Archive | Behavioral finance

Three Reasons to Ignore Market Downturns

“Long-term investors shouldn’t worry about daily or weekly blips in the markets.” How many times have you heard that? It’s true of course, but most investors don’t heed the advice. And to be fair, it’s hard to ignore the financial markets when there’s non-stop commentary in the news and on social media.

Since markets began falling early last month—the S&P/TSX Composite Index shed more than 11% in the six weeks following September 3—some investors are starting to get spooked. As one wrote to me recently: “A word of encouragement would be appreciated for those of us who recently began the Couch Potato plan and are now seeing our ETFs going down.”

Words of encouragement are helpful, but “don’t worry, be happy,” doesn’t cut it. So here are three specific reasons why a falling stock market shouldn’t shake your confidence in a balanced index portfolio.

1. Downturns are ridiculously normal. A reasonable expected rate of return for a global equity portfolio might be about 7% to 8%. But this is an annualized average over the very long term. In any given year, equity returns is likely to be much lower or much higher.

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Do You Really Know Your Risk Tolerance?

Almost 75 years after it was written, Fred Schwed’s Where are the Customers’ Yachts? remains one of the most entertaining books ever written about the investment industry. Here’s one of its best remembered lines: “There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own.”

As Schwed recognized all those years ago, no one can really gauge their risk tolerance by filling out a questionnaire, or by pondering standard deviations. It’s easy to say that you have a long time horizon and you won’t panic in a downturn. But the fact is, no one really knows how they will react until they have actually lived through a devastating bear market.

And if you only started investing in the last few years, you haven’t been tested yet.

According to a Bloomberg article published earlier this month, the S&P 500 has now gone more than 1,000 days without a correction of 10%. The last time investors enjoyed a run like this was a 1,127-day period that ran from July 1984 to August 1987,

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Why Practice Doesn’t Make Perfect in Investing

In almost everything we do—whether it’s learning the violin, playing chess or excelling in sports—practice makes us better. In his bestselling book Outliers, Malcolm Gladwell popularized the “10,000 hour rule.” It says no matter how talented one might be, becoming a virtuoso musician, a chess grandmaster, or an elite athlete typically requires approximately 10,000 hours of practice.

Even more important, you need to receive useful feedback during your practice. In Thinking Fast and Slow, the psychologist Daniel Kahneman explains that learning to drive is one activity where feedback is immediate and clear. When you’re taking curves, you instantly know whether you’ve turned the wheel too sharply or applied the brakes too hard. This makes it relatively easy to improve as a driver. By contrast, a harbour pilot learning to guide large ships experiences a longer delay between his actions and their outcomes, so the skill is harder to acquire.

Now consider how these ideas apply to investing. Someone who has little experience is likely to make many mistakes—which is normal in any new activity. They might think they’re well diversified even if they own just five Canadian stocks, or they may choose a bond based solely on its yield,

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How One Investor Found Inner Peace

Most people who embrace index investing are attracted to the low fees and the proven performance compared with a majority of active strategies. But another advantage sometimes gets overlooked, and that’s the peace of mind that comes from a long-term plan that allows you to ignore the distractions of daily market movements.

I recently received an email from a long-time reader named Steve, who described his investing journey. “I’m curious if my experience of ‘inner investing peace’ is unique or typical,” he says, so with his permission I’ll share some of the details.

“I’m in my mid-40s and I was already familiar with the theory behind passive investing when your blog was becoming popular back in 2010,” Steve writes. “I’d already had run-ins with expensive mutual funds, and I had already done a fair amount of (unsuccessful) investing in individual stocks as well. I had a friend who traded options, and I even dabbled in that. I then moved on to dividend growth investing for a while. My problem was I was never patient enough: I wanted results immediately.”

Shortly after the crash of 2008–09, Steve began reading about indexing and the evidence won him over,

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When the Smart Money Does Dumb Things

Investors can a learn a lot from pension funds, particularly when it comes to diversification, risk management and long-term thinking. But it seems professional money managers are not immune from the behavioural challenges that plague retail investors.

Doug Cronk, who writes a useful blog called Institutional Investing for Individual Investors, recently pointed me to a couple of industry articles that make it clear the pros are just as human as the rest of us. (I interviewed Doug last fall for an article called “Invest like a pension fund manager” in Canadian Business.)

