A Daddy's Financial Tips

Hello. Hello. I know it’s been a while, but it has been for good reason. I’m excited to announce my wife and I welcomed our second child into the world a couple of weeks ago, and Daddy has been busy! Well I’m back, and since I’ve now gone through this miraculous process twice, I thought I would kick things back off by sharing a few financial tips when it comes to having a baby.

• Be prepared before your due date! This isn’t just a financial tip, and as I can now attest with our second child coming two weeks earlier than originally expected, it is critical. Have the nursery ready, have some essential supplies purchased, and have some clothes bought. Have the car seat properly installed and your personal and professional calendar winding down. It’s truly awesome to welcome a little one, but it’s also hectic, overwhelming, and exhausting. You don’t need unnecessary stress that can be avoided, and financially, you don’t want to be in the position of having to buy and pay for things out of necessity without careful consideration and without the opportunity to thriftily shop around.
• If your income will be impacted due to maternity leave or paternity leave via unpaid time off or disability insurance versus your typical salary, budget for this before the baby! I would suggest you work towards boosting your cash reserve so that your lifestyle can remain the same even though your income will be reduced. Frankly, I might even suggest that you save up more than you think you’ll need to offset your lower income because having a baby is an expensive time between all the medical expenses, all the necessary purchases, and the one-off’s that become needed, but weren’t originally expected.
• If you’re buying nursery furniture that can be converted as the child gets older, do you really intend on utilizing that feature? If so, you may want to consider going ahead and buying the additional pieces before they become discontinued and you end up getting stuck with the typically pricier, convertible furniture you didn’t use or couldn’t convert.
• Similarly, before you buy the car seat, consider the car seat’s life expectancy. When does it expire (yes, most have expiration dates)? How big of a child is it made for? Will it last until the child can face forwards, will it last until the child no longer needs a car seat, or is it just for the first couple of years? We ended up purchasing two car seats the first time around, and I’m glad that we did, but as an inexperienced dad-to-be, I can tell you I didn’t know I’d need more than one car seat for one kid when we bought the first car seat.
• This is a little opposite to my message of urging you to be prepared, but don’t be over prepared for the first few months of life. By that I mean don’t go crazy buying insane amounts of newborn diapers and 0 – 3 months’ clothes. Your child will likely need a size 1 diaper at some point, and then size 2, and then size 3, and so on. Your child will also need clothes for the rest of their life, not just the first three months, and they grow quickly! All I’m saying is that those newborn diapers and super tiny outfits may not be useful for very long, and they are not free!
• Realize that all baby outfits likely face the same fate: spit-up or worse. There are some latest and greatest name brand baby outfits out there that cost quite a lot, and if you want a few, or you can afford lots of them, then go for it. That said, there are a lot of very reasonably priced very nice looking outfits that aren’t nearly as expensive and will share the same fate of being at the mercy of stain-removers and the washer and dryer. Dress your baby how you want to dress your baby, but don’t let their fashion derail your finances!
• I don’t often recommend specific companies or services, but get Amazon Prime. The ability to order extra baby mittens, diapers, wipes, formula, a baby scale, or an outfit for your favorite team’s game and get it without leaving your house in a day or two is unbelievable. They cannot be making money on my family right now with all the shipping fees that are free through Amazon Prime, and don’t worry, we do recycle our cardboard!
• Take care of the new baby’s business. This starts with the application for a Social Security Number and a birth certificate in the hospital, but your homework is not done. You need to get your baby added to your health insurance, dental insurance (if you have it), and vision insurance (if you have it), and most of the time this has to be done within 30 days of the birth and requires a Social Security Number and a proof of birth. The forms are long and the interactions with these government agencies and insurance carriers is not particularly fun, but it must be done correctly and in a timely manner.
• If you don’t have wills, power of attorneys, and health care directives, now is the time (your will is how you name a guardian for your children). If you do already have these documents, go back through them and examine your retirement plan and insurance beneficiary designations to make sure your wishes would be fulfilled and your child would receive what you would intend them to. If, like us, you now have more than one kiddo, make sure you have the proper wording in your documents and beneficiary designations to not accidentally exclude any of your children!
• Finally, be careful with unnecessary extras. “Unnecessary” can be a matter of opinion, but with all the digital sharing of everyone’s baby’s everything and all the “super cute” products available for purchase out there, be careful. I would suggest you not order anything after 9 PM to make sure you’re not sleep-buying and anything terribly pricey without talking to the other parent to keep the peace.

Having a baby is one of life’s most amazing experiences, but without careful preparation, thoughtful consideration, and prudent restraint, it can be financially challenging. Certainly, get your precious baby what they need, and splurge and get them a few things that are just neat or fun to have to celebrate the occasion, but be sensible. Remember, your new baby is going to need you for at least 18 more years, and anything you don’t spend now can go towards their car, their college, or their wedding!

