Monday, June 1, 2015

The Wrong Investing Goals

Big Cajun Man published an amusing list of “frustratingly correct” answers to financial questions. Some of these questions and answers illustrate nicely that most people have the wrong ideas about financial goals.

The big man’s first question and answer:

Question: When is the best time to sell my stock?
Answer: When it reaches the highest price.

One criticism of this answer is that it offers no prescription for how to determine when a stock is at its highest price. But, apart from this, the answer is correct for active investors who try to beat the market. This is the way most people think about investing.

However, the majority of active investors must underperform the market. We see this play out year after year. The vast majority of investors would benefit if they stopped trying to beat the market either by themselves or by finding an advisor or fund managers to try to beat the market for them.

For investors who embrace passive investing, the first answer to the question of when to sell a stock is that they don’t own individual stocks in the first place. They tend to own low-cost broadly-diversified ETFs and mutual funds.

If we ask passive investors when they should sell their funds, the answer is when they need money or need to rebalance their portfolios. The answer “When it reaches the highest price” is incorrect to a passive investor.

The next question and answer:

Question: Any tips on how to win the lottery?
Answer: Yes, buy the winning ticket.

Once again, this answer offers no prescription for how to pick a winning ticket, but to lottery players, this seems like the correct answer. However, for those who have figured out that lotteries are a terrible deal, this answer is wrong. The real answer is that you win the lottery when you don’t buy any tickets.

I quite liked the final question and answer:

Question: Is there such a thing as good debt?
Answer: No. If you owe money, you owe money, which is bad.

As I’ve said before, there can be good reasons for going into debt, but the debt itself is still bad. This mindset can help people keep their debts to a minimum even when they go into debt for good reasons.

Overall, I find that even among investors who claim to have embraced indexing, the majority still think about jumping in and out of the market in misguided attempts to avoid market declines. They still think the correct answer to when to sell is when prices are at a maximum. True index investors are still rare.

7 comments:

  1. I never claimed they were GOOD answers, Market Timing is an exciting idea that people rarely get right, but they remember all the times they "could have made a fortune" had they gotten in or out of the market (or bought the right lottery ticket). People are funny that way. I could have been a great basketball player, was I a foot taller and actually athletic too.

    Thanks for kibitzing on my submission.

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  2. BCM's answers are aspirational answers -- we aspire to achieve these. But the first thing that a practitioner does is say, "how do I do that?"

    If you react without thinking, then your decision is done without process. If you have a process, then over time, you try to refine the process to meet the aspirational goal.

    Our investing decisions are partly luck and partly process. If you have no process, then it's all luck.

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    1. @Anonymous: I don't think I've made my point clearly enough. Only active investors would "aspire to achieve" BCM's answers. Unfortunately, almost all novice investors think this way. Those who have figured out that they lack the skill for discerning an asset's the high and low price points don't strive for BCM's answers. They focus on buy-and-hold and sensible asset allocation.

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    2. @Mike: Your point was clear; thanks for expanding on it. BCM's answers through a more experienced lens are actually quite interesting. Agree for a novice or for an indexer, a process such as passive indexing is suitable. It makes the buy/sell decision a no brainer - buy monthly/weekly and sell when money is needed. The other part of selling is that, at fully taxed rates (e.g. 35%), one has 65-cent dollars to re-invest. Often it's better to keep the government as a partner and use their 35 cents to compound for very long periods of time before turning the taxes over.

      For all three cases, if one doesn't have a process, one will run into trouble. For question 2, if one doesn't have a process that says "the house wins always, I'm out", the risk of loss is certain.

      For question 3, if one doesn't have a process for managing liquidity risk (income vs debt schedule) and asset risk (asset pricing vs debt pricing), one will quickly run into trouble.

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  3. I also think true indexers are very rare.

    Debt is very bad. I can't wait to be done with it in 5-7 years. That's the game plan anyhow.

    Mark

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  4. re: all debt is bad, that's true for most of us, but it's actually not a universal truth. I have a friend (true story!) who uses debt as a tool in his business. It helps him grow and expand, sell more product, hire more people. All good stuff. The debt in and of itself is just a tool, like anything else - not inherently evil.

    As he said to me once, a $1MM debt seems big - until you use it to generate $10MM. Then a $10MM debt seems bad - until you use it to generate $100MM. At that point the $1MM debt seems laughable.

    The same is true for mortgages on homes. I think if used cautiously, mortgages are not bad debt, they're just a tool.

    But all onboard with the quote otherwise - if it's not being used as a tool, then debt is bad. And I suspect that most consumers' debt is bad debt.

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    1. @Glenn: It may be that the combination of business debt and the benefit you get from using the money is a net positive, but it's important not to lose sight of the fact that the debt by itself is bad. I often see students make this mistake. They say that going into debt for education is a good thing and they don't try to minimize how deeply they go into debt (because it's "good debt"). The truth is that it is usually reasonable to borrow for school, but students should live frugally to minimize the debt they end up with.

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