Monday, July 24, 2017

The Behavior Gap

The title of certified financial planner Carl Richards’ book The Behavior Gap refers to the gap between “what we should do and what we actually do” when it comes to financial decisions. The book identifies a great many of the mistakes we make, and almost all readers who are honest with themselves will identify with some of the mistakes.

Richards is well known for his napkin drawings, and there are plenty of them in this book. One says that the cost of your mistakes rises with your level of overconfidence. “Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.”

We know we shouldn’t buy high and sell low, but “we make investing decisions based on how we feel rather than what we know. Falling stocks scare us; rising stocks attract us.”

In a drawing offering investment advice, Richards says the chance that a fund will stink rises with its expense ratio. He offers more advice when he says our decisions about how much of our company’s stock to hold should be based on principles of diversification rather than “our feelings about what’s going to happen.”

On the subject of stock mania, Richards tells the story of how during the tech bubble in 1999, he resisted “the temptation to buy technology stocks” initially but eventually gave in and lost money. It’s the last people in before the bubble bursts who get hurt the most.

Richards believes that financial planning begins with life planning. “Find out who you are and what you want. Then you can stop wasting your life energy and your money on stuff that doesn’t matter to you—and start making financial decisions that will get you to your true goals.”

If we take action based on the latest news, we’re likely to do the wrong thing. “Try going on a media fast.” “When thoughts about the market arise, let them go. Go for a bike ride.”

I was surprised to see a financial planner write that “Financial plans are worthless.” However, he followed that up with “but the process of financial planning is vital.” A single static financial plan will become obsolete as life takes a few unexpected turns. Plans need to adapt.

We’re used to being told not to make overly rosy assumptions, but “pessimistic assumptions often discourage people from doing anything to improve their outlook.” I’ve known people who buy lottery tickets because they see winning as the only way to improve their lives. They just don’t understand or believe in the power of saving small amounts regularly.

“While making wise decisions about how you invest your money is important, it doesn’t have nearly the impact of working hard and saving more.” I’m all for encouraging people to save more, but a low-cost index investor could easily end up with twice as much money each month in retirement as someone who spends an investing lifetime chasing the latest hot mutual fund. This seems at least comparable in value to saving more money each month.

In one section, Richards describes so accurately the mood in a company whose stock is soaring that it seemed like he was talking about my employer back in the late 1990s. People had “visions of early retirement,” and they knew they “should sell some of the shares,” but they hung on anyway. Many of my colleagues saw 7-figure paper valuations evaporate.

I recall asking colleagues whether they would buy back the company’s shares if they were converted to cash right now. This only caused one of my colleagues to sell. I sold too few shares myself. Richards calls this the “Overnight Test” and asks if your portfolio went to cash overnight and you wouldn’t rebuild the same portfolio today, “what changes would you make,” and “why aren’t you making them now?”

“What makes us feel safe may be at odds with the numbers.” I’ve learned this truth when it comes to retirement. My wife and I need different things to feel it’s safe to retire. For me, it’s a set of spreadsheets that analyze all the numbers in a dozen different ways. I’d just be guessing about what would put my wife at ease.

We’ve heard that simple solutions are best when it comes to finances, such as saving diligently and choosing low-cost diversified investments. “We often resist simple solutions because they require us to change our behavior.” “We’d rather look for a magic bullet: something to save us from the day-to-day grind of simply doing the work that needs doing.” “It’s much easier to entertain ourselves with the fantasy of finding an investment that will give us a fantastic return than to save a little bit more money each month. But in the end, the fantasy will fail us.” Well said.

This book is both entertaining and helpful for readers prepared to admit to themselves that they’re guilty of some of the mistakes that create this “behavior gap.”

Friday, July 21, 2017

Short Takes: Reality Check for Novice Investors and Retirement Planning

Here are my posts for the past two weeks:

Are We Saving or Investing?