I’ve got to run. Someone’s awake and it’s my turn!

Tom

Losses and Gains Are Not Equal!

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In economics and behavioral finance there is an idea called prospect theory. The idea is that most people seem to value losses and gains differently. Does the idea of losing $5,000 feel the same to you as gaining $5,000?

Some actually call prospect theory by a different name: loss aversion. This is because many studies seem to show that losses are about twice as psychologically impactful as gains. Now I’m no psychologist, but I must say, based on my experience in the financial industry, I tend to believe in this theory. When the Dow goes down 300 points in a day, I get more emails, more calls, and more app updates, and the stock market gets more coverage on the television and radio. When the Dow goes up 300 points in a day, I don’t get anywhere near the number of inquiries or hear anywhere near as much media coverage. Is this phenomenon because of fear? Is it because bad news sells? I don’t know, but I think it’s at least partially because of simple math.

Suppose you have $100,000 invested in the stock market and the next bear market hits and your portfolio goes down 30%. You’d be down $30,000 and your investments would now total $70,000. That would certainly stink, but a drop like that is by no means out of the question. Now what kind of bull market will you need to get your portfolio back to where it was? A 30% return? Wrong! You would need a return of 42.86% ($70,000 x 1.4286 = $100,000). Wait. It would take a 42.86% investment return to regain a $100,000 portfolio after the $100,000 portfolio was only down 30%? Precisely. Maybe losses aren’t always twice as mathematically impactful as gains, but losses are more impactful. I think this somewhat surprising and profound math may be part of the reason why losses are intuitively more impactful than gains.

A lot of people think all I do is manage investments. I manage a lot more than that. I manage goals, dreams, fears, and behavior. By having a proper financial plan and investment strategy in place that makes sure you have enough cash, bonds, and alternatives, you can withstand the downturns of the stock market. You can be positioned financially to have the confidence and courage not to sell your stocks low and permanently realize your temporary, paper losses. You can then wait for the next bull market to come, and when it does, when others are getting greedy and buying stocks high, you can rebalance your portfolio and recharge your cash, bonds, and alternatives so you will be prepared for the next market cycle.

I always tell my clients what I think is absolutely best for their unique financial strategy, but if anything, I must admit I err a little on the conservative side. It’s not that I’m chicken. It’s not that I’m pessimistic. I just know losses and gains are not equal psychologically, mathematically, or financially.

-Tom

Is Your Investment Advisor Doing the Hokey Pokey?

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Over the last few months I have had numerous conversations with people regarding their investment advisor’s dance moves. It seems that over the past year there has been a lot of “dancing” going on in some people’s portfolios. Something along the lines of you put your money in the market, you pull your money out of the market, you put your money in the market and move your investment strategy all about. If that has been your investment advisor’s tune or you self-manage your investments and that’s your typical jam, I have one word for you: stop.

A strategy largely based on putting your money in and out of the market is essentially a market timing strategy, and imperfect timing is a very common cause of poor investment performance. The truth is, no one is smart enough or consistent enough to successfully invest with a money in and money out approach over a long period of time. Sure, you can be lucky and look brilliant over a short period of time, but, even so, the transaction fees and short term capital gains taxes generated by jumping in and out of the market time and time again will also diminish your investment returns.

Most people know they need to have a large portion of their assets invested to have a good shot at hitting their retirement goals and to protect their hard-earned assets against inflation. Investors need an overall investment strategy that is historically appropriate for their age and stage in life, withdrawal needs, and risk tolerance. Beyond that, it’s my professional opinion that relatively small tactical adjustments are appropriate when there are specific opportunities or risks in the market or world that you’re trying to navigate, but drastic investment strategy changes should be the exception - not the rule. Sometimes taking action and making a lot of changes in your portfolio can feel good, but “surgery by chainsaw” rarely works out best. Instead, considering things like the amount of U.S. versus international stocks, large cap versus small cap stocks, growth versus value stocks, corporate versus municipal bonds, and long-term versus short-term bonds can be a good idea. 

Consider this year for example. Who knew 2016 would get off to one of the worst starts for a calendar year in market history? What if you’d completely jumped out of the market in February because you thought it was the beginning of the next cyclical pullback and you missed the bounce back of March, April, and May and endured transaction fees and realized capital gains? How many people actually thought Great Britain would vote to leave the European Union? What if you’d completely jumped out of the market in June due to the surprise result, media barrage, and overreaction of other investors and you missed the swift recovery and positive market performance since then?

When investing you shouldn’t make too many one-way, all-in bets. You should view investing as a mechanism to give you a high probability of achieving your financial and life goals. Investing is a marathon, not a sprint. It’s not sexy and it’s not news, but I do firmly believe investing in a prudently diversified portfolio with a long-term outlook really does give you the best chance to accumulate and preserve wealth.

