When I studied Economics and Finance in business school, I learned many useful things about investing, but over time I have discovered that they were not nearly enough. Here are the exceptions to what I learned in graduate school, as well as some new realizations. Sometimes, what you think you know is incomplete or just plain wrong. And sometimes, you learn things you never knew you never knew.
Yes, Virginia, bubbles do exist. Years ago my professors downplayed the importance of speculative bubbles, but I think the evidence is clear. In the last 15 years I would argue that we have had (at least) four separate bubbles. Two of those bubbles have already popped, and of those I am sure there will be no disagreement. Bubble #1 was technology stocks (remember all of the dot-com companies?) of the 1990s and bubble #2, housing prices, which from 2001 – 2006 went sky high, simply because people fell in love with the sure-fire benefits of owning them.
Now, I cannot prove it yet, because prices are still high, but I believe we have had a bubble in gold, and to some extent, silver prices. (I wrote about this last November.) The phrase “as good as gold” has a long history and a certain charm, but I would not bet my own money, nor my clients’ money for that matter, on whether gold will continue to do so well.
A Bond Bubble?
I believe that we have also had a bubble in bonds. Admittedly, bonds have done extremely well in the past, but you don’t win a race by looking backwards. Are too many people flocking to the supposed “safety” of bonds? We will see.
Diversification works, but not always. It is foolish to concentrate your investments in a narrow selection of securities. Because we cannot predict the future, we diversify. But in a crisis, when investors are panicking, most assets fall, in lock step.
There have been some exceptions; we can count on cash to be stable, and money market funds have been a safe, if not very profitable, bet. U.S. Treasury bonds usually rise when other riskier assets are falling, but even this may change at some point in time.
A fairly quick recovery of the economy usually follows a recession, but not if it is caused by a financial crisis. This is something Carmen Reinhart and Kenneth Rogoff demonstrate in their book: This Time Is Different: Eight Centuries of Financial Folly. We are living through a very slow recovery, which should not surprise us, given the financial crisis that started the Great Recession.
Decisions by the Federal Reserve are very important but not a sure thing and, certainly, not always the right thing. The Fed can influence interest rates, the economy and people’s expectations. They can slow the economy down when it is overheated, and they can give it a boost when the economy is not growing, but there are limits to just how much they can accomplish. We will learn more about this in the next few years, as events are still unfolding and history is still being written. And, speaking of history, it has shown us (witness the Great Depression) that the Fed’s decisions are not always the right ones. The hope of course, is that they, and other central banks, have learned from past mistakes.
Those in the know, don’t always know. Economists are not very good at predicting anything useful: the growth in the economy, interest rates, exchange rates, stock prices. Top management of a publicly traded stock may be buying their company’s shares like there is no tomorrow, but they can be wrong. Hedge fund managers who have had spectacular results can make bets that turn out spectacularly wrong. Investment “experts” are right some of the time, but are wrong frequently. (See this post.)
Investor behavior is more important than investment returns. To get the long term returns that stocks have delivered over time, you cannot periodically panic, sell your stock investments, and “go to cash.” If your strategy is to “get back in” at a safer time, you will undoubtedly miss the rebound in stock prices. (If you were out of the stock market in 2003 or 2009, you cannot get those large returns back.) Just because the media and your friends are telling you how terrible things are, don’t go along with the “end of the world” story. (See this post.) If you do panic, you will almost certainly hurt your results.
I am thankful that I learned Micro Economics, Macro Economics and Monetary Economics from some wonderful professors. Knowing what incentives drive producers and consumers and how markets work is very helpful. But it is not enough.
In graduate school, I loved studying Modern Portfolio Theory. MPT was so new that we read the original groundbreaking work, before it was even in textbooks. But I am always looking for practical ways to implement it.
Understanding risk premiums and historical returns of various investments is useful, but it is not sufficient. Mathematical models are helpful, but they are not foolproof. To me Portfolio Optimization is a useful framework in theory, but not very practical in application.
We should always remember that people and events are not as predictable as we would like to think. Economics is a social science not a physical science. Psychology frequently plays an important and changeable role. We should not forget that our crystal ball is always cloudy.
The following guest post is a personal story written by an intelligent, conscious friend, who wishes to be anonymous. I post it here, because all couples need to work on their communication regarding money issues. And all individuals and couples need to be aware of why they make the decisions they do.
