Has anyone ever called you out after saying “I know” about something you really didn’t have much competency in? You thought you could indefinitely skate by as a perceived expert and nobody would ever know the truth. Then one day, you finally met your intellectual match at the wrong time. Growing, up, I was definitely a “know-it-all” and had this need to prove my dad wrong. It wasn’t until later in life when I found myself in a study group with a successful business consultant that my all-knowing way of being was called out. I was trying to swallow lunch when he pointed this out to me in front of our group. Whatever I was trying to eat suddenly stopped moving down my throat and there was this pressure on my chest. I was ashamed, embarrassed and quite uncomfortable. It’s been many years since that lunch. And when I hear myself randomly say “I know” about something, I always pause to check myself. Do I really know or am I just trying to look good?
Looking at money, feelings of shame and/or guilt usually suppress open discussion about the subject, even within families. This “no-talk rule” has consequences. Indeed, what else in life gets better on its own absent good conversation? What I was blind to see throughout childhood and my young adult years was that people actually cared about my success. What a concept! And I missed it entirely, in pursuit of looking good. In that light, I also want to see you succeed. So, as you read this, I invite you to temporarily suspend what you think you know on this subject matter. Just try this material on for size and see if it fits. If it doesn’t, then you are free to go back to your own methodologies.
Distinct from prudent investing is another behavior that oftentimes goes without mention - gambling. It’s important to acknowledge this as I’ve seen first-hand the impact on families when the rules of investing are broken. We’ll get into those specific rules later in this paper. Psychology Today1 defines gambling as:
So how do you know if you are gambling or speculating with your investments? What are the warning signs? One in particular is believing that you need to have a prediction about what will happen in the future to make effective decisions. One of the greatest fallacies perpetuated by the financial services industry is that sustained superior performance is a factor of special skill and not luck. There are 3 specific ways that this shows up for investors: Market Timing, Track Record Investing and Stock Picking.
Investopedia2 defines Market Timing as follows:
“Market timing is the act of moving in and out of the market or switching between asset classes based on using predictive methods such as technical indicators or economic data. Because it is extremely difficult to predict the future direction of the stock market, investors who try to time the market, especially mutual fund investors, tend to underperform investors who remain invested.”
Remember the old adage – A broken clock is right twice a day. My favorite one is - A blind squirrel eventually finds a nut. The problem is that the broken clock is mostly wrong and the blind squirrel is going to have a really rough life. Keep this in mind: In order for market timing to really work, you’ve got to be right twice – when to ‘get in’ and when to ‘get out’. If Market Timing actually consistently worked, the following chart would not exist. What did it cost an investor to sell off shares in an S&P 500 fund and move to cash for the amount of trading days along the bottom? Being out of the market for just 30 days out of 5040 trading days produced virtually nothing. Inflation won. This is an incredible indictment against fear and greed. Let this sink in for a bit before moving on…
Can you recall a time when you panicked and exited a volatile market by moving to cash? What were the emotions you experienced? Did you feel out of control? What did you learn through the experience? Critical to your portfolio design is an understanding of where your specific circumstances and historical volatility come into play.
Important Tip: If you see the phrase ‘Tactical Asset Allocation’ in your investment marketing material, it’s most likely disguising a Market Timing strategy. Language matters and you should know exactly what your money manager is doing with your money and why.
The next practice I’ve seen that’s problematic for investors is what I call “Track Record Investing”. We have seen it with the recent explosion of crypto-currency where people literally took out second mortgages on their homes to catch the wave to riches. This behavior has been happening a really long time (at least since 1636). Do a google search for the “tulip mania”. You’ll see some striking similarities in the growth and crash patterns with crypto-currency. Is it a viable and sustainable alternative to banking as we know it? Perhaps. But it’s not my job to predict and tell you what it’s going to do going forward. And your job is to exercise extreme caution when people tell you they know what’s going to happen in the future. And who can forget when people were taking out 2nd mortgages leading up to 2008/2009 to buy additional real estate to ‘flip’ or rent?
