Seven Deadly Sins of investing

The single most important risk to a portfolio of investments is a poorly defined or constantly changing strategy. You must have a long-term approach to which you adhere over time regardless of the current favor of the particular strategy. You will need to resist the psychological pressures of investing:

Consider these “seven deadly sins of investing”:

  • //gluttony//– hoarding cash when you should invest or evaluating by only one category when you should look at the big picture;
  • //greed//– looking for big winnings when time and patience pay off;
  • //pride//– not selling your losers or old, familiar holdings when a new idea is better;
  • //lust//– listening to the information barrage and adjusting your portfolio constantly rather than filtering it out to stick with a plan;
  • //envy//– chasing fads or looking at a friend who has “winners”, making investing look more like gambling, when actually you should sell your best and buy trailing but good positions (as in the “dogs of the Dow” technique);
  • //anger//– not forgiving yourself for mistakes and moving on; and
  • //sloth//– changing beliefs to fit your decisions or portfolio rather than applying the lesson that you should review a portfolio intellectually and objectively and decide if you would still buy the holdings today.

You should review your asset allocation at least annually. A stock market rise will leave you over-weighted in stocks, meaning that you should sell out of stocks and buy into bonds and cash to maintain the allocation. If the stock market goes down, you should do the reverse. In fact, you should sell from your better mutual fund managers and buy the managers that have not done as well recently because those excelling and those lagging are both likely to return to the mean over time. Reallocating may seem wrong, especially when bond yields are low and CD rates are low. Nonetheless, history tells us to override the psychological urges, take “profits” from those currently doing well, and re-deploy them with assets that are more likely to provide future returns.

Adhering to a sensible investment strategy is how money is made over time. You may feel that you missed out compared to someone who is all in the right stocks now. However, you will also be glad to miss out when that person’s holdings go down faster than the market and you have non-stock investments that increase in value. Also, when there is a new influx of capital, you need to have a strategy so you can sensibly filter the barrage of information from people wanting to help you handle you finances.

The financial world today – adjusting expectations and planning rules

Has investing changed in the last few years? A recent Morningstar post began with this statement:

BlackRock’s Larry Fink says be 100% in equities. PIMCO’s Bill Gross claims equities are dead. Vanguard’s Jack Bogle preaches stay the course with a balanced portfolio. To read the headlines, it seems that three of the best and most trusted names in finance are decidedly at odds with one another. In truth, their forecasts are far more similar than dissimilar. [from Should I Stay or Should I Go? – Don Phillips, 10/11/2012]

His point is that neither extreme, 100% stocks or 100% bonds, is rational. Instead, we have to realize that returns will be less for now and yet still invest well.

**Expect less: ** Interest rates are at all-time lows, making fixed income returns meager, and equity investments may depend directly or indirectly on renewed growth and employment, which is not rebounding significantly any time soon regardless of who our next President is.
**Diversify more:** The correlation among asset classes is closer than before, making diversification more challenging. As Feifei Li said in a recent Morningstar post, it is not a question of having all your eggs in one basket but of having too many eggs. This would mean adding market-neutral, commodities, and real estate, to a portfolio of just stocks, bonds and cash. Among other ideas, writing calls could even be a good strategy to create income so that you have a positive return in an otherwise flat market.
**Cut back withdrawals:** Where we used to say, as a rough rule, a 4% rate of distribution would allow the portfolio to grow to face future inflation, while any higher withdrawal rate would eat into principal quickly. Today, the rule may be a 3% rate, or we may need to use other ways to analyze the proper rate of withdrawal, such as the Withdrawal Efficiency Rate from a recent Morningstar post [see below]
**Tax planning: ** As we indicated in a recent post, taxes will have more impact so tax planning to achieve even a 3% rate of return is essential. With the changes coming in 2013, good planning could add to your returns over time. **See** [[http://sab-esq.com/2012/10/20/2012-year-end-tax-planning-2012-vs-2013-tax-strategies-requiring-action-now|Year-end-tax-planning-2012-vs-2013-tax-strategies-requiring-action-now]]

