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

You Might Be Well Diversified If...

Credit: MR LIGHTMAN

You are probably familiar with comedian Jeff Foxworthy’s “You Might Be a Redneck” routine. If you’re not, you should be! His routine is hilarious, and since I was born and raised in the Southeast, I've seen some of what he is talking about. I’ve seen driveways where it doesn’t look like the boat has left the driveway in 15 years. I’ve seen people whose dog and wallet were both on a chain. I’ve seen yards where if someone mowed them, I believe they might just find a car! It’s funnier when he does it, but you get the point. Either way, it got me thinking about an idea for today’s post…

By now you’ve probably gotten the year-end statements for most of your investment accounts, and if you’ve looked at them closely, you might have noticed 2014 was kind of a weird year for stocks. I say it was a weird year for stocks because some of the classes of stocks had very different returns. U.S. stocks ended up having a pretty good year after some ups and downs, but international stocks finished the year down for the most part. If you took a closer look at U.S. stocks, you likely found that the stocks of large U.S. companies (“large cap stocks”) did pretty well, but the stocks of smaller U.S. companies (“small cap stocks”) were not up nearly as much as their larger counterparts. Small cap stocks were even negative for a good portion of the year!

Statistically speaking, the S&P 500 (an index that represents large cap stocks) was up between 13% and 14% for 2014. The Russell 2000 (an index that represents small cap stocks) was up around 5% for 2014. The MSCI EAFE (an index that represents international stocks) was down around 5% for 2014. Why do I tell you all of this? To share with you that, if you had a stock portfolio filled with large cap stocks, small cap stocks, and international stocks, you probably didn’t end up with the 13% to 14% return “the market” had in 2014 that the television pundits, radio hosts, and investment newsletter writers keep talking about! As Jeff Foxworthy might say, you might be well diversified if you did not end up with the S&P 500’s return!

I’ve also heard it said that you know you are well diversified if there is always part of your portfolio that you are “mad” at. I’m not sure that’s always the case, but there is definitely some merit to that statement. If you were mad at your bonds in 2013 when the stock market roared, I bet you were pretty pleased with them in 2008 and 2009 when the stock market took a dive. If you were mad at your stocks in 2008 and 2009, I bet you have been pretty pleased with them the last five years or so. So all in all, you might just be well diversified if there’s usually a part of your portfolio that you aren’t pleased with.

If what I’ve said so far hasn’t really applied to you because you only own one stock or a couple of stocks, I’d offer two things. First, concentration in a single stock is how you can accumulate and/or evaporate wealth - not preserve wealth. Second, you might be well diversified if you can’t name every holding in your portfolio from memory!

As your friend and someone who wants you to do well and make as much money as you can, I wish you were completely invested in the S&P 500 last year and got that 13% to 14%. However (and please read my next words very carefully), as your humble financial blogger and a financial advisor who believes in the long-term investment strategies of diversification and compounding, I certainly hope you didn’t!

-Tom

Mary, Mary, Quite Contrarian

Credit: africa

Mary, Mary, quite contrary. How does your garden grow? No, I haven’t lost it or begun experiencing some sort of Benjamin Button-like reverse-aging process. I just think this old, English nursery rhyme might have a little more to do with successful long-term investing than you might think! Let me explain.

Have you ever jumped on a sports team’s bandwagon? Have you ever jumped off and been accused of being a “fair weather” fan? Have you ever resisted a trend, such as smartphones or Facebook, and eventually come around? Did you by chance donate your seersucker suit or throw away your boat shoes right before they came back in style? I’m a loyal sports fan, and the day I wear a seersucker suit will be quite a day, but I must admit that I can think of several times in my life where I arrived a little late to the metaphorical party, and even a few occasions when I rode a trend, a belief, or an idea all the way down the metaphorical flagpole. I usually stick to my guns, and I will always stand up for what I truly believe in, but it is often much easier to get caught up in what everyone else is doing and follow the crowd. It’s often warmer in the herd, so to speak.

Unfortunately, the bandwagon doesn’t always lead to successful investing. I’ve heard it jokingly said that if someone continuously buys stocks high and sells stocks low, they will repeat their actions until they are broke. It’s a witty and true statement, but it’s definitely not funny. I’ve also heard it said that any stock tip you hear is already too late, and unless you know something you probably shouldn’t know, I tend to believe that is pretty accurate. In my book, successful investing is about developing a prudent, long-term investment strategy with an appropriate mix of stocks, bonds, cash, and other investments for your risk tolerance and age/stage in life, and sticking with it. Successful investing is about investing, not trading. It’s about not chasing past performance and trying to repeat recent results with last year’s hottest industry, sector, or stock. Successful investing is about avoiding the temptation of a $700 “poison” apple (or should I say AAPL?), and at the same time, knowing to ignore the same overly sardonic radio host who has been telling you to go to all cash or gold for the last five years. Sometimes you can buy a stock high and ride it higher or sell a stock low and it will still go lower. However, I have come to believe that successful portfolio management is usually about investing in a diversified strategy filled with quality companies; buying some positions for value and some positions for growth; watching closely and looking for occasional tactical opportunities; and riding the market volatility as if it were a cross between a mechanical bull and an eventually upward-headed escalator.