In short, Track Record Investing is simply believing that a particular stock or fund will outperform the market in the near future since it produced superior results in the recent past. One way to illustrate Track Record Investing would be to look at the history of tech stocks during the 1990’s. The mainstream media seemed to help average investors violate the basic rules of investing better than anyone. The following major magazine covers and corresponding NASDAQ Composite Index snapshots tell the story. Money Magazine almost timed the climax perfectly. Time Magazine came in a bit earlier (September 1999):
Many investors in the late 1990’s reported “feeling safe” about pumping more money into technology stocks as prices were skyrocketing. The whole notion of keeping a strategic allocation and rebalancing a portfolio was abandoned by many. Fear and Greed are extremely powerful emotions and love to influence your money decisions. Many investors had to learn the hard way, and suddenly, 8 trillion dollars were wiped off personal balance sheets across America. One thing is for certain - more bubbles to come. Will you be prepared? If you learn (and apply) the simple rules of prudent investing and some risk management, you will.
The last area for discussion here is Stock Picking. Essentially, one hopes or believes that the stock will produce sustained superior returns over time. Emotionally, there can be an irresistible attraction to this arrangement. Perhaps you believe your company will produce superior results over time and therefore load up on company stock. Or maybe you inherited a stock from an iconic company and it’s been doing well. Or you believe the advertisements that proclaim things like: “We have the best research” or “We meet annually with the executive leadership”. Whatever the case may be, avoiding the concept of a globally diversified portfolio carries uncompensated risk. That risk is simply transferred back to the owner of the stock. That begs another question – Do you have a system to actually measure the level of diversification and risk in your portfolio? If not, then consider it a critical factor in developing your confidence.
Eugene Fama is an American economist and Nobel Laureate in Economics. He’s considered to be one of the top economists worldwide and continues to present the results of his ongoing research at a young age of 80! He’s best known for the work he’s done on portfolio theory, asset pricing, and stock market behavior. Some of his work is cited at the bottom of this article and is worth further inquiry. Here’s what he’s got to say about investment managers who are seeking to beat the overall market3:
So what should you do now? The first step to establishing superior confidence as an investor is to simply eliminate the 3 aforementioned key behaviors – Market Timing, Track Record Investing, and Stock Picking. This will then allow us to focus on the right things. Thankfully, that list is just as short. Here are the three key elements to producing an investing experience that’s distinguished from one of speculating and gambling:
Own Equities, Diversify, Rebalance
These three rules are well supported by academic science. I will be addressing it in more detail in our next article, so thanks in advance for your patience! I know you’re thinking one of a few possible things right now…
- How do I do this?
- I already do this!
- How does this guy get paid?
- What’s this guy talking about?
- Does this guy know what he’s talking about?
- I’ve already got mutual funds so I should be okay.
- I’ve got my 401(K) and a match so I should be okay.
- I don’t have time to investigate what’s going on with my money.
- My investment advisor is a good friend or relative so why would I get another person’s opinion?
Here’s the important thing to take away from this. You don’t have to know everything about the stock market to be a prudent investor. Owning a globally diversified portfolio and rebalancing it consistently, in accordance with your specific objectives is a function of engineering and coaching, not emotion. There is a level of academic rigor and empirical testing here that could be of tremendous value to the way in which you grow and enjoy your wealth. You have the opportunity to see how much Market Timing, Track Record Investing, and Stock Picking is actually costing you in real dollars. I would be happy to accompany you on this journey of building your financial future and to help you navigate around the obstacles that limit an investor’s potential.
- “Determinants of Portfolio Performance,” Financial Analysis’s Journal, Gary P. Brinson, L. Randolf Hood, and Gilbert L. Beebower, 1986. “Revisiting Determinants of Portfolio Performance: An Update,” Brinson, Singer, Beebower, 1991. “Determinants of Portfolio Performance II: An Update,” Benson, Singer and Beebower, 1996. Eugene F. Fama, “Random Walks in Stock Market Prices,” Financial Analysts Journal, September/October 1965 Fama, Eugene; French, Kenneth. “The Cross-Section of Expected Stock Returns”. Journal of Finance. 1992 Markowitz, Harry. “Portfolio Selection.” Journal of Finance. 1952.