Risk capacity is your ability to absorb losses without affecting your lifestyle.  The wealthy have the capacity to lose thousands, millions, or even billions of dollars.  Jeff Bezos, founder of Amazon, recently lost $6 billion dollars in a few hours when his company’s stock dropped dramatically.  Despite this loss,  he was still worth over $56 billion.    His risk capacity is orders of magnitude greater than most people’s net worth.

The unlucky home buyer who bought a house at an inflated price using creative financing found out that the losses they faced exceeded their net worth.  As a result many people lost their homes and many declared bankruptcy.

There are some new tools available to measure your risk tolerance and determine how well your portfolio is aligned with your risk number.  Click HERE to get your risk number.