I believe that individuals and couples will learn something from the experience Anonymous shares, his honest assessment and changed behavior.
Money Challenges for a Conscious Couple
Like Roger, I am a Certified Financial Planner (now retired, however) and have an MBA in Finance. For several years, I have been very involved in The Mankind Project, a men’s organization which is dedicated to improving the world by helping each man achieve his full potential. My wife is a therapist who counsels people on developing effective communication, especially with their primary partners and family members, and learning to live life to the fullest.
You might imagine, then, that we, a happily married couple, would be very effective at communicating with each other about any and all matters that arise in a marriage, including those issues with a financial aspect. Unfortunately, that is not the case; the issue of managing our finances has been far and away the major point of contention in our marriage. Embarrassing as they may be, I will relate our struggles with the hope that, by sharing this, you can learn from our mistakes.
One thing that we have never had to worry about, fortunately, is having enough money. I was an executive at several different banks; I earned a good salary, received stock options, had a 401k, and I now receive a small, but entirely adequate, pension. Just as important, I did not marry until I was in my 50’s, and my then wife-to-be had no children. Thus, as a childless mature couple, we avoided the major expenses of child rearing and college.
When we got married, my wife was an independent, intelligent businesswoman from New York City who made good money in a commission-based job. I moved into her NYC apartment afterward, and was, I admit, pretty unhappy. Having lived in that apartment for over 20 years, my wife essentially “owned” it; The apartment was filled with “her” things, top to bottom, and I missed having my own stuff around me.
Life Events Caused a Re-evaluation
I got laid off from my bank job in 2001- the fourth lay-off in ten years, as banks went through one round of layoffs after another. That was the last straw; I examined my life hard and decided that, in order for me to be happy, I had to quit the corporate game, and move back “home” to the Washington, DC area. I had enough money saved so that both of us could stop working full-time, if we so chose. My wife, understanding that I was just not happy in NYC and open to a change, agreed to give up her established career and move to the DC area.
Once settled back in the DC area, my wife attempted to re-create the success she had had in NYC by doing the same type of work—helping people find jobs (attempted being the operative word.) For whatever reason, and in spite of her incredible work ethic and outgoing, buoyant personality, she just could not replicate her NYC success. (And with all due respect to Frank Sinatra and the lyricist who wrote the words to that wonderful old song, New York, NY, “If you can make it there, you can make it anywhere” simply did not apply in my wife’s case.) So, she became dependent upon me and my savings to live. Of course, I didn’t mind her being financially dependent on me, but I also didn’t think it unreasonable for me to assume that I would be the one who would control our finances. In my mind, it made perfect sense; I was the financial expert, after all. I believed that she should be grateful, not just for my generosity but for enabling us both to retire at relatively young ages, and for my willingness to take control of the finances. I truly thought she would not mind relinquishing financial control to me.
Our Background and Baggage
Both my wife and I had come from homes where money was tight, thus a constant issue between our respective sets of parents. That was the baggage we each carried into the marriage; we both viewed money, not as a tool for enjoyment, but rather as security.
It’s often been said that money is power, and I recognize that implicitly. But here is what I failed to recognize: that the person in power does not have the same “sense” of a power imbalance as does the person out of power.
I enjoy working with numbers and have more experience with and knowledge of money management than my wife. So, it was only natural for me to take on the role of Chief Financial Officer for our family, and for many years, my wife had no objections to it. I paid all the bills and made all the investment decisions and we did just fine.
Having gotten married for the first time when I was 54, I was used to making decisions on my own, without consulting anybody else. Even after getting married, I didn’t really see the need to change my behavior and consult with my wife, especially in areas where I felt supremely confident, namely with respect to money management. After all, she couldn’t possibly add any value to the decision making process, given her lack of knowledge. I didn’t know it then, but my wife was very hurt at how easily I could make financial decisions on our behalf, but without consulting her.
Mauled by the Bear Market
The Great Recession of 2008-2009 presented us with a particularly challenging time. As with so many others, our nest egg suffered a major hit, and we lost over 25 % of our savings. One major bone of contention was my investment philosophy; I was (am) basically a “buy and hold” kind of investor and was more than willing to leave our asset allocation alone. My wife, on the other hand, had told me, even prior to the downturn, that we should get out of the stock market, because she “did not have a good feeling.” I was the financial expert so I dismissed her “feeling” and overruled her.
