We often see debates about whether or not volatility of returns is a good measure of risk.  This debate is related to what I think is a bigger issue: the difference between perceived risk and actual risk.  Perceived risk is influenced by observations and “dollar bias,” but actual risk comes from the full range of what might happen and its influence on buying power. Dollar bias and buying power In some contexts we forget about inflation and view dollars as constant over time.  For example, we tend to focus on nominal returns and think that it’s okay to spend gains as long as we leave the principal intact.  But the principal will erode with inflation if we spend all the nominal gains. Another context where we see this bias is with mortgages.  We can calculate that with a 30-year $400,000 mortgage at 4%, the first year’s payments will only reduce the principal by about $7000.  But even with only 2% inflation, the buying power of the principal will erode by abo...

Before reading Barry Ritholtz’s book How Not to Invest , I wondered if the “Not” in the title was a sign it would be filled with gimmicky ways of giving investment advice.  It isn’t.  Investing well is simple enough, but the world tries to push us towards many types of poor choices that lose us money.  The best advice is a list of the many things to avoid when investing.  This book gives readers the benefit of Ritholtz’s extensive experience with staying on the simple path to investing success. The book is organized into four parts: Bad Ideas, Bad Numbers, Bad Behavior, and Good Advice. Bad Ideas Part of what makes it so easy to push investors toward bad ideas is that we believe secret ways to create wealth exist when, in fact, they don’t exist.  “We don’t like to admit it, but nobody knows anything about the future—not just you and me, but the so-called experts too.”   I’ve had the experience of getting people to agree that the future is unknown, and ...

There is no shortage of studies showing that average investors underperform the market averages, often by 2-3% per year.  However, Barry Ritholtz’s excellent book How Not to Invest says that average investors underperformed by 5% per year one decade and only 2% per year the following decade.  How could this be?  It doesn’t appear to make sense.  So, I started digging. The Data Here are simplified version of the chart I saw on page 382: So, average investors trailed a basic 60/40 portfolio by 2.4 percentage points per year.  This is plausible.  Investors pay expenses, and some of them do some market timing.  Here is what I saw on the next page: This time the behaviour gap is 3.8 percentage points per year for 20 years.  Ritholtz makes the point that “The longer the holding period, the greater the impact of errors that disrupt compounding.”  This is true as it applies to the final dollar value of your holdings.  After all, 20 years of mis...