After all, isn’t that what it’s all about?

-Tom

Best Financially or Best For You?

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Some people might think my job is to make my clients as much money as possible. Some people might think my job is to make my clients the highest rate of return on their investments as possible. Generating investment returns within a client-agreed-upon degree of risk is the job of an investment advisor, but as a wealth advisor, my job is two-fold. Not only do I serve as my client’s investment advisor, I’m also charged with being my client’s financial advisor. Of course, I’m always plenty focused on investment strategy, but I’m simultaneously focused on helping my clients get what they want out of their lives.

For example:

• How much cash should you hold? From a strictly financial perspective, conventional wisdom says three to six months’ worth of living expenses if you’re still working and one years’ worth of living expenses or more if you are retired. That is my baseline recommendation with my clients, too, but if you find yourself constantly worked up about what is going on in the world and holding a little more cash would lead to less stress during the day and better dreams at night, then go for it! It’s not necessarily best financially, but it may be best for you.
• How should your portfolio be allocated? Based on an investor’s age, stage in life, and withdrawal requirements, historical return patterns generally lead most good investment advisors to roughly the same recommended allocation, but what if bear markets cause you indigestion and angst to almost a medical level? Given current interest rates and bond yields, it is absolutely critical to have enough allocated to stocks to have a chance to sustain or grow a portfolio over the long-term and to have a shot at protecting your purchasing power against inflation, but within reason, if your indigestion and angst could be soothed by having a few more CDs and bonds and a few less stocks, then why not? It’s not necessarily best financially, but it may be best for you.
• How much should you withdraw? Financially speaking, it’s rarely advised to withdraw unnecessarily from your investment assets, but if you don’t, what is going to happen?  You may end up with some slightly happier heirs?  Your favorite charity may one day receive a bigger check? So often I see people do everything in their power not to withdraw money from their hard-earned assets because they are trying to keep their nest egg as big as possible. Now if a client’s financial stability or financial security is even remotely endangered by a potential withdrawal or their rate of withdrawals, I certainly raise the issue, but there are times after people have shared their dreams with me where my advice is for them to simply spend some of their money. You’ve always wanted that sports car? Get the car. You’ve always wanted to take your entire family on a beach vacation? Take the vacation. You want to help your family financially now when they need it versus later after your death when they potentially won’t? Help your family now. You want to give a substantial gift to a charity or cause you support so you can see the impact? Give the gift. It’s not necessarily best financially, but it may be best for you.

In my opinion there are two kinds of returns: your return on your investments and your return on your life. I would advise that you always be reasonably cautious when it comes to your financial situation, but when it comes to your comfort, confidence, happiness, satisfaction, and fulfillment, strongly consider that what may be best for you may not always be best for you financially. Return on investment is important, but so is return on life!

-Tom

When a Man Loves a Stock

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I was waiting to pick up a to-go order one night after work last week and I was still deep in thought about a recent client meeting. The tax planning and risk management portions of the meeting had gone very well, but I once again could not break through on the investment strategy piece. Despite repeated recommendations over numerous years to try and get this husband and wife to further diversify their portfolio, a vast majority of their net worth is still tied up in one particular stock. It was at that moment that an old song I happen to like came over the speakers: Percy Sledge’s “When a Man Loves a Woman.” Here is what I heard:

When a man loves a stock
Can't keep his mind on nothing else
He'll trade the world
For the good thing he's found

If holding the stock is bad he can't see it
The stock can do no wrong
Turn his back on his best friend
If he put the stock down

 

When a man loves a stock
Spend his very last dime
Trying to hold on to what he thinks he needs
He'd give up all his comforts
Sleep out in the rain
If things don’t turn out the way he thought it’d be

 

Well, this man loves a stock
He gave it almost everything he had
Trying to hold on to its precious dividend
I hope it don’t treat him bad!!!

 

When a man loves a stock
Down deep in his soul
The stock can bring him such misery
If the stock plays him for a fool
He's the last one to know
Loving eyes can't ever see…

 

Now with apologies to Percy, my thoughts and his lyrics got a little mixed up. Still, it is kind of uncanny how interchangeable “woman” and “stock” is, isn’t it?

Based on my experience I think it probably is safe to say that the degree of emotional attachment employees sometimes develop with their company’s stock, investors sometimes develop with the stock of companies headquartered in their state or region, and heirs sometimes develop with stocks they have inherited can only be rivaled by romantic crushes. No matter the stock, and no matter the consensus outlook on that particular stock, I always remind people with significant holdings in one or a couple of securities of companies like Enron, Wachovia, and General Motors. Anything can happen to the stock they love, and although concentration can sometimes lead to wealth accumulation, diversification certainly helps with wealth preservation.