We stood pat and watched our net worth go down, and down again. Never giving up, my wife would regularly lobby for us to get out of the stock market and, as usual, I would resist. It wasn’t until near the absolute bottom of the market, that my wife’s constant lobbying (and I admit now, grudgingly, my own annoyance for not having listened to her in the first place much earlier), persuaded me to finally really listen. She wanted the mortgage on our house paid off, so I sold off enough stock from our portfolio to pay off the loan balance. In truth, to me, paying the mortgage off didn’t make sense – smart investors buy low and sell high! But the majority of people do the opposite. Much to my chagrin, we later joined the masses in buying high and selling low.
Preparing to be a Widow
A couple of years ago, the husband of one of my wife’s dear friends died after a long bout with cancer, and his wife had to learn how to handle the family’s financial affairs. Unfortunately, she was not well-prepared to take on this task, and struggled with the burden of it, in spite of her husband’s well-detailed instructions on what to do with each account. It was my wife’s observance of her friend’s struggle that was the wake-up call that she, too, should become more knowledgeable about our finances. Now.
My wife insisted that I make no financial decisions without consulting her first. I hated the idea, but acquiesced once I realized how strongly she felt about it. It took me some time to get used to the idea of it, but now we have regular meetings to discuss how our finances look and what we should do or changes we should make. My wife has assumed responsibility for monitoring our expenses, using the free on-line tool, Mint.com. She has become disciplined in reviewing each and every expenditure on that system and assuring that it is correctly categorized. I calculate our net worth on a monthly basis and evaluate our asset allocation. As a result of our most recent look at our asset allocation, we decided to change our portfolio allocation, together.
My Advice for Couples
To those couples who argue over money (and really, who doesn’t nowadays!), I suggest the following:
- Understand that both money and knowledge are power.
- Share the three major tasks of managing your money, i.e., paying bills, monitoring expenses and investing.
- Monitor your expenses on a monthly basis. The free on-line tool, mint.com, is a wonderful way to understand what you are spending money on and how much by category.
- Determine what asset allocation you are comfortable with and rebalance your portfolio so that you stick to your target. Take on only the amount of risk that you are comfortable with and that you need to achieve your goals.
- Monitor your net worth on a quarterly basis.
- Have regular financial meetings to discuss expenses and investments.
And most importantly, never assume anything with respect to your partner’s feelings about money management- have the tough discussions early on to make certain you are both on the same page.
Postscript by Roger Streit
Many people are not motivated, or do not have the time, to analyze and monitor their financial situation. A good financial advisor should be able to help you assess your goals, discuss your risk tolerance, set up a sensible portfolio, and even help you unpack your feelings about money. Do-It-Yourself is not right for many people.
The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good.
At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets.
So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies like the Australian dollar are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and Swiss francs.
It is all reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets.
As to what happens next, no one knows for sure. That is the nature of risk. But there are a few points individual investors can keep in mind to make living with this volatility more bearable.
* Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor’s of the US government’s credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
* Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.
* Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive of months of gains totalling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
* Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road.
* Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving.1 A globally diversified portfolio takes account of these shifts.
* Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.
The market volatility is worrisome, no doubt. The feelings being generated are completely understandable. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value will re-emerge, risk appetites will re-awaken, and for those who acknowledged their emotions without acting on them, relief will replace anxiety.
Jim Parker, a Vice President of Dimensional Fund Advisors, wrote this essay. It is posted here with permisson.
“In the short-term the stock market is a voting machine, while in the long-term it is a weighing machine.” – Benjamin Graham.
On Friday evening, the Standard & Poor’s debt rating agency downgraded all U.S. government debt with more than a year of maturity, from the top AAA rating down to AA+. To put that in perspective, now only 17 countries enjoy the AAA rating on their government bonds. Typically, that means that they are considered the safest havens for cash, and therefore are able to pay the lowest interests rates on their borrowing.