The Four Pillars of Investing

The Dangers of Personifying the Stock Market

Things get quiet in the middle of summer, but I still have a couple of short takes:

Dan Bortolotti warns novice index investors that the bull market can’t last forever. When markets inevitably stumble, active managers will be quick to claim they could outperform during bear markets, even though the evidence doesn’t back up that claim.

Potato shows how to answer the question of whether you’re on track for retirement by going through an example case. As he shows, you can never know for sure that you’ll get the retirement you want, but you can find out if you’re way off.

Thursday, July 20, 2017

The Dangers of Personifying the Stock Market

Most people understand that the stock market reflects the collective actions of all stock traders, but we often personify the market, talking about it as though it has its own free will. This can lead to investing errors.

When we say that “stock markets struggled this week,” we don’t literally mean that there exists some sentient entity called the “market” that has the desire to rise, but was unable to do so this week. But thinking of it this way can create the illusion that you have only a single foe when you trade stocks.

It can also create the illusion that we can all somehow succeed against the market. When someone says that some past market event was easily predictable, such as the 8-year recovery from the 2008-2009 crash, many would agree. But it can’t be true. If we all knew stocks would rise so much, then buyers would have driven prices up right away.

When we see the stock market as the collective action of all buyers and sellers, it becomes clear that there had to be a lot of uncertainty among traders 8 years ago because stock prices just rose slowly instead of jumping all the way back up immediately. In fact, we must always be in a state where most traders are uncertain, because, if they weren’t, stock prices always shift up or down until they were uncertain.

If you’re trying to beat the market by getting higher than market returns, your real opponents are all the other stock traders, not just some single entity. Traders can’t all be winners. For every dollar of market outperformance, there has to be a dollar of underperformance.

So, when you try to beat the market, you have to ask yourself whose trading dollars you expect to take. Even worse, because almost all trading is done by professional investors these days, you need to ask yourself which investment pros’ dollars you expect to take.

None of this proves that you can’t beat the market. But it does show that the deck is stacked against anyone who tries, particularly after factoring in the costs associated with trying to beat the market.

Monday, July 17, 2017

The Four Pillars of Investing

While reading William J. Bernstein’s book The Four Pillars of Investing, I was unsure of how to summarize it. After finishing I’d say that it aims to give readers the right knowledge and expectations to become successful do-it-yourself investors. Without a solid grounding in each of the four pillars, investors are at risk of making expensive mistakes.

The first pillar, called “theory,” is less intimidating than it sounds. It teaches the link between risk and reward and that “high previous returns usually indicate low future returns, and low past returns usually mean high future returns.” This is particularly true of stocks because they show more mean reversion than you’d expect just from randomness.

We tend to think of money market funds as safe, but they get their returns in part from commercial paper that “does occasionally default.” There is no excess return without some risk.

Bernstein explains the Gordon equation, which states that the market return is equal to dividend yield plus the rate of dividend growth. He goes on to explain that to this we have to add the rate of stock buybacks and subtract the rate of new share issuance. One point I’d add is that companies can make their dividend growth appear higher for a few years by increasing the proportion of earnings they pay out in dividends. For this reason, one might substitute earnings growth for dividend growth. But this has its own problems for companies that game their earnings accounting.

An amusing bit was using Trump Casinos as an example of a business with a high risk of defaulting on loans. I doubt Bernstein had any idea that years after writing it, his book would come to seem political.

It’s not hard to see what Bernstein thinks of active management when he refers to a mutual fund’s advisory fees as “what the chimps get paid.” He also says “It should be painfully apparent by now that most of the investment industry is engaged in nonproductive work.” He sums up his arguments with “Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it—that is, by indexing.”

Because of the possibility of high inflation, the author believes that “Long-duration bonds are generally a sucker’s bet.”

The second pillar is the history of investing. The main purpose of this pillar is to teach readers that market bubbles and crashes happen fairly regularly, and we need to keep our wits about us and stick to a plan. As George Santayana said, “Those who cannot remember the past are condemned to repeat it.”

I’ve written before about Bernstein’s distinction between investing and saving, and I won’t say any more about it here.