I cannot tell you how many potential clients and friends have come to me recently ready to get back in the market now that the market has been on a fairly steady upward climb for almost five years. Unfortunately, they’ve been on the sidelines, primarily invested in what they put their temporarily battered portfolios in near the bottom of the last real market downturn. In the long term, it’s good that they are getting back in, but I can tell you right now that we are closer to the next temporary downturn today than we were yesterday. I just hope they don’t sell at the next bottom and repeat until they are…

So many people cheer for a winning team and so few for a losing team. As I said earlier, it’s natural and easy to do, but successful investing is about having a really good strategy in place that you understand, believe in, and have confidence in. It’s about digging in for the long haul and letting your portfolio do its job. It’s sometimes about selling when the tide is coming in and buying when the tide is going out. It’s about cautiously looking around when the masses are stampeding in one direction into all stocks or all bonds or all cash or all precious metals and at least considering the road less travelled. Now don’t take this strategy to the extreme and sell a bunch of good stocks so you can buy a bunch of “stinkers,” but rather reflect on where markets are going, not where they have been.

I’m not asking you to do anything in particular. I’m just asking you to think about being a little contrary to a majority of the bandwagon investors out there. Think about being a little contrarian.

Mary, Mary, quite contrarian. How does your portfolio grow?

-Tom

The Lightning Round: Take 2

Credit: FreeDigitalPhotos.net

Thanks to all of you for the many questions I received. I’m back from vacation and ready to roll, so now, as promised, here are my responses to five of your questions...

1. What is the difference between banks and credit unions? And which is better?
                                                                                                                              - Sandy              

Banks and credit unions are very similar. A credit union is essentially a group of owners or members who have pooled their cash to form their own bank; think teachers’ credit unions, airline credit unions, corporate credit unions, etc. It is usually a special bank for employees of a certain company or people of the same organization or trade. Since credit unions are smaller, they are known for having better customer service and for being more flexible. That being said, they probably have fewer account options, a less sophisticated website, and fewer locations than bigger commercial banks, like Bank of America or Wells Fargo, which are some of the possible advantages of banks.

Another major difference is that credit unions are usually not-for-profit, so they probably charge lower fees and offer slightly more favorable interest rates on savings accounts and loans to their members. However, because they are smaller, credit unions can also be more susceptible to failure than the larger national banks.

Are you trying to decide between a bank and a credit union? If so, and without knowing your details, I might leave my savings or rainy day fund with a credit union to get higher interest returns and maybe take out a mortgage or loan with them to get a better rate and more personal service, but I'd keep my day-to-day accounts with a larger bank, so I would have more branches to visit, more ATM access, and a larger network of customer service resources at my disposal if I was out of town. Hope that helps!

2. I’m heading to graduate school in the fall. Although my husband and I have saved up towards it, we will need to take out loans. In the years after I finish my degree, is it better to aggressively pay off the loans before saving towards a house down-payment, or to pay down loans at a moderate rate while saving for a house? Keep up the good work!
                                                                                                                               - Anonymous

Great question! Please don’t be too mad at me, but the answer is: it depends.

If you are close (or think you will be close) to hitting that “magic” 20% down payment threshold when you and your husband decide to buy a house, I would probably pay down the loans at a fairly minimal rate and direct most of your saving firepower towards hitting the 20%. Remember, 20% down usually means more favorable interest rates, lower monthly payments, and probably avoiding the additional expense and complications of Private Mortgage Insurance (PMI).

If 20% down is not a reasonable goal for you, I would probably direct more savings firepower toward extinguishing the loans. Student loans may offer a potential tax deduction, but they are usually just a fixed expense that can be a painful burden on recent college graduates and relatively new workers. The sooner you can eliminate that debt, the sooner your cash flow will improve, your financial position will strengthen, and you will probably even feel better.

Also worth mentioning is that the interest rates on your loans do matter. If the interest rates are much more than 5% or 6%, I would definitely work toward extinguishing the loans. If the interest rates are lower, historical returns would tell you that you might be better off in the long-run saving or even investing some of your funds. I’m pretty conservative and have a disdain for debt, but as you might recall, even I list paying off loans as tied for 7th place on my list of financial “Bear Necessities.” Good luck heading back to school!

3. Paying off student loans vs. saving for your child's college (and where/how to set that up) vs. saving for retirement.
                                                                                                                               - Rebecca

This is also a good question, and since it’s a little related to the second question, I thought we’d go ahead and cover it now. (For those of you looking for the Cliff Notes, saving for retirement gets the gold, paying off student loans gets the silver, and saving for your child’s college takes the bronze.)

