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Monday, March 26, 2012

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 
Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won't. To reach your financial destination, you can either:
  • get lower returns and save more money over time (thus having less to spend )
  • get higher returns and save less money over time (thus having more to spend)

There's no option to save less and get low returns--that won't work.

The difficulty investors face is that they want to take little or no "risk"--avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn't your destination, then it's the wrong route. You can make valid choices among routes that will get you where you want to go, but you can't successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro's and con's of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 
  • cash (including checking, savings, CDs, etc.)
  • bonds
  • commodities
  • stocks
  • real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980's to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term--or their wished-for ability to time the market--to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term "reward" with significant long term risk, and stocks and real estate provide short term "risk" with real long term reward. If you want to reach your goals, and don't suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns--and the vast majority of people do--then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, March 19, 2012

Investor, know thyself

 
From a psychological perspective, being a part of the herd feels comfortable.  Going against the herd, in contrast, feels almost unbearably miserable.  

Believe it or not, investment success is mostly about understanding this psychology, making a conscious choice to be in or out of step with the herd, and then acting accordingly over time.

Let me describe this in more detail.  If the market is hitting new highs and your portfolio is going nowhere, it feels almost unbearably painful.  If the market is hitting new highs and your portfolio is fully invested, it feels great to be "participating" in the run-up.

This is called herd psychology for good reason.  When running with the herd, animals are least likely to become a predator's meal.  When running against or away from the herd, you're quite likely to become lunch.  Our general psychology reflects this herd bias because it worked oh-so-well during human evolution.  Being away from the herd is painful.

This carries implications for investing.  If you prefer running with the herd, or know yourself well enough to acknowledge you'll feel miserable standing apart from the herd, then invest in an index fund.  The benefit is you won't feel the psychological pain of being out of step and thus make big investing mistakes at just the wrong time.  The downside is you'll generate mediocre results and thus have to save more money over time.  

They key is objectively understanding your temperament, and then making a choice that you can actually--not hypothetically--stick with.  You must know yourself, first.

If (and that's a BIG if) you have the temperament or will-power to run apart from the herd, the benefit is you can achieve above average results, and thus have a bigger retirement or reach your retirement goals with less required savings over the years.  But, you must be able to tolerate the psychological pain of being out of step.  This is no trivial matter.

Most people say they would prefer to do better than the herd, but very few actually have the stomach to do so.  They believe they can stick relatively close to the herd and generate better results, but they simply can't.  They say they can tolerate being out of step, but when their portfolio is going nowhere and the market is moving up, they get cold feet and decide to jump back into the herd.

This is why they do worse than both the herd follower and the out-of-stepper who can stay the course: flipping from out-of-stepper to herd follower and back again--at the time of maximum psychological pain--over and over again, generates terrible results (Dalbar publishes results each year supporting my position).

The important point isn't which method works best by itself, but which method you can stick to from a psychological standpoint.

Beating the herd is not impossible, but it requires a willingness and ability to go against the herd through the psychological pain of being out of step.  Fewer can do it than are willing to admit it to themselves, but that's also why it works.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, March 14, 2012

Americans generally not prepared for retirement

The latest Employee Benefit Research Institute survey is out, and it's not pretty (and hasn't been since I started following it).

Only 14% of Americans are very confident they will have enough money to live comfortably in retirement.

Employment insecurity is the most pressing financial issue facing most Americans.

60% of workers have less than $25,000 in savings and investments (!) outside their home and defined-benefit plans (pensions).

Half of retirees said they left the workforce unexpectedly (due to health problems, disability, layoffs, or their employer closing)--meaning that most of those expecting to work longer won't really have that option.

I don't know if retirement just seems too far in the future, or if the virtue of thrift has gone by the wayside, but most Americans aren't doing what it takes to prepare for their future.  

They may heartily blame someone else, but "truth be told, if you are looking for the guilty, you need only look into a mirror." 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, March 12, 2012

Know what you're getting yourself into

Suppose I gave you 3 investment options:

  • Investment A charges 0.05% in fees per year
  • Investment B charges 0.20% in fees per year
  • Investment C charges 1.5% in fees per year

Which would you choose?  

A lot of investors, and their advisers, would blindly choose Investment A because they believe lowest fees always win. To which I would ask: lowest fees for what? The goal of investing is not to minimize fees, but to preserve and grow capital.

Suppose I gave you 3 new investment options:

  • Investment A has 0% standard deviation over 5 years
  • Investment B has 18%  standard deviation over 5 years
  • Investment C has 68%  standard deviation over 5 years

Now, which one would you choose?

Most finance professors, investors and their advisers would chose Investment A because they believe lowest volatility wins. Risk equals volatility, they'd say, so reduce risk by investing with lowest volatility. To which I would ask: is the goal of investing to avoid volatility, or generate returns?

Suppose I gave you 3 new investment options:

  • Investment A has returns of 5% a year for 5 years
  • Investment B has returns of -8%, +20%, -8%, +32%, and +20% over 5 years
  • Investment C has returns of -5% a year for 4 years, then jumps 146% in year 5

Now, which investment would you choose?

Most investors would choose A because B would be "too much of a roller coaster ride" and C would "go nowhere" for too long. To this situation, I'd ask: is the goal of investing the avoidance of "roller coasters" or "going nowhere," or to generate returns?  

Suppose I gave you 3 final investment options:

  • Investment A generates a 5% annualized return over 5 years
  • Investment B generates a 10% annualized return over 5 years
  • Investment C generates a 15% annualized return over 5 years

Which would you choose this time?

Most investors and advisers would chose Investment C because it produces the best return.  On this one, I'd agree.