Next time I will once again attempt to articulate the risk-adjusted advantages of a prudently diversified portfolio, but I may just have to make the next meeting a dinner meeting. Perhaps old Percy Sledge’s tune will come on again and resonate with my clients like it did for me. Here’s hoping, because loving eyes sometimes can’t see.

-Tom

Extra! Extra! Read All About It?

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I don’t know about you, but I prefer my sports teams winning versus losing, sunshine to rain, and the stock market trending upward as opposed to trending downward. I’m not sure the media does. Think about the coverage surrounding Mark Richt’s exit from UGA, the Braves’ rebuilding and relocating, and the Falcons’ collapse after starting 5-0. Think about the coverage every time we have tornadoes or, better yet, every time we might see a snowflake. Think about the coverage when the stock market is down a few hundred points in one trading day. There is so much more “breaking” news, so many more news alerts, smart phone notifications, and headlines that are shared when the news is bad. After one of the most volatile and negative months investors have experienced in several years, I’d like to ask you to briefly turn over your phone, mute your television, silence your radio, and turn off your computer for just a few minutes and look at the last ten bear markets with me.

A bear market is defined as a drop of at least 20% from the most recent market high. Below, is a pretty fascinating chart put together by J.P. Morgan showing the characteristics of the last ten bear markets (click on it).

As you can see, markets were down around 86% during the Great Depression. Markets were down 28% during the Cuban Missile Crisis. At a point during the 70s, and during the OPEC oil embargo, markets were down 48%. Markets were down 34% at a time in the 80s after Black Monday and the 1987 market crash. Markets were down 49% in the early 2000s when the tech bubble finally burst. Markets were down 57% during the Great Recession.

Folks, the S&P 500 was down about 5% in January and I’ve seen a whole host of headlines using phrases like “market crashes,” “market plummets,” and “investors robbed.” A catchy title or headline is obviously and purposefully trying to get you to buy a paper, watch the news show, or click a link, but I think it’s important to keep things in perspective.

On the right side of J.P. Morgan’s chart you may have also noticed some data on the bull markets or market recoveries. Markets roared back after the Great Depression, the Cold War, the inflation of the 70s, the Federal Reserve intervention in the 80s, the bursting of the tech bubble, and the Great Recession. On average, the last ten bear markets have been around a 45% pullback while the last eleven bull markets have been around a 151% pop!

Don’t get me wrong, I am concerned about a lot of things going on in the world, and I would not be surprised if market volatility continued. Inevitably, at some point, there is going to be another entry on the “bear side” of J.P. Morgan’s chart. Of course history also seems to offer there will then be another entry on the “bull side” of J.P. Morgan’s chart…

What am I telling people to do? The same things I’m always telling people to do! Make sure you have enough cash set aside to feel comfortable and for any large, upcoming expenses. Make sure that your portfolio is prudently diversified for your risk tolerance and age and stage in life. As hard as it is to accept, volatility is the friend of the long-term investor. The thing is, you have to stay buckled in during the down times in order to fully participate in the up times.

At the rate many media outlets are going, I really don’t know what phrases and terms they will use when we have our next bear market. I don’t know how far they’ll go to try and convince everyone that this time is different. I’ll continue to vigilantly monitor the markets, but don’t expect me to get caught up in some headline. I’m much more interested in focusing on the cataclysmic stinkage of my sports teams and the next allegedly imminent blizzard!

-Tom

Normal Investors – Status Quo

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Think back to Thanksgiving. Remember the turkey, the dressing, the delicious side dishes, and the waiting on Aunt Ethel to finish warming her green bean casserole? Think about where you were sitting. Was this where you always sit? If you typically celebrate Thanksgiving in the same way, at the same place, with the same people, I bet you were sitting in your usual place. Given the chance, would you have chosen a different seat? Unless you’re still stuck at the “kid’s table,” you’re over an air vent, or that really smelly cousin is next to you, I bet you would prefer not to change seats.

Where do you bank? If it’s with a big, national bank, I bet there’s a pretty good chance it’s where your parents banked or where you have banked for a long time. Why do you still bank there? Is the interest rate spectacular? Is the customer service spectacular?

Why do many people sit at the same spot every year at Thanksgiving? Why do many people bank with the same bank for all of their lives? I think it’s because it’s easier to stay with what you know. It’s easier to stay with what you have. It’s easier to keep the status quo. An inherent desire to keep the status quo is a fifth tendency I believe many normal investors have.