Here’s the list, and I’ve included the current yields on each country’s 10-year government bonds in parentheses. This lets you see what the top-rated countries pay on their debt, compared with the 2.5% interest the U.S. government has to pay on its 10-year U.S. Treasuries:
France (3.41%), Germany (2.83%), Canada (2.93%), Australia (5.75%), Finland (3.19%), Norway (3.29%), Sweden (2.82%), Denmark (3.06%), Austria (3.30%), Switzerland (1.53%), Luxembourg (NA), Guernsey (NA), Hong Kong (2.29%), the Isle of Man (NA), Liechtenstein (NA), the Netherlands (3.17%), and Great Britain (3.11%).
The first thing to notice is that the U.S. government is still borrowing at very attractive rates compared with the triple-A nations, and Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government. Why? The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find. The United States still offers the deepest and most liquid bond market in the world.
The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy. S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance. They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders–sort of like one of us telling the bank that we’re thinking seriously about not making any more mortgage payments.
David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.” A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”
Long-term, our government faces some difficult choices. The question now is whether we’ll get action from Congress or more political posturing. We’ll get an early look between now and Tuesday, as a new Congressional committee, made up of Democrats and Republicans, will be set up. The committee will be looking for $1.5 trillion in deficit cuts that have not yet been specified through the debt ceiling compromise. (A total of $917 billion in cost reductions has already been earmarked).
What should investors do?
What does all this mean for investors? The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff. Early indications are that global markets have been negatively affected by the S&P downgrade.
But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market. Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year. The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.
The awful nature of the debt ceiling debate, plus the downgrade, has clearly added fear and uncertainty to an already sluggish economic recovery. The Treasury debt downgrade is a blow to U.S. pride, and a warning to Congress–particularly those representatives who think the U.S. can simply walk away from its obligations without consequences.
However, as the decline in Treasury rates made clear, the downgrade is largely symbolic. Congressional gridlock and partisan posturing could leave us with a long 15 months until the next time we have a chance to vote on their job security. But it might be helpful to think back to last summer, when concerns about a double-dip recession and mild panic sent the S&P 500 down a long unhappy slide to a low of 1022.58 on July 2, 2010, with a few additional bounces along the bottom until a September rally. Investors who sold out of the markets at that time missed significant–and largely unexpected–gains through the fall, winter and spring, as people gradually realized that the world was not coming to an end. (Despite periodic “end of the world” stories promulgated in the press, the world never does end.)
Our Cloudy Crystal Ball
No one can predict stock market prices, because in the short term, emotions can rule the market, and they are visibly tilting toward panic right now. Longer-term, market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing.
The Price of Panicking
The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between. Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning, and the U.S. will emerge from this crisis like it has all the others. In the past, investors who managed not to succumb to the panic like so many did last summer did extremely well.
The alternative is to get out of the market now (after prices have already declined) and wait to get back in, when the economic environment is settled, and things no longer look downright dangerous. The price you pay for this respite from anxiety is usually very high. By the time you feel comfortable being an investor in stocks again, prices will typically be much higher than when you sold.
Selling low and buying high has never been a winning strategy.
Over the years, as I have spoken to quite a few people about bonds, the various conversations have often taken a different direction, depending on the “environment” at the time. Take, for example, 1999, when common stocks were on a tear; then I had to explain the reasons why anyone would want to invest anything at all in the bond market. And in recent times, in this “environment” I’ve actually had to talk investors out of investing too much of their money in bonds.
These are both examples of what Behavioral Economists call “recency.” Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data.
A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio. When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country. In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date. Depending on the circumstances, you may or may not realize the promised returns.
Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy. Bonds are considered safe and therefore have a lower expected return than stocks. But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk. Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them.
Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment. Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe.
Portfolio strategists view bonds as a way to provide stability to a portfolio. Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings. The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time. The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.
It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues. I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.
Over the long term, stocks have always outperforned bonds. And over time, it is the erosion of purchasing power that is the biggest risk for most people. Most bonds do not protect you from the ravages of inflation.
In the long-term, you need both equity investments for growth and bond investments for stability. How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.
To be continued.
I’ll admit that Jim Cramer is a very colorful character. He has an opinion on the relative merits of thousands of companies’ stocks, and he seems to personally know the CEOs of each and every one of them. And he talks way faster than most people can listen.
While I do use CNBC’s web site, I hardly ever watch their TV channel. I always recommend that investors shy away from Mad Money, and in fact all TV shows of that ilk. You know the kind that “shares” “opportunities” for you or makes predictions on interest rates, stock prices, commodities, etc. etc. etc.