If you recognized that Investments A, B and C were consistent throughout my examples, then excellent observation on your part.  

Investment A is basically a saving account or Certificate of Deposit (not that you can find that kind of yield now). There is no daily market quote for the instrument so it appears not to fluctuate at all (which means the volatility appears to be zero), the fees are very low, the returns are steady, but the result is low compared to other alternatives.

Investment B is basically an index fund invested in the stock market. The fees are low, but not as low as at the bank, the returns are unpleasantly volatile--hence the roller coaster comment--but generate a very respectable return of 10% per year (assuming the market is at average value).

Investment C is basically a value-style investment. The fees are high, the standard deviation of returns is quite volatile, the investment goes nowhere for 4 years before taking off (meaning that it doesn't track with the overall stock market--which vexes professors, investors and advisers to no end!), but the returns are truly outstanding.

My attempt here is not to say that investment C is the right choice for everyone--it most certainly is not--but to illustrate the choices investors are faced with and some of the inherent trade-0ff's they must make.

If you believe that low fees are the most important criteria, then I'll quote Oscar Wilde: "The cynic knows the price of everything and the value of nothing." Price is what you pay, value is what you get. It's a mistake to look at price and not what you get for that price.

If you can't stand volatility of any kind, like watching your investment double one year and plunge 50% the next, then you should probably avoid the stock market. If 5% returns aren't enough to allow you to reach your financials goals, you have a true dilemma on your hands. If 5% returns will get you where you want or need to go, then why bother with more volatile options?

If you invest in stocks, don't expect 10% returns each and every year, but 10% returns over time assuming you invest when the market is at fair value. If you invest when the market is high, you won't get 10% returns; if you invest when the market is low, you'll do better than 10%.  In either case, don't expect a smooth ride. There is no such thing as a free lunch, so don't expect to invest in the stock market and get bond-like or savings-account-like returns.

If you want better returns than a saving account or the stock market offers, then don't expect steady returns or returns that track the market. To do better than the market, you may have to be willing to "go nowhere" for quite some time.  Better returns will very likely be more volatile, look very different than the market, and test your patience. Conversely, an investment that is steady or mirrors the market is extremely unlikely to generate above average returns.

Successful investing is less about fees and volatility and more about knowing what you're getting yourself into. If you buy C and expect A or B, you'll be disappointed and bail out before good results accrue. If you buy A and expect B or C, you'll be disappointed with low returns. If you buy B and expect A, you'll be scared out by volatility. If you buy B and expect C, you'll wonder why you're not tracking to the market.

Most financial plans fall apart not because things go awry, but because people don't know what they are getting themselves into and bail out at just the wrong time. Successful financial planning begins with a clear understanding of the options, the likely outcomes, and the probable path to the destination. People leave a restaurant when they expect steak and potatoes and get foie gras and escargot.  

My wife has a saying, "you knew it was a snake when you picked it up." Know what kind of snake you're picking up, and don't judge it by nonessential characteristics.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, March 05, 2012

Counter-intuition

To most people, good investing seems frustratingly counter-intuitive.

When the economy is on its back, looking like it will never recover, and the stock market is hitting new lows--that's the best time to invest. When the economy is breaking growth records and the stock market is hitting new highs--that's the absolute wrong time to pile in.

Or, as Warren Buffett more succinctly put it: "be greedy when others are fearful and fearful when others are greedy." (He should know, you don't become one of the richest people in the world and the most successful investor over the last 60 years if your approach is fundamentally flawed.)

But, most people can never really get their brain around this paradigm. They easily accept that they know nothing of particle physics, brain surgery and rocket science, but they just can't accept the notion that investing and economics are similarly complex.

To most, investing is counter-intuitive.

But, to me, this counter-intuitiveness makes perfect sense. Investing is not like physics, surgery, rockets, home building, plumbing or most other things people do. In most fields, man is competing with nature.  

A physicist is trying to understand the rules of nature with mathematical precision such that it can be harnessed. The surgeon wants to understand disease and human physiology such that he can operate to restore health. A rocket scientist uses the rules discovered by physicists to harness nature's power to propel and guide a payload into space. A home builder seeks to erect a structure that will keep out the elements and provide a comfortable and convenient abode for its dwellers. A plumber desires to harness water to serve man's needs within buildings. All of these fields are concerned primarily with overcoming nature.

Investing is different. It's more like sports or warfare in that it is inherently a competition of man against man. And that, I believe, is why it seems counter-intuitive to most.  

With investing, you are not just trying to figure out which company will survive and thrive, but how other people perceive that company. The price you pay is not based solely on a company's underlying fundamentals, but on how investors in general understand and interpret those fundamentals (or just plain feel about a company).  

When people are excited about an investment, like Apple, they tend to bid the price up above underlying fundamentals. When they hate a company or think it is going the way of the dodo, they bid its price down below fundamentals.

When they think the economy will go ever higher, they want to be fully invested. When they think it will never improve, they want to pull all their money from the market--right now!

But, this herd-like behavior is almost always reflected in prices before such people buy and sell. The price they pay or receive is for the perception of a company or the economy, not just the underlying fundamentals.

In the long term, however, the fundamentals win out. As Benjamin Graham put it, "in the short run, the stock market is a voting machine, in the long run, it's a weighing machine." In other words, stock prices reflect human emotion in the short run and underlying fundamentals in the long run.

Which is why successful investing seems counter-intuitive. When everyone is selling and it seems like things can never get better (2009), you want to be buying. When everyone is buying and it seems like a new era of non-stop growth has dawned (2000), you probably want to be selling.

Because most people will never get their brain around this, counter-intuitive investing will continue to work for those who can harness other people's short-term emotions. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.