In my line of work people usually come to me for one of two things. Some people want me to analyze how they’re doing financially and to let them know if they’re forgetting anything major or if they’re doing anything blatantly wrong, but a majority of people want me to analyze their financial situation and make recommendations as to how they can improve or enhance their financial standing. In both cases, I often end up trying to get people to tweak their financial status quos. From my experience I’ve found that trying to convince someone to diversify out of a particular stock they’ve always had can be like trying to convince a teenager they can’t keep dating someone, trying to tell someone they need to reduce their lifestyle a little can be like trying to tell a sports fanatic they can’t watch all of their team’s games, and trying to get someone to change their insurance coverage can be like trying to get someone to change an ingredient in grandma’s legendary potato salad recipe. Even if people concur with my recommendations, achieving the implementation of those recommendations, can be another thing entirely.

This status quo tendency to stay with what you know and are used to negatively impacts many investors. It can cause someone not to prudently diversify their investments. It can cause someone not to reallocate/rebalance their portfolio at the top of a bull market or at the bottom of a cyclical pullback. It can even cause someone to never invest at all!

Another part of the status quo tendency is that many people, like myself, don’t enjoy making difficult or complicated decisions. Consider organ donation. Are you an organ donor? Are you not? Don’t you want to help others? Don’t you want every chance to live before your organs are “harvested?” Let’s consider organ donation in Europe. Look at the chart below showing the percentage of citizens in certain European countries who are organ donors.

 

Why are there so many less organ donors in Denmark, the Netherlands, the United Kingdom, and Germany? It’s because in Denmark, the Netherlands, the United Kingdom, and Germany, you have to opt-in to be an organ donor. If you go with the default, you are not an organ donor. In the other countries illustrated in blue, the opposite holds true. You have to opt-out to not be an organ donor. If you go with the default, you are an organ donor. I find this pretty convincing that many people feel it’s easier to go with the status quo than really spend the time and energy considering and implementing a difficult decision like whether to be an organ donor or not; or whether to diversify investments, cut spending, or adjust insurance.

Change can be good, but change is not always better. It’s my job to give people confidence when they have a good thing going, and to give people questions to ponder and recommendations to consider when I believe the status quo can be improved upon. Don’t just be a normal investor. I encourage you to really consider your status quo, and to tweak it if necessary.

-Tom

Normal Investors – Overconfidence

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There I was at the starting line of the famous Peachtree Road Race. I was finally old enough to be a part of the 4th of July tradition I’d watched my dad do every year of my life. I was stoked. I was a soccer player and I ran after the ball for a full hour without stopping every Tuesday, Thursday, and Saturday, so this so called “10-k” was going to be a piece of cake! When our wave started, I took off. My dad stayed with me for the first bit and then he started telling me we needed to slow down to save some of our energy for the finish. What did he know? Besides, a few runners were actually passing us! I think that first mile may have been my only career eight minute mile, but boy, by the fifth mile of the race, twelve-year-old Tom knew his dad was right.

I like to think I was a pretty cool guy in high school. In some ways I was. In some ways I was probably not. Being an avid ultimate Frisbee player with some of my band buddies was probably not my coolest hour, but we sure did have fun. We were good, too. So good that word travelled and some friends on the cross country team challenged us to a game one Saturday. Cross country whatever! I was in great shape! For a solid week my band friends and I went over and over how bad we were going to destroy our cross country friends. I think that was the last day I enjoyed running…

Of course there was that accounting test my junior year in college. I was tired. I wanted to do something other than study. Besides, I had things under control. I usually did well on tests. My scholarly roommate and fellow accounting major urged me to go over that small little bit the professor glossed over about a couple of terrible things called deferred tax assets and deferred tax liabilities. I actually remember saying, “If he asks me about that on the exam, he can have it!” I cannot tell you how much I ate those words. Literally, my roommate waited for me to look up and make eye contact across the room so he could give me that told you so look. Yes, yes he did.

I like to think I’m a pretty self-effacing guy, but from time to time in my life, I’ve been overconfident. Most of the times when I’ve been overconfident, it hasn’t worked out too well. Most of the time when investors are overconfident, it doesn’t work out too well, either. Humble pie doesn’t taste so good!

What? You don’t think you’re ever overconfident? Well let’s see about that. Do you consider yourself an above-average driver? You might be, you might not be, but studies suggest as many as 95% of people think they are above-average drivers, and that’s just impossible. Statistically, 50% have to be above-average drivers and 50% have to be below-average drivers. In the Atlanta metro area, I dare say a lot of people are the latter! Either way, overconfidence is the fourth tendency that I would suggest many normal investors have.

I think overconfidence is a pretty natural thing. I think that people tend to value their own judgments and opinions over those of others, even if other people are “experts.” Think home projects, grilling, sports, parenting, politics, etc. In the investment management world I believe this is why many investors have a little trouble letting someone else professionally manage their portfolio. They value their own judgments and opinions, they want to be in control, and they want to see action in their portfolios. This leads to many "do-it-yourselfers" trading more in their portfolios than I would typically recommend, and that usually means more trading fees and expenses, more taxes, and a lower investment return over the long-term. Consider this chart presented by Saturna Capital that assumes a 7% annual return for ten years and a 23.8% tax rate:

Lower turnover (aka less trading) typically means higher portfolio values. Be an investor, not a trader!