But my advice is to avoid Jim Cramer, in particular, because he convinces people that the right way to invest is to pick individual stocks, to time the market and to trade. For most people, this is a formula for losing money. By trying to “beat” the market, they are more likely to underperform. This isn’t just my opinion; it is supported by actual studies of how well individual investors do.
I have chosen to write about Jim Cramer now, because the last few days have been so dramatic. I think events indicate that he pretends to, but really doesn’t know, what the future brings.
If case you weren’t paying attention to the day-to-day swings in the stock market (and good for you if you weren’t), here’s what happened.
On Tuesday, May 31st, the stock markets had a tremendous rally, i.e. stock prices went up worldwide. That very night on his TV show, Cramer was beside himself with glee, ranting that this trend was very likely to continue. As he put it, “We haven’t seen this kind of global move for ages!”
You can watch the May 31st show:
Well, in the immortal words of Gomer Pyle (I know I’m dating myself), “surprise, surprise, surprise.” Since that prediction, just a week ago, the stock market fell over the next four consecutive trading days, on Wednesday, Thursday, Friday and Monday.
So what did Cramer have to say about the four days worth of declines on Monday night’s show? Sometimes “it’s right to be grim about what’s happened.”
You can view Monday’s show:
After the stock market had a large rise, Cramer was terribly optimistic. After the stock market declined, Cramer has a decidedly downbeat view. This change happened in one week. Should you take his views seriously? I would not, but you must decide for yourself. Do you want to be buffeted by changes in the day to day stock market? Or would you be better served by having a sensible long-term plan that takes into account your needs, your goals, and your willingness and ability to take risk?
What will happen next week or next month? I haven’t a clue. And that’s the point. No one can know the future; surely, you’ve heard me say that once or twice. In my opinion, you don’t have to be a good forecaster to be a good investor. You need to have a plan, and you need to stick to it.
Where to find a good planner? I would start with NAPFA, if you want someone to manage your investments and the Garrett Planning Network, if you are a confirmed do-it-yourself investor. You will still have to do your own due diligence. (Disclosure: I am a member of both groups.)
Friends don’t let friends watch Jim Cramer.
“After more than a quarter-century as a professional economist, I have a confession to make: There is a lot I don’t know about the economy.” – N. Gregory Mankiw.
The well-kept secret that the media won’t tell you is that, in spite of the fact that they do it all the time, economists find making predictions fairly tough, and they’re really not very good at them.
I’ve commented on this before, and past posts are grouped under the Series: The Cloudy Crystal Ball.
If You Have the Answers, Tell Me
In this Sunday’s New York Times column, Harvard professor and economist N. Gregory Mankiw admits with some humility what he doesn’t know. And he doesn’t know a lot, apparently. That list includes the very things we care and worry about as consumers, investors, Americans; things such as the future direction of the U.S. economy and unemployment, the future amount and impact of inflation on consumer spending and business investment, and how long the U.S. government will be able to borrow money at such low interest rates.
How refreshing for a professional economist to be humble.
Professor Mankiw’s column is brief and well worth reading.
He concludes with this, “If you find an economist who says he knows the answers, listen carefully, but be skeptical of everything you hear.”
Larry Swedroe has, for many years, expressed similar skepticism about the ability of forecasting to add value. Mr. Swedroe is director of research for The Buckingham Family of Financial Services, author of several books that I have read with great pleasure, and he is my absolute favorite blogger at Wise Investing.
Never In Doubt, Often Wrong
Here is something he said in 2002.
The track record of economists is dismal (perhaps that is the real reason it is called the dismal science). The track record of market strategists is equally dismal. Despite this, the press and media focus on forecasts (though rarely holding the forecasters accountable, for accountability would end the game) and investors pay great attention to them; allowing the forecasts to influence or even determine their investment strategy.
Buckingham’s Swedroe on Housing, Oil, Investing
In a recent interview aired on Bloomberg TV, which is well worth viewing in my opinion, Swedroe said emphatically, “There are no good forecasters.”
Not merely offering a criticism of forecasters and prognosticators, he also discusses the “right way” to invest. Specifically, Mr. Swedroe advises controlling risk by widely diversifying, keeping costs down and keeping taxes low. And, of course, by not buying actively-managed mutual funds.
