Friday, September 9, 2011

Fear and Greed and the Recency Effect

“Fear is a darkroom where negatives develop” - unknown

“Hell has three gates: lust, anger, and greed”- the Bhagavad Gita

We tend to remember those events that occurred most recently. And more recent events receive a heavier weighting in our thinking. This is referred to as the “recency effect” and it is present in all human endeavors.

In investing I find that it manifests something like this:

“The stock market is rising, therefore it will always rise and will never decline”

- or –

“The stock market is declining, therefore it will always decline and will never rise”

Rising markets tend to trigger a greed response (“I want in now!”) and falling markets tend to trigger a fear response (“I want out now!” or at least “I don’t want in now!”). Psychologists have proven that in humans there is more pain in a loss or percevied loss than there is pleasure in a gain or perceived gain. One method of avoiding loss is by avoiding risk. There are many different types of risk but most people think of risk as “losing money” which I have seen defined in different ways over the years. Probably the most common way of thinking of “losing money” is to see an investment position trade at a price that is lower than what was paid. Risk of loss is, by definition, present in all investment activity – one can’t expect a particular investment to rise __% without accepting the risk that it can fall by the same amount. Yet I do see investing behavior that contradicts this common sense conclusion. Economics is a social science that studies human behavior. In my opinion, economics is mistaken in assuming that all economic decisions are rational i.e., that the person making the decision has thought through both sides of the decision before coming to their conclusion. The flaw is that humans tend not to be rational creatures but are driven by emotion, by what they see on tv, hear on the radio, read on the web, hear from their friends – the recency effect played out in near real time.

Naturally, financial advisors are humans too and just as susceptible to the recency effect as any investor. I imagine that someday a computer algorithm will be written that will attempt to replace humans as financial advisors but I doubt it will successful. Why? No computer program will be able to deal with the client’s feelings of greed and fear. Helping another human cope with greed and fear requires a great deal of trust, and no computer will ever be able to build trust with another human. Why? Because humans are not rational, whereas computers are nothing but rational. Maybe it will be possible in a far-off future populated by Artificial Intelligence, but certainly not in the lifetime of anyone reading this. So do human financial advisors need to act like computers? Is it even possible? No and no. To be able to help another irrational, emotion-driven human make good choices, the human advisor first must conquor his own greed and fear. Like they say on the plane: “Place the mask over your own face before helping others”. How does an advisor get to this place? The only effective teacher is the school of hard knocks, experience, trial and error. And the trials are never over.

We are experiencing a new round of fear this week – maybe we should call it “Fear of Greeks bearing gifts” - as the Euro Zone comes to a major fork in the road regarding Greece’s sovereign debt. Equity markets around the world have sold off in a typical fear response but remember: for every seller there is a buyer.

If you have an investment plan, stick to it.

If you don’t have an investment plan, get one – and stick to it.

Friday, July 29, 2011

Debt Ceiling delight

“We all think we’re going to get out of debt.”
-Louie Anderson (comedian)

European debt. Greek debt. Italian debt. Irish debt. Portuguese debt. Spanish debt. And of course, good ol’ USA debt. Debt, debt, debt. One can’t turn on the tv or check for news on the web without being pummeled about the world’s debts. The stock market gets whipsawed whenever government debts bubble up to headline level. Yes, it’s bad. The public debt loads of many industrialized countries already exceed 100% of their economies’ GDP (Gross Domestic Product) – Japan is at something like 220%, Italy’s at 120%, here in the US it’s 60-80%, depending on whom you ask. The greater problem of course, is not the debt level itself, but the rate at which it is growing. Pretty soon, Uncle Sam will be getting a cash advance on his Visa to make the payment on his MasterCard. If you’ve ever seen this happen to someone you know the end result is not pretty.

I’d like to believe that our elected representatives are not dumb enough to ride their “principles” over the Cliffs of Default, but we’re in uncharted territory with 25% of the House Republicans having signed up as members of the Tea Party Caucus. The bottom line effect of default would be much higher interest rates paid by the government on future borrowing. Not to mention the severe haircuts on the value of existing bonds. These higher rates would have a ripple effect through the US economy and impact all economic activity: higher mortgage rates, higher auto loan rates, higher credit card rates, higher business loan rates and on and on. Forcing default for the sake of “principles” is a bad idea and I hope cooler heads prevail.