Finally, I wanted to share an interesting study that I came upon done in 2001 by the Quarterly Journal of Economics. They studied portfolio turnover and the investments of male and female households and they found that single men trade the most, married men trade second most, married women trade the third most, and single women trade the least. Guys, based on what we learned from the chart above, I think that means the women are right again!

If you enjoy investing and you like the rush of trading, I encourage you to carve away a small portion of your assets and make it a hobby. It’s one thing to open a box with a zillion pieces, not completely read the instructions, watch a video online, and tell your wife you’ve got it under control - maybe you do, maybe you don’t. It’s another to be overconfident when it comes to your family’s nest egg!

-Tom

Next up: status quo

Normal Investors - Familiarity

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Imagine you are just getting home after a very busy and stressful day at work. You just closed the door to the garage, dropped your bag on the couch, and are making your way up the stairs towards something you value deeply - comfortable clothes. Yep, there’s that old pair of jeans you wore yesterday. You know the ones with the slightly worn knee and the stretched out belt loop from where you like to rest your thumb? Best of all, they’re everso slightly stretched out from your wearing them yesterday. Don’t worry, I won’t tell anyone!

Of course there’s a similar feeling when you return home after travelling, whether for business or for pleasure. That moment after you’ve filled the laundry bin, returned your toothbrush to its normal spot, and have finally put up the suitcase. Oh it’s nice to see your shower, your couch, and most of all, your pillow! Wouldn’t you agree?

As you’ve undoubtedly gathered, I’m talking about familiarity. Whether a pair of comfortably worn jeans or your old friend of a pillow, familiarity feels good. It’s what you know. It’s what feels right. It’s what feels safe. Familiarity is also the third tendency that I present to you as a trait many normal investors have.

I would offer that many people go with what they know, especially when they are unsure of what is best. Consider some research done by Vanguard back in 2010 that found that Canadian investors were 65% invested in Canadian stocks, U.S. investors were 72% invested in U.S. stocks, and Australian investors were 74% invested in Australian stocks. Canadians, Americans, and Australians certainly have their differences, but do you really think the before mentioned investment allocations coincidentally showed that degree of “home bias?” I don’t. Investors were investing in what they felt they knew.

To take this a step further, let’s spend a moment on company stock. Regardless of the company, most people I come in contact with who work for publicly traded companies tend to own stock in their employers. Why? Do they think their company’s stock is going to really pop? Sometimes. And sometimes, they’re right, but sometimes they’re not. I’ve met many successful employees and successful investors who have a significant portion of their wealth in “their” company stock, and they desire to continue holding that stock even when they are no longer actively working for the company. Why? I think it’s because it’s easier for someone to feel safe investing in a company that they know a little about rather than the broader market which they may not know as well. Employers are aware of this, too, and that’s one reason employees are often incentivized with company stock in an attempt to align the employee’s financial success with the company’s future financial success and encourage hard and good work from employees.

(As an aside, I attended a lecture given by a professor from the Wharton Business School earlier this year, and he shared that a study was currently being done on what stocks were the hardest to get investors to diversify out of based on their location. #2 was supposedly getting a Seattle resident to sell some Microsoft stock (Microsoft is based in Seattle). Guess what #1 was? Getting stock in The Coca-Cola Company out of an Atlanta resident’s hands! Do any of my local readers here have any Coca-Cola stock? If you don’t, I bet you have friends and family who do!)

Familiarity feels good. Investing in companies that are based in your country is normal. Investing in the company you work for is normal. Investing in companies that are near and dear to your city or state is normal. However, you have to be careful when considering the investment risks of being overly concentrated in a single stock, a single sector, a single asset class, or a single country’s stocks. The risk-adjusted returns of a diversified portfolio are often still king. Going with what you know, what feels right, and what feels safe can be a crutch and a safety blanket, but what if your crutch was named Enron? What if you’re a Greek citizen and Greek companies are what you know? What if your paycheck was coming from Lehman Brothers, the pension benefit you were working for was guaranteed by Lehman Brothers, and most of the stock you owned was invested in Lehman Brothers stock? It’s normal to invest based on familiarity, but that may not always be best.

There’s nothing I hate more than when a grocery store I frequently visit decides to remodel. It’s frustrating. It doesn’t feel like it used to, I don’t understand the layout, and I don’t know where anything is, but I will get used to it. Eventually the new layout will feel familiar. Sort of like an investment portfolio that has recently been adequately and prudently diversified, eventually the new layout will feel familiar.