**References:**
**Should I Stay or Should I Go?** – Don Phillips, 10/11/2012
It seems that three of the best and most trusted names in finance are decidedly at odds with one another. In truth, their forecasts are far more similar than dissimilar.Eggs Are Not Enough: The Truth About Diversification – By Feifei Li | Posted: 10-22-12
**Eggs Are Not Enough:** The Truth About Diversification – By Feifei Li | Posted: 10-22-12
Diversification means not putting all your eggs in one basket. But do you own too many eggs?
**Retirement-Withdrawal Strategies Quantified** – David Blanchett, CFA, 10/19/2012
According to a new Morningstar metric, the best approach incorporates portfolio value and life expectancy.

Keeping perspective while the debt ceiling “crisis” continues ….

While Congress and the President continue the political battle on the “debt crisis,” here is more for proper perspective:

First, the yield on Treasuries if falling, not rising. If there were a serious issue about the US ability to repay, then US bonds would see high rates. That is, unlike Greece, which is in real trouble, or even Spain or Portugal, the US is still able to borrow at very favorable rates. So, the markets in general, up to this point, believe that the “crisis” has nothing to do with the economy or the strength of the US relative to other nations.

Second, the debt issues have come about after the extended bull market ended in 2008. That is, high stock values and prosperous markets yielded high tax revenues. With this, there were years of budget surpluses, even after tax cuts were enacted. But, post 2008, that has changed. The change in the economy and stock values, even with some markets approaching their 2008 high points, has led to much lower tax revenues.

Finally, from Floyd Norris in the New York Times, we have this summary:

“If rationality does prevail, the debt ceiling will be raised. For that matter, there is no good reason to have a debt ceiling other than to give politicians a chance to grandstand. The important decisions for Congress and the White House concern spending and taxing. Borrowing, or paying back debt as happened for a couple of years before the Bush tax cuts, is a result of the interplay of those decisions and the state of the economy.”
And
“There is a risk that many analysts now are making the opposite mistake. Deficits have skyrocketed in recent years for reasons that are clearly temporary, or that will be temporary if the economy recovers. In some of the debate, the short-term problems are mixed up with longer-term demographic concerns caused by the aging and retirement of the baby boomers and the rising costs of Medicare, the health insurance program for Americans over the age of 65.”

So, with fingers crossed for the prevailing of rationality soon, that is my update. Let me know if you have questions or comments

Irrationality and investing

The Morningstar article reprinted below on Investor Irrationality is worth reviewing in these challenging times

The article makes the case for asset allocation, with a long-term view, and to holding on and not attempting to time the market.

Implicitly, the article makes the case for having a good advisor work with you to avoid falling into these traps of irrational investing. We hope are guidance has worked!

Thanks,

Steven


In Practice: Patterns of Investor Irrationality

by Jim Licato and Alina Tarlea | 10-15-09

We value your feedback. Leave your comments, insight or criticism at the end of this article.

Here are some common ways issues of behavioral finance show up in practice.

The Melting Pot

Despite the recent run-up in the stock market, it is safe to assume that investors are still a bit hesitant to get back into the market (or to stay in the market), let alone consider the riskiest of investments. What investors should understand is that separate types of investments perform differently from one another, which has made it possible to lower the risk of volatile assets by combining them with other types of investments.

Allocation Return Risk

Large Stocks 20% 9.4 17.3

Small Stocks 20% 11.7 25.1

Bonds 20% 8.8 11.8

Cash 20% 5.8 0.9

International Stocks 20% 9.8 19.1

Total Portfolio 9.8 11.0

Mental accounting is a pattern of investor irrationality in which an investor mentally compartmentalizes investments while neglecting to focus on the portfolio as a whole. Mental accounting can often impede investors from making sound financial decisions.

