Wednesday, November 18, 2015

Taking My Investment Decisions Out of the Loop

All the evidence says that the vast majority of us aren’t good active investors. Our choices tend to be worse than random, and we pay investment costs on top of this. Even index investors can have these problems. Here I explain how I’ve tried to automate my investment decisions as much as possible to take myself out of the loop.

Investors have many worries. Is now a good time to be buying stocks? Should I be selling now? Are there better mutual funds than the ones I own now? Should I shift more money into bonds? Less?

Unfortunately, the evidence shows that most of us make worse than random choices when we try to answer these questions. It’s tough to admit that we can’t beat a coin flip.

My response to this dilemma is to ignore my opinions on the market and invest in indexes. And as long as I’m not trying to beat the market, I maximize my returns with low-cost highly-diversified index ETFs.

But even after making this decision, investment choices can creep back in. For example, when adding new money, which ETF should you buy? I automate this choice using a fixed asset allocation. I have a target percentage of my portfolio for each ETF I own. When I have new savings to invest, I buy those ETFs that are below my target percentage.

Another investment choice that can creep back in relates to rebalancing. If my ETFs have different returns, my portfolio’s percentages can get out of balance too much to fix when I add new money. However, if I use my judgment on when to rebalance, I’m effectively making an active decision. So, I have a method to compute rebalancing thresholds. If my percentages get outside a range computed in my portfolio spreadsheet, then I rebalance.

This leads us to the next subtle form of decision-making. If I bury my head in the sand instead of paying attention to my spreadsheet, I’m effectively overriding the spreadsheet’s decision and substituting my own active decision. This is a common problem because many of us can’t bear the thought of selling an investment that has gone up to buy one that has gone down recently. I deal with this problem by having my spreadsheet send me an email with rebalancing instructions. I get these rarely, but always act on them.

The next area where my own discretion sneaks in is with new money. Over time I accumulate dividends and build savings in the various accounts that make up my portfolio. I have to decide when to invest this cash. In this case, I again let my spreadsheet decide. I have a formula for balancing trading costs against the opportunity cost of sitting on cash. This results in a cash-level threshold for each account. If the spreadsheet tells me the cash level in any account goes over its threshold, it’s time to buy.

I don’t believe the advice to “trust your gut” works well in investing. The evidence says your gut isn’t worth much. No doubt there are other subtle ways that my own decisions worm their way into my portfolio, but I believe I’ve managed to keep myself almost completely out of the loop, just the way I want it.

9 comments:

  1. This is a great post. You're right that 'gut' decisions can creep in at quite a few deep levels, some of these I never really thought about.

    But I'm curious how you have your spreadsheet set up to send you email; it seems very automated, something I would love my spreadsheet to do. I see your post in March 2012 about computing thresholds, but I didn't find anything about sending out notifications.

    Thanks!

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    1. @Sebastien: Thanks. Take a look through the comments on the following post for instructions from one of my readers on automating the sending of email:

      http://www.michaeljamesonmoney.com/2014/11/a-deeper-look-at-my-portfolio.html

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    2. That's awesome! Talk about Crowd-Sourcing. I'll add that scripting to my sheet and see if it works.

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    3. @Sebastien: I felt the same way when I first got this working. I can go weeks paying no attention to my portfolio at all knowing that I'll be notified if I need to do anything.

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  2. My gut tells me you are trying to tell me something.... but I am not sure what. (insert photo of Homer Simpson doing anything)

    I always like to hear the argument, "I can't do any worse than choosing at random", but surprisingly, YES YOU CAN (and will).

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    1. @Big Cajun Man: The main way you can get worse than random results is to make random choices and pay fees to do so. Another way is to take on uncompensated risk by having a too-concentrated portfolio.

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  3. I'm pretty good about not "deciding" to invest when investing my monthly contributions. But I still struggle the odd time when I have a bigger chunk of money to invest all at one time. Then I find myself "deciding" on when a good time is to pull the trigger, even though I realize that sort of market timing is most often a loser's game.

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    1. @Juan: I think this just makes you human. My solution to keeping myself from delaying action was automation. Your mileage may vary.

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