-Tom

Next up: overconfidence

Normal Investors – Overreaction and Underreaction

The second tendency that I would suggest many normal investors have would be the tendency to overreact and underreact. (If you missed out on the first part of my behavioral finance series on five of the characteristics most “normal” investors seem to have, you can catch up right here!) Of course, before I dive into how investors can, and often do, overreact, I must consider my own behavior this past weekend…

As many of you know, my wife and I are fairly avid UGA fans. Fine, fine, we’re full-fledged Georgia Bulldog fanatics! I mean I got up at 3:30 a.m., left my home at 4:00 a.m., and arrived in Athens at 5:38 a.m. to claim a small piece of generally lucky land between two curbs that my family, friends, and I have tailgated at for the last six years for a game that kicked off at 3:30 p.m. Who would do that? Well evidently me and several thousand more of my closest Georgia brethren considering “our spot” was already taken by someone even crazier than me! Oh the genuine rage I felt as my low beams displayed his silhouette on my very own game day island! That didn’t keep my group down though as we continued with our pregame festivities in the middle of what must have been a monsoon; festivities that included steak, seafood, a houndstooth cake and elephant ears (so we could eat the opposing mascot), and a crimson punch (so we could drink the opposing mascot). Then there was the wretched game where our beloved and favored Bulldogs were supposed to avenge our painful championship game defeat a few years ago only to be shellacked, annihilated, and otherwise dismantled by one of our hated rivals from the West.

A lot of pretty normal people are college football fans, but there is a good portion of that last paragraph that might lead you to believe that I'm a little bonkers. My point is that sports fans often overreact. They react with way more pride and celebration after victories and way more dismay and disgust after losses than they probably should. Many investors do the same thing. Investors can have a good experience with a product or service, and then they suddenly want to buy some stock in the company that made the product or delivered the service based solely on their positive experience. Investors can enjoy some decent growth and gains in a stock they have previously bought a little bit of, and they can develop an insatiable and blind appetite for more and more of that very same (and already appreciated) stock. Investors can get more and more excited about a roaring bull market (think the Dotcom Bubble) and want more and more stock exposure in their portfolios even though the investment return party has been going on quite a while. Of course, investors can also panic more than a Southerner in a snowstorm and completely sell out of a position based on the rampage of some talk show host who is trying to get ratings. A chain email about tax rates going up or a presidential or congressional proposal can also get an investor to sell out of everything just as if they’d seen a mouse, snake, or spider.

Overreacting as an investor can be dangerous. It can lead to one-way bets. It can lead to frequent trades which are costly and tax-inefficient. It can lead to dangerous concentration in one stock. It can lead to dangerous concentration in cash. There are certainly times as an investor where swift and substantial action is needed, but if you are investing prudently, that shouldn’t be very often. Part of my job is being the voice of reason, being the voice that isn’t that worried about the scary financial spider that man on the radio was yelling about, and being the voice that isn’t so sure that someone has really found that Fountain of Youth your neighbor confided in you about. Overreacting about football is one thing - it’s a game. Overreacting as an investor is another - it costs real dollars and cents.

The second part about normal investors reacting is actually underreacting. I like to illustrate this by considering Western Union’s lack of interest in Mr. Bell’s telephone patent, IBM’s lack of interest in the Xerox machine, and Kodak’s lack of concern with digital technology. In my own experience, I have found that investors rarely underreact when it comes to their investment portfolios, but instead they underreact when it comes to their own financial trajectory. I stand by that spending all that you are making is not a terribly successful retirement strategy, going into retirement with a large mortgage remaining is not a positive for your retirement cash flow, and that recurring credit card debt is one of the worst things since Brussels sprouts, but not everyone adequately reacts to those messages. Similar to ignoring a scratchy throat a few mornings in a row or that ant you saw in your kitchen the other day, underreacting to financial matters that could be nipped in the bud now can lead to some real serious financial problems in the future.

It’s normal and human to not always react in the optimum way, but financially, it’s important to try to. Maybe it’s all the children’s books I find myself reading now, but I kind of think of Goldilocks. Don’t overreact, don’t underreact, try to react juuuuuust right!

-Tom

Next up: familiarity

Normal Investors - Loss Aversion

Credit: David Castillo Dominici at FreeDigitalPhotos.net

As I mentioned a couple of weeks ago, I'm now going to do a series of posts on what makes normal investors “normal.” You see, a vast majority of traditional investment theory is based on the assumption that all investors are always rational. Essentially the people who completely believe in the Efficient Market Hypothesis believe that if investors have access to enough information, they will always act rationally and choose the investment portfolio best suited to their needs. They also believe that if investors always act rationally, then the market will always behave rationally. Maybe it’s me, but I don’t feel like the market always behaves rationally, and neither do some other very smart people.