In a February article in Pensions & Investments, a strategist explains that many pension funds have an investment plan that calls for them to increase their allocation to bonds when their plan is well funded. This is what investors might call “taking risk off the table”: the idea is that if equity markets have been strong and you believe you’re comfortably on track to meet your goals, you can afford to reduce the risk in your portfolio. However, the strategist says many fund managers are reluctant to carry out this plan: “According to their glidepath they should be starting to shift asset allocation now,” he says.

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The Failed Promise of Market Timing

I’ve long believed the most difficult part of being a Couch Potato investor is resisting temptation. Index investors are asked to be content with market returns, but they are bombarded daily by fund companies, advisors and market gurus who promise more.

Back in May 2012, I wrote about one of these enticing strategies, described in The Ivy Portfolio by Mebane Faber and Eric Richardson. The so-called Global Tactical Asset Allocation (GTAA) strategy grew out of Faber’s widely read research paper, A Quantitative Approach to Tactical Asset Allocation, first published in 2007. It begins with a diversified portfolio inspired by the Yale and Harvard endowment funds, combining traditional and alternative asset classes. The “tactical” part involves using market timing to move in and out of these asset classes based on 10-month moving averages.

Faber updated the paper in early 2013 and it now includes four full decades of data. From 1973 through 2012, the GTAA strategy shows exactly one negative year: a modest loss of –0.59% in 2008. And over those 40 years, the GTAA delivered an annualized return of 10.48% with a standard deviation of 6.99%,

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The Powerful Pull of Possibility

If the evidence in favour of passive investing is so strong, why isn’t the strategy more popular? I hear that question all the time, and there are several answers, including effective marketing by investment firms and a general lack of awareness. But there’s another reason that affects even those who are well aware of the research. It’s the deep emotional appeal that comes from the possibility—however small it might be—of achieving market-beating returns.

I thought about this recently during a conversation with an investor who was considering moving from his current advisor (who used a highly active strategy) to an indexed approach. Robert had been with his advisor for more than 10 years, and it was clear his portfolio had lagged the indexes over that period. He also complained the advisor was providing no financial planning and no tax management: there was only active investment management, and it had failed for more than a decade. Why, then, did Robert find it so hard to break free?

As we spoke, the answer became clear: Robert wasn’t disputing that indexing had a higher probability of success. He just wanted to hold onto the possibility of outperformance.

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Pulling Off the Bandage Quickly

Deferred sales charges (DSCs) may have been the mutual fund industry’s greatest marketing innovation. Back in the 1980s, it wasn’t unusual for funds to be sold with front-end loads of 5% or more. Then fund companies realized it’s a mistake to charge an entry fee that discourages people from buying your product. Better to draw them in for free and charge them dearly to leave: DSCs typically start at about 6% and continue on a sliding scale for six or seven years, with no time off for good behaviour.

For investors who have six-figure mutual fund portfolios, the cost of selling funds with DSCs is downright painful: in our DIY Investor Service we have worked with clients who have had to swallow more than $5,000. There are no doubt countless others who want to break free of a bad relationship and start fresh with a low-cost portfolio of index funds, but who just can’t bring themselves to fork over those DSCs. They’d prefer to sell their funds gradually over two or three years in order to reduce the upfront cost.

That’s understandable, but in most cases it’s probably the wrong decision. While there may be ways to make a gradual exit,

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The Biggest DIY Investing Challenges

At the recent Canadian Personal Finance Conference in Toronto, I participated in a panel discussion that touched on a wide range of investing topics. My co-panelists were Michael James and financial planner Jason Heath, and we were moderated by the esteemed Big Cajun Man. The first question we were asked to address is whether it makes sense to use an advisor or to invest on your own.

That was a tough question to tackle in a room full of committed do-it-yourselfers. It’s also one I’ve struggled to answer honestly in the last couple of years. I’ve been an advocate of DIY investing for some time, and I still believe many investors with uncomplicated situations are capable of managing a simple index fund portfolio on their own. Indeed, I think anyone with less than $100,000 or so should seriously consider doing so, because it’s awfully difficult to find an unbiased, fee-based advisor unless your portfolio is larger. And unfortunately, it’s all too easy to find a commission-based mutual fund salesperson who will turn your wealth into his own.

But over the years, as I’ve corresponded with readers—and more recently started working with clients—I’ve learned that DIY investing is much harder than it sounds.

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