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January 14, 2011 by Joe Pitzl, CFP?
I recently attended a presentation by one of my favorite authors and speakers in the financial services industry, Doug Lennick of the Lennick Aberman Group. Lennick has long preached that one of the greatest flaws in mainstream financial theory is that it assumes investors will behave rationally. However, research has proven that investors, in fact, frequently will behave irrationally.
During this session, Lennick made a simple, yet profound statement that financial products are not necessarily the problem. It is the behavioral use of financial products that leads to problems.
Nearly a decade ago, Warren Buffett famously stated that derivate securities are “financial weapons of mass destruction”. As he always seems to be, Buffett was absolutely right: the root cause of the recent financial crisis can be directly linked to these products. What derivatives are is beyond the point of this article, so please bear with me and simply note that they are a financial product. At the end of the day, I submit that it was not the derivatives themselves that brought our global economy to the brink of complete disaster, it was the way they were misunderstood, misused and (un)regulated that caused the collapse. In fact, the derivative products themselves did exactly what they were supposed to do!
While everyone remembers Buffett calling derivatives financial weapons of mass destruction, very few realize that his company, Berkshire Hathaway, uses derivative positions extensively in their portfolio. A key difference between Buffett and Wall Street is the way they are used. Since making the more famous proclamation above, Buffett has also gone on record stating that “derivatives aren’t evil”. As noted above, we all know by now that he tends to use financial products more wisely than the average person.
Inherently, all financial products “work”. Whether we are talking about stocks, bonds, mutual funds, annuities, life insurance, derivative contracts, gold, or tulip bulbs in Holland, they do precisely what they are supposed to do. While I am certainly not advocating that you run out and start buying and selling derivatives contracts, I do believe every investor could benefit greatly by simply making better decisions about whether it makes sense to use certain products, how they use them, and to what extent.
Given that it is a new year, the annual ritual of making predictions and setting resolutions is in full swing. Every media pundit, financial expert, barstool adviser and brother-in-law has an opinion on where the country is heading, what to invest in today, what to sell and how we can save the planet from global economic collapse. I present two very simple predictions for 2011 (and 2012, and for every year from now through 2025 and beyond):Financial products will continue to do exactly what they are designed to do.Investors will continue to make poor decisions with them.
I had the privilege of spending some time at a conference this fall with a colleague by the name of Carl Richards, who founded and operates the website www.behaviorgap.com. Richards is quickly becoming a popular writer and speaker due to his uncanny ability to simplify personal finance with a napkin and a Sharpie. To summarize the essence of the last few paragraphs above, Richards drew the following sketch:
The inspiration for this drawing lies in the results of Dalbar’s studies on investor behavior. As he outlined so eloquently in his New York Times Bucks Blog post, investments continue to work, but investors continue to fall short.
While everyone else continues to try to predict where the DOW will be at year-end, or what the spot price of gold will be in 6 months, I recommend you focus instead on simply closing the gap outlined in the image above. The following quotes and commentary provide timeless advice from some of the best investors in history. These simple, yet timeless truths will guide you in your efforts to better manage your investment behavior in the year ahead:
“Individuals who cannot master their emotions are ill-suited to profit from the investment process.” – Benjamin Graham
The greatest factor in successful investing is having the ability to control your behavior and emotions. Research proves year after year that investments work better than investors. As outlined in the image above and substantiated in the Dalbar research, this “behavior gap” amounts to a whopping 5% on an annualized basis. This can be directly tied to people buying into certain funds or areas of the market when they feel good (prices are high) and selling out when they do not feel good (prices are low).
“Price is what you pay for something, value is what you get.” – Warren Buffett
Regardless of how great a company or sector of the market may seem, high relative prices reduce future returns. Conversely, low relative prices increase future returns. If a particular segment of the market has performed particularly well (as defined by its price increasing), it is ill-advised to buy more into that area. You are better off rebalancing out of those areas by selling your gains and using them to buy into the areas that have underperformed.
“The stock market has a very efficient way of transferring wealth from the impatient to the patient.” – Warren Buffett
Making decisions based on variables that are impossible to predict or control over the short-term lead to people buying into the market or selling out of the market at the wrong time. Remember that every asset has an inherent value that is independent of its price. Over time, the price will ultimately revert to the mean. However, it may take years to realize the value you anticipated when you purchased the asset in the first place.
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.” – Peter Lynch
A disciplined, diversified investment strategy does not exactly provide for great cocktail party conversation. We all know someone that completely knocked an investment out of the park at some point in their life, so it is tempting to try to get in on the action. However, chasing the hot performing investment category or succumbing to your emotions in a down market can sabatoge your ability to build wealth.
“I would rather be approximately right than precisely wrong.” – John Maynard Keynes
It has been said that the purpose of economic forecasting is to make astrology look respectable. Nonetheless, it is a favorite pastime of many investors as they try to seek the best area of the market to be in for the year ahead. Contrary to what most people believe, long-term investment success actually requires that you are comfortable underperforming certain areas of the market in a given year to more effectively manage risk over the long-run. The consistent compounding of returns over time leads to investment success, not hitting home runs in the short-term. You are far better off rebalancing out of a hot segment of the market a bit early than risk doing so too late.
“History teaches us that investors behave wisely…once they have exhausted all other alternatives.” – Steve Leuthold
The erosion of long-term returns and portfolio growth is magnified far more than most people believe on the downside. The following chart emphasizes the impact of losses:
Portfolio Decline Return Needed to Break Even
The academic world loves to refer to investment risk in terms of volatility (short-term ups and downs). If you are a day-trader, volatility implies risk. As an investor, start to redefine investment risk as a permanent impairment of capital. A 10% decline will not permanently change your lifestyle and will provide a high likelihood of recovery. However, overloading your assets into a hot sector carries a higher risk of a crash. A 50% decline in your asset base may, indeed, change your plans dramatically. Taking a flyer trying to find the next Microsoft has a much higher likelihood of the bottom scenario than turning you into the next Bill Gates. It is incredibly difficult to recover from a big loss and most people never do.
As a New Year’s resolution in 2011, set a goal to achieve greater investment success by becoming a better manager of your investment behavior.
Joe Pitzl, CFP?
Director of Financial Planning
Intelligent Financial Strategies, LLC