In 1956, Mr. Vernon Smith introduced the concept of behavioral finance. In the 1960s, psychologist Mr. Peter Slovic began analyzing investor’s behavioral biases. In 1974, psychologists Mr. Amos Tversky and Mr. Daniel Kahneman introduced heuristics - the study of how people make decisions or solve problems, often using their experiences and biases. Since then, academics, brokers, and financial advisors have continued to try to understand the difference between a “completely rational investor” and the actions a lot of people take when investing their own money. Behavioral finance attempts to explain the difference between what traditional investment theory says should happen in the market and actual market behavior. Please don’t get me wrong, behavioral finance does not assume that investors are irrational; it assumes investors are normal human beings. I find behavioral finance to be a fascinating field of study that helps me better understand my clients, and that’s why I’d like to share five biases many normal investors seem to have, beginning with loss aversion.

1. Let’s pretend you’re on a game show, and I’m the host. I’ve given you $1,000. You have two choices: A) you can choose to walk away with a sure gain of an additional $500, or B) you can choose to take your chances with the flip of a coin. Heads, you’ll gain another $1,000. Tails, you’ll gain nothing. What do you choose A or B?
2. Alright, let’s once again pretend you’re on a game show, and I’m the host. I’ve given you $2,000 this time. You have two choices: A) you can chose to walk away with a sure loss of $500, or B) you can choose to take your chances with the flip of a coin. Heads, you’ll lose nothing. Tails, you’ll lose $1,000. What do you choose A or B?

Now if you are a completely rational person trying to do what is in your best interest, wouldn’t you choose A both times and walk away with $1,500? I mean, if you choose B in either example, you could end up walking away with only $1,000 when you could have had $1,500 by simply choosing A with no coin flip involved whatsoever. What if I told you these two questions were real questions from a study written by Tversky and Kahneman, and the results of the study showed most people chose A for the first example, but most people chose B for the second one? Why would anyone do that? Because of the way the questions are worded! I, and many people who have conducted similar studies, would submit because people are willing to do anything to avoid the pain of loss. Some call this phenomenon the Prospect Theory and quantitatively suggest that losses are twice as painful to investors as gains are pleasurable. Shown on a graph, this might look like:

 

 

 

This loss aversion associated with many investors is financially dangerous because it can lead people to sell profitable investments too early (because they don’t want to lose their modest gains) and unprofitable investments too late (because they don’t want to actually recognize their losses, and they’d rather keep hoping they can regain their initial investment than acknowledge what has happened). Coupled with our nation’s unfavorable capital gain taxes on profitable investments that are sold that were held for less than a year, and you could have a double whammy!

 

I can tell you from my experiences fielding calls and replying to emails over the past couple of volatile weeks in the market, a 2% daily loss is not equal to a 2% daily gain in the eyes of some investors. Maybe it should be, but it’s not. I even had a gentleman on one of those days where the market was down a few percentage points apologetically acknowledge that he knew he didn’t call me when the market was up 2% in one day. We shared a laugh, and I told him I’d call him the next time it was up 2%. I can’t blame him though, he’s just being a normal investor who has a double aversion for loss.

 

-Tom

 

Next up: overreaction and underreaction.

2 Much Cents Update

 

It’s been quite a year. We’ve moved, we’ve had a baby, and so much more. I’d originally planned on doing another Lightning Round about half way through the year, but what can I say? Time flies when you are having fun, you’re busy, and sleep is a bit of a luxury! I still can’t believe it’s already August, so before we get any closer to 2016, it’s time for The Lighting Round: Round 4. Many of you probably remember past “Lightning Rounds,” but let me take a moment to back up for newer readers.

The Lightning Round is designed to be an interactive post where I ask you to submit any financial question you may have. Between now and midnight, August 16th, I will accept questions, and I promise that I will eventually answer every single one of them. However, the first five topics that I receive (that I think would be of interest to a large portion of my readers) I will answer publicly as my next post!

If you’re fine with me using your first name and you want to be a part of a 2MuchCents post, go ahead and submit your question. If you’d prefer to use an alias or to be listed as “anonymous,” or if you would prefer I just get back to you privately, please let me know that as well. Please feel free to contact me via Facebook, email, LinkedIn, my cell, or by asking a question directly on this post.

After The Lightning Round, I will begin a series called “Normal Investors.” My plan is to ask you questions about yourself, how you think about money, financial choices you have made, and your investment strategy. Then, I’ll share with you what I’ve learned about that particular fact pattern or scenario from studying behavioral finance. You, like I was, may be surprised to find out that a normal investor may not always be a rational investor. That’s fine. Actually, it’s a good thing because if you know how most normal investors are going to act, you can sometimes adjust your behavior and benefit financially. If you are also aware of some situations where individuals may be prone to act irrationally when it comes to their finances, you may be able to save yourself should you ever face one of those scenarios. I find the evolving field of behavioral finance very interesting and incredibly useful. It is my hope you will as well.

The phone lines are now open. I want to hear from you!

-Tom