This investor behavior is often evident when international investments are introduced. Risks that often raise red flags when investing internationally include currency, economic, political, and market liquidity. When clients view this particular investment in a vacuum, they are usually less receptive to include it in their portfolios. They are dismissing the potential diversification benefits of international investments and possible improvements in the risk/return trade-off.

While the relative safety of cash and bonds may be soothing, especially during this day and age, investors are sacrificing long-term growth. Some investors may be willing to sidestep greater returns because the volatility of stocks may be too intimidating. As shown in the table, by focusing on the whole portfolio (and not just the individual components), an investor would actually experience a risk level that was lower than bonds and a return that was comparable to stocks.

It is important to note that some mental accounting may be helpful for your clients. For example, if it is helpful for them to mentally account for investments in terms of the goals they are trying to achieve (retirement, college savings, etc.), mental accounting could be warranted. In most cases, however, where your clients are reluctant to get back into the market, or to just stay the course, having them concentrate solely on the total portfolio may help pacify them.

Short-Term Focus

It’s tempting for clients regularly to monitor their investment accounts. Instant access to real-time quotes and a barrage of media reports on daily stock market fluctuations can make it difficult for clients with a long-term investment horizon to stay focused on their goals. In reality, these daily market movements may not be as extreme as they seem. As investors look longer term, their perception often changes. (1989-2008 probability of losing money in the market: daily 46%, monthly 37%, quarterly 30% and annually 25%)

Short-term market fluctuations can be quite volatile, and the probability of realizing a loss within any given day is high. However, the likelihood of realizing a loss has historically decreased over longer holding periods. The [parenthetical above] illustrates that while the probability of losing money on a daily basis over the past 20 years was 46%, the probability dropped dramatically to 25% when analyzing an annual time period.

Periodic review of an investment portfolio is necessary, but investors shouldn’t let short-term swings affect their view of the future.

Investor Returns

Time and time again, financial experts have recommended a long-term approach to investing and have cautioned investors against market-timing attempts. Despite these warnings, a typical trait of investor behavior is overconfidence. People exhibiting this behavior believe they have the ability to identify market highs and lows, and they invest based on this belief.

It is extremely difficult, however, to consistently time the market, which is why overconfidence can lead to disappointing results. (related graph available on request) Contrary to their desired strategy, many investors end up buying high and selling low, which drastically diminishes their returns.

Morningstar Investor Returns measure how a typical investor performed over time, incorporating the impact of cash inflows and outflows from purchases and sales, as opposed to total returns, which assume investors held the investment for the entire time period. The graph compares average investor returns for stock and bond funds to the returns of stock and bond benchmarks. For all but two time periods analyzed, investor returns have been consistently lower than market returns.

Regret and Risk

Investors often react emotionally after realizing an error in judgment has been made. Investors prone to regret may base investment decisions on regretful decisions they made in the past, encouraging them to become either risk averse or to take greater risks.

Consider the situation of each of the following investors. Client A purchased shares in Company ABC on Jan. 1, 2007. He sold the shares at the end of June 2007 because the stock’s performance was flat. Client B considered purchasing shares in Company ABC on the same day Client A sold his shares, but she decided to take a pass. Company ABC went on to triple in price from July 2007 through July 2009. Which investor is unhappier as a result of his or her decision? The outcome is the same; both investors should have the same amount of regret. However, studies show that the regret of having done something is greater than the regret of not having done anything. Therefore, Client A has more regret than Client B.

There’s another layer to regret. Daniel Kahneman and Richard Thaler asked 100 wealthy investors to bring to mind the financial decision they regretted most. Most participants reported that their greatest regret was from something that they had done. Those who reported a regret of not having done something were shown to take on more risk; they held an unusually high proportion of their portfolio in stocks.

Jim Licato is Morningstar’s research and communications manager. Alina Tarlea is a Morningstar research and communications analyst.

Let us know if you have questions or comments. Thanks,

Steven