In my book, gaining financial independence should be everyone’s long-term financial priority. By financial independence, I mean achieving the ability to sustain a standard of living or quality of life that you like or are willing to tolerate for the rest of your life without having to continue to work. This is primarily achieved by living within your means, saving for retirement, and paying off debt. As far as student loans vs. saving for retirement, I’d probably recommend maximizing any contributions to a 401(k) plan or retirement plan to the point that you receive any maximum employer matches you may have available to you and then making maximum IRA annual contributions (to a Roth, if possible) before I did much more than the minimum payments toward student loans. Then, as I mentioned in question #2, I’d suggest you look at the interest rates, consider your personal risk tolerance, and then either assault the debt principle or look at saving or investing a little more.

Saving for your child’s college is admirable and a goal of many parents, but it really should come after your own financial situation. I know this may sound harsh, but what if your child one day gets a scholarship or decides not to go to college and those funds you painfully tucked away could have been used toward paying off your own student loans or saving for your retirement? Besides, if worse comes to worst and you haven’t saved enough money to pay for all of your child’s college, they can always take out student loans themselves. After all, you mentioned that you have student loans, and I know you turned out alright! All this being said, if you feel that it is your responsibility as a parent to pay for your child’s college education and you have the additional financial capacity to set aside some funds for your child’s college, the sooner you start saving, the better. I would recommend opening a 529 plan, a state-run education savings plan, because they are easy to set up and relatively flexible, and distributions used toward your child's qualified college costs come out tax-free. You could ask if grandparents, aunts, or uncles would also be willing to contribute, and many of the plans offer convenient, automatic age-based investment allocations that will periodically adjust to prudent risk allocations as your child gets closer to college (more risky when your child is younger, less risky as your child gets closer to college).

4. Do you watch shows like Squawk Box or Mad Money? Would you recommend those shows?
                                                                                                                              - Anonymous

(Squawk Box is as CNBC puts it, “the ‘must see’ pre-market morning news and talk program, bringing Wall Street to Main Street” and Mad Money is a show hosted by television personality and former hedge fund manager, Jim Cramer.)

I chose your question because I thought it was an interesting one, but, I do not watch these shows. I have previously watched Squawk Box, and I’ve seen Mad Money on the television in waiting rooms and in airports, but I don’t watch these particular shows or shows like them very regularly. They are intriguing, but personally, they stress me out and make my blood pressure go up.

The main reason I don’t watch these shows is because they target people with different investment philosophies than mine. There is nothing necessarily wrong with these shows, they are very popular, and many people might well claim that the advice they get from watching investment talk shows has helped them financially. Maybe so, but I don’t believe in acting impulsively. I believe if someone is talking about a stock tip, it’s often already too late. I believe in investing in a diversified portfolio made up of different holdings that will perform well under different market conditions. I believe in the cost savings and tax effectiveness of long-term investing versus short-term trading.

I’m all for people watching Squawk Box and Mad Money if they enjoy them and find their reporting insightful, but I would not recommend these shows to someone per se because I feel like they try to convince the viewer that they are suddenly empowered to trade and invest after watching. Call me crazy, but I believe that it’s a lot easier to lose money quickly than to make money quickly, and I will be the first to admit that watching Iron Chef does not make someone an exceptional cook!

5. Recently, my credit card was fraudulently used. I was alerted of the fraudulent charges by the financial institution the card is through, was able to remove the charges and got a new account number. I've heard about more elaborate identity protection services, but I am not sure if they're worth the investment. Do you ever recommend these types of services to clients? Also, are there any steps you'd recommend to clients after they experience credit card fraud, such as getting credit reports, etc.?
                                                                                                                             - Kristen

I’m so sorry to hear about your troubles. Several months ago, someone bought several hundred dollars worth of shoes with one of my credit cards, and I had to go through a similar routine. It’s not pleasant, and if you are like me, you feel a little violated, but you can recover and move on.

As you mentioned, there are many identity protection services available. As identity theft and cyber crimes continue to rise, there will likely be even more services available in the future. However, generally speaking, I do not recommend these types of services to clients. They could work and they could be worth the investment, but if you are vigilant, you are likely one of your own best (and least expensive) forms of protection.

I advise people to review their credit card statements and bank statements closely every single month, whether in electronic form or hard copy (which you must already be doing if you caught the fraudulent charge, so good job!). I advise people to be careful about using auto-pay and just assuming all is well. I advise people to save their receipts, use their checkbook ledgers, or use a program like Excel or Quicken to track their cash inflows and outflows to make sure they are the only ones spending their hard-earned money.

If you’ve already had one card fraudulently used, I would follow the steps I have mentioned above even more carefully just in case. If you have the option to have your credit card companies call you for purchases over a certain amount or purchases outside of the country, I would recommend utilizing these features. I would recommend not using the same password, secret question answer, or PIN for all of your financial accounts as an additional safeguard. Also, as you mentioned, checking your credit reports once every year or two (you are allowed to check for free once every 12 months, but you don't want to check too often because it can impact your credit score) can also be a good idea to make sure your identity is secure and all of your financial affairs are in order.


Thanks again for all the questions. Please always feel free to ask me anything that you think I may be able to help you with though, Lightning Round or not.

-Tom