Inflation Watch

The price of oil has dropped significantly since last quarter and currently hovers around $97 per barrel for West Texas Intermediate (WTI). The price of gas at the pump has come down quite a ways as well. The Federal Reserve continues to hold their overnight rate at near 0. Inflation is creeping up though – the “all items” CPI for the 12 months ending June 30 was +3.6% - expect to see price increases at the grocery store.

Tuesday, May 31, 2011

Why Investing is like Sports

Is your interest in the fortunes of your favorite sports team any different than your interest in the fortunes of the stock market?

Let’s say you are a fan of American football. Your team plays a game every Sunday for 16 weeks (except for one off day). How do you feel when they lose? How do you feel when they win? How do you feel when they win or lose a few games in a row? Here’s a graphic that will help us illustrate our point:

Do you have any detachment when it comes to how you feel about Your Team’s success or failure? Of course not. One Sunday you want the quarterback to run for President and the next you want him to run from the stick you are wielding. Is any of this logical? Of course not. You feel it in your gut. Your brain is there to merely prevent you from running your car off the road when the coach elects to go for 2 - when the PAT kick would tie the game - and doesn’t get it and your team loses. Now you know the feeling we’re talking about – some days you feel like the elevator can’t take you high enough and some days you only want to take it so you can jump off the building – preferably with the afore-mentioned quarterback or coach firmly in your grasp, along for the ride.

Guess what?

This is exactly how many investors approach investing. If the Dow is on a 3-day winning streak, they are euphoric, they can’t see an end to the up-ticks on the chart and wonder why they didn’t invest more last week when the Dow had a 3-day losing streak. They berate themselves and their advisors for missing out. And why didn’t we get into (fill in the blank with the over-priced IPO of your choice) when it opened? Yet, during the 3-day losing streak, they were despondent and nearly suicidal over not having held back more cash.

Call it the human condition. Here are 6 ideas investors can use to avoid the elevator ride between hope and despair:

1. Build a portfolio based on your intellectual tolerance for risk. Keep it simple – use mutual funds. Re-balance it periodically. In between re-balancing, ignore it.
2. Don’t buy market-capitalization weighted index funds – their ups and downs are multiplied by the overweighting in large companies. Consider equal-weighted index funds.
3. Buy dividend-paying stocks in large US companies that make things that people buy or that sell the things the other companies make. According to Modern Portfolio Theory, it only take 8 stocks to diversify business and industry risk. Divide your capital by 8 or more and go shopping.
4. Reinvest all dividends for individual stocks that allow you to do so. This compounds your dividend yield.
5. Don’t watch the markets everyday – or even any day. Invest your funds and then ignore them for whatever time frame you’ve determined will pass before you will conduct a review. Monthly? Quarterly? Semi-annually? Annually?
6. Hire an advisor who understands you to do this for you.

Thursday, May 19, 2011

But I'm Not Dead Yet!

“The reports of my death have been greatly exaggerated.”
~ Mark Twain

When is an inheritance not an inheritance? When the very event that creates the inheritance has yet to occur. If you are still vertical, then by definition, your assets are not yet an inheritance. Your children and perhaps other family members, may think otherwise. They may think they are entitled to an “advance” on the inevitable. Yes, it is inevitable. In spite of the popularity of living and advances in medical science, the mortality rate has not budged from its historical ratio of 1 to 1, i.e., all of us.

I remember a conversation I had with my Dad sometime in the ‘70’s when I needed use of his extensive tool collection. He said something along the lines of “When are you going to get your own?” and I retorted “I’m just gonna wait until you die Old Man and then I get them all.” He didn’t think much of that. About 30 years later, my wish came true. Be careful what you wish for.

I don’t know if there have been any studies done, but in my experience one of the primary financial problems (holes punched in their retirement boat) for retired people is their inability to say “no” to their children when it comes to what we might euphemistically refer to as “inheritance advances”. This is a problem that afflicts all, regardless of asset balance – the bigger the balance, the bigger the “advances”.

Don’t misunderstand me. If its affordable, then “it’s your money” as they say. BUT CONSIDER IF IT IS AFFORDABLE FIRST. Don’t say “yes” and then discover that it’s not a good idea after the fact. If you have more than one child, how do you tell the second, third and fourth “no” after you said “yes” to the first? It’s not “their” money until you’re dead and they should be ashamed of themselves for asking.