I enjoyed a joke at the expense of the company “Yahoo!” where Bernstein asked if the name is an interjection “or was it simply a noun, meant to describe the company’s shareholders.”

The third pillar is the psychology of investing. People consistently make many types of investing mistakes. The first step in avoiding these mistakes is to understand them.

Some examples of mistakes are assuming “that the immediate past is predictive of the long-term future,” and our search for patterns that aren’t there. “The pricing of stocks and bonds at both the individual and market level is random: there are no patterns.”

Another mistake is seeking status through the types of investments you use. “Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partnerships, and the like—are designed to bleed them with commissions, transaction costs, and other fees.”

The fourth pillar is the business of investing. This pillar is a warning about the financial industry. “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” “Under no circumstances should you have anything to do with a ‘full service’ brokerage firm.”

Most mutual-fund companies aren’t much better: “The primary business of most mutual-fund companies is collecting assets, not managing money.”

The sections of the book on the four pillars are strong, but the “assembling the four pillars” section isn’t as strong. A couple of the reasons for this aren’t Bernstein’s fault: the discussion of specific investments is getting dated and is too U.S.-centric for a Canadian like me.

My main criticism is that he ends up building portfolios that are too complex. For most people, the potential benefit of slicing up portfolios into ETFs or funds based on market caps, growth/value, geography, and other factors is too small to justify the extra work. No doubt some people could manage all this well, but many investors would make mistakes and end up spending too much on commissions, spreads, higher MERs, and realized taxes. Simpler is usually better.

The short section on investing with children is excellent. He advocates buying index funds for children, letting them watch the ups and downs once each quarter, and letting them spend some dividends. I tried to do something similar for my sons, but mostly failed. Bernstein’s approach would have been better.

Bernstein is very positive about an approach to investing called value averaging. It doesn’t work. I’ve discussed why here and here, and described some experiments I ran here.

The subsection on rebalancing places a lot of emphasis on which method gives the highest returns. This can be misleading for investors. When you own many stock funds based on various factors, rebalancing can give a small boost in returns. However, most investors just rebalance between stocks and bonds. The purpose in this case is to control volatility, not boost returns.

Overall, I found this to be an excellent book for steering investors toward making good decisions about the things they can control, and remaining calm about the things they can’t control. Readers who get through the whole book are likely to become better investors.

Wednesday, July 12, 2017

Are We Saving or Investing?

When we buy shares in a company, are we saving or investing? Most of the world would call this investing, but William J. Bernstein disagrees. In his excellent book The Four Pillars of Investing, he explains why he calls this saving:

“When you and I purchase shares of stock or a mutual fund, we are not investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving.”

He continues

“Only when we purchase shares at a so-called ‘initial public offering’ (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing.”

It’s certainly important to make a distinction between a simple change of ownership of shares and a company getting new money to run its operations. But I find the terms Bernstein uses very unsatisfying.

When I commit money to my trading account with the intent to leave it there for a long time, I am saving. When I choose to convert cash to shares, I’m not saving again. The word most people use for this activity is “investing.” If we wish to make the distinction Bernstein is making, then I think “trading” is a better word than “saving.”

But even this doesn’t describe the situation fully. It’s true that the net actions of buyer and seller provide no new capital to the company. But the buyer has aligned his economic outcome to the fate of the company. The buyer’s viewpoint is that he has invested in the company and the seller has withdrawn his investment, even if the company doesn’t see it this way.

The most troubling part of this semantic game is that it gives an opening for obnoxious types to derail any type of investment discussion with “actually, you’re not investing at all.” It’s amazing how often people in a narrow technical field think they can police the meaning of a word that has one meaning in the technical field and another well-established meaning among the broader public.

The point Bernstein was leading up to in his book is that IPOs have historically been poor investments, on average. So, investors would do well to avoid IPOs altogether. This is a good point to make, but we need better terms when discussing the distinction between IPOs and the secondary market than investing/saving.