Now that most of us have filed our tax returns (or extensions, if you’re waiting till the last minute again) it may be a good time to think about that other inevitable – death. I don’t mean to sound morbid, but let’s face it, not a one of us is going to live forever. This is not exactly an original thought. Witness the memorable aphorisms of yesteryear. Tempus Fugit and Carpe Diem. (For those of you who slept through high school Latin classes, I’ll translate: Time flies and seize the day.)
And witness the recent obituaries – much more than a few – of lovely people who died in their 50s or 60s, an age I now consider young.
Financial planners have to deal with life’s uncertainties and we do our best to prepare our clients for some really unpleasant possible outcomes, e.g. dying very young, becoming frail and needing long term care when very old, or worse, becoming frail and needing long term care when very young. In many cases, the economic blow can be softened to some extent by buying insurance, whether life, disability or long term care, for ourselves and for our families.
And since we can not know how long we will live (only that we are living longer), insurance companies have developed a new policy called “longevity insurance” which only pays off if (and only if) you live past 85.
But life is about more than financing the future. The other side of saving for “tomorrow” is enjoying “today.”
Everyone has different goals and priorities. For some, enjoying today means buying a new and snazzy car, for others, taking a trip to Europe with dear friends or even taking a year off to do charitable work.
The challenge, of course, is to strike the right balance between current consumption and saving for the future. And of course what matters is the kind of life you want.
One life coach uses a series of questions to help clients determine what is truly important to them. The first question is “If your doctor told you that you had 5 years to live, what would you do now?” The discussion proceeds from there and can have a striking impact, because it allows you to focus on what really matters to you.
In the future, I will be writing about practical concerns and strategies for spending less and saving more. But for now I wanted to emphasize that the quality of life should be foremost in our planning.
Jim Parker of Dimensional Fund Advisors recently wrote a column on the proper approach to risk, as it applies to investing. To me it’s all common sense, but that sometimes is in short supply, just when you need it the most! Read on to see if you agree.
A wise man once said that to profit without risk and to experience life without danger is as impossible as it is to live without being born. That all may be true, but which risks are worth taking and which are not?
The fact is even the most self-declared risk-averse people take risks every day. There are routine risks to our safety in crossing the road, in riding public transport, in exercising at the gym, in choosing lunch and in using electrical equipment.
Then there are the “big decisions” like selecting a degree course, choosing a career, finding a life partner, buying a house and having children. These are all risky decisions, all uncertain, all involving an element of fate.
In making these decisions, we seek to ameliorate risk by carefully weighing up alternatives, researching the market, judging possible consequences and balancing what feels right emotionally and intellectually, both in the short term and in the long.
Sometimes, we ask an independent outsider to guide us in making our decision. They do this by providing an objective assessment of the potential risks and rewards of various alternatives, by taking a holistic view of our circumstances and by keeping us free of distraction and focused on our original goals.
In investment, this is the value that a good financial advisor can bring—not only in understanding risk and return and how to build a portfolio but in knowing the specific needs, circumstances and aspirations of his or her individual client.
Quite simply, many people who invest without the help of an advisor take risks they do not need to take. They gamble on individual stocks, they rely on forecasts, they chase past returns, they fail to rebalance their portfolios to take account of changing risks and they run up unnecessary costs and tax liabilities.
To use an analogy, this is like trying to cross an eight-lane highway in the face of heavy traffic when there is a pedestrian bridge a little way down the road. You may well get to your destination safely through the traffic, but it will be despite your actions rather than because of them. Understanding risk in investment begins with accepting that the market itself has already done a lot of the worrying for you. Markets are highly competitive, which means that new information is quickly built into prices. Instead of trying to second guess the market, you work with it and take the rewards that are on offer.
Your biggest investment is in spending time with an advisor building a diversified portfolio designed to meet your long-term requirements, then meeting them periodically as your needs change and to ensure you are still on course.
In considering all of this, it is important to understand that risk can never be totally eliminated. If there were no risk, there would be no return. But your chances of a good outcome are far greater if you use the accumulated knowledge of financial science and the guiding hand of an advisor who knows you.
To sum up, risk and return are related. But not all risks are worth taking. The process of working this out starts with not trying to do it all alone.