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 – 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

Why You Need to Rebalance



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Suppose you invested $100,000 on January 1st, 1995. You invested $50,000 in the Barclays U.S. Aggregate Bond Index and $50,000 in the S&P 500 (U.S. stocks). Between January 1st, 1995 and December 31st, 2002, you were in for quite a ride as the Dotcom Bubble expanded and eventually popped. Your bonds would have offered annual returns of 18.46%, 3.64%, 9.64%, 8.70%, -0.82%, 11.63%, 8.43%, and 10.26%. Your stocks would have offered annual returns of 37.58%, 22.96%, 33.36%, 28.58%, 21.04%, -9.11%, -11.89%, and -22.10%. Declining interest rates and the mania surrounding Internet-based companies fueled some really good returns during that period. In fact, if you didn’t touch your $100,000 portfolio at all during that period, I’d estimate you would have had around $206,000 by the end of 2002.

Do you notice how the last three years of S&P 500 returns from 2000 – 2002 were negative as the bubble popped and a recession began? Wouldn’t it have been nice to have liquidated your portfolio on December 31, 1999 and missed the stock market pullback? If you had, your portfolio would have been around $248,000 on December 31, 1999; $42,000 better than it would have been worth three years later!

By now I hope you know me well enough to know I’m not the type to ever advise you going all in or all out of the market. When it comes to market timing like that, I’m just not that smart, and I don’t think anyone else is, either. I believe in calculated tactical adjustments to a portfolio if you see a medium to long-term trend, but I do not believe in ultra-short-term trading and all-in / all-out investing. There's just too much uncertainty!

Some of you that were investing back in the late 1990s and early 2000s may be able to remember how hard it would have been to sell out of your high-flying stock portfolio on December 31, 1999. That was a time (like many times before) where the sky felt like the limit.

Great, Tom. You’ve told me this story about how I would have been better off selling my January 1st, 1995 portfolio on December 31st, 1999 versus holding it until December 31st, 2002, but then you told me no one can know exactly what the future holds and not to invest all-in or all-out. What can I do? You can rebalance.

Rebalancing your portfolio is something you should periodically do to bring your portfolio strategy back in line with your initial investment strategy. Sure, it can be a hassle, it can generate some capital gains taxes, and it can generate some trading fees, but oftentimes, it’s worth it. Hopping back to our 50% bonds and 50% stocks January 1st, 1995 portfolio example, did you know that by December 31st, 1999 your portfolio would have only had 29% bonds and would have swelled to 71% stocks? Would you be happy if the portfolio strategy you agreed to in 1995 drifted that much? I don’t know many investors who would be pleased with a divergence from their investment strategy of that magnitude. That’s why in the spirit of trying to more closely maintain your investment strategy and hedge your bets on the markets continuing to roar upward vs. correct downward, periodically rebalancing your portfolio is the way to go. Excluding taxes and fees, if you would have rebalanced your January 1st, 1995 portfolio at the end of every year back to a 50% bonds and 50% stocks portfolio, your portfolio would have had around $216,000 by then end of 2002; $10,000 better than if you had done nothing at all. Rebalancing your portfolio can generate taxes and transaction costs, but it also, and more importantly, allows you to not drift too far from your investment strategy. Rebalancing is a prudent way to hedge your bets on the market going up or down in the future.

I don’t often trade a portfolio, but when I do, I prefer to rebalance. Does that make me the most interesting wealth advisor in the world?

-Tom

Trading vs. Investing

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Last week I ended up waiting in line for a fairly long time while my car’s emissions were tested at a very busy car maintenance facility. I had come straight from work, so I was still dressed up in a suit and tie, and in hindsight, I guess I might have looked a little out of place at a Jiffy Lube. Another customer who had finished reading the same sports section of the newspaper I had, and seemed to be even less interested in the Judge Judy rerun playing in the background than I was, decided to strike up a conversation with me. I’m fairly social and am always up for meeting new people, so it wasn’t too difficult to chitchat until he asked me what I did. When I responded that I was a financial planner and investment advisor, he countered with, “So, you’re a stock trader?” I politely replied, “Of sorts,” but that’s not what I do; that’s not even what I recommend. A harmless conversation with a nice stranger at a Jiffy Lube was not the place to dive into the important differences between trading and investing, but it got me thinking that today’s post just might be!

Trading and investing might be synonymous to some people, but not to me. In my mind, “trading” usually means the frequent buying and selling, or sudden buying and selling, of financially significant quantities of a handful of securities. When I think of the term “investing,” I think of a long-term time horizon, occasional and strategic buying and selling, and a well-diversified portfolio. Before you stop reading and accuse me of splitting hairs, please let me give you three reasons why trading is not investing, and why I believe investing is better. 

• Taxes – Let’s say a single lady makes around $75,000 this year. When you look at the 2013 federal tax brackets, she falls in the 25% bracket. This lady is doing pretty well for herself, but she’s doing even better considering that she bought 5,000 shares of Bank of America stock in August of 2012 for $8 a share. She likes “dabbling” in the market from time to time, and she felt she had made a great pick with Bank of America, but now she wants to buy another stock, so she sold the 5,000 Bank of America shares in June of 2013 for $13 a share. Because she held those Bank of America shares for less than a year, her gain must be taxed at her ordinary income tax rate, so her investment will land her roughly $18,750 after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 25% tax rate)). If she had treated those Bank of America shares as a longer-term investment and sold them in August of 2013 (after she had held the position for a year) for the same $13 a share, the federal long-term capital gain tax rate of 15% would have applied! Her investment could have landed her roughly $21,250 ($2,500 more than $18,750) after federal taxes (((5,000 shares x $13 sales price) – (5,000 shares x $8 purchase price)) x (1 - 15% tax rate)) even though the theoretical sales price was the same! There are certain situations where selling a security with a short-term gain makes plenty of sense, but it’s always worth considering the potential tax benefits of longer-term investing versus the potential tax consequences of shorter-term trading. 
• Costs/Fees – Whether someone is into stock trading or investing, there are times when new securities need to be bought and old securities need to be sold. In my book, transactions should always have a strategic aim, be executed for tactical, security-specific reasons, or be completed to free up cash, but everyone should remember that transactions are not free. There are costs and fees to facilitate transactions, and depending on your investment custodian and/or investment advisor, these costs and fees could range all over the place. For argument’s sake, let’s consider E*Trade’s fee of $9.99 per trade. If someone were to make 10 trades a year through E*Trade, they would incur around $100 in fees. That might be peanuts to some people, but $100 worth of fees on a $10,000 brokerage account is a loss of 1% of the total account! That means, at best, those fees would dampen the positive performance of someone’s $10,000 brokerage account, and at worst, those fees are just additional salt in the wound of the negative performance of someone’s $10,000 brokerage account. Costs and fees are too insignificant to drive a stock trader or a stock investor’s transaction decisions, but they are significant enough to consider, particularly if the number of transactions is excessive and/or the account’s value is relatively small.
• Diversification – When I was a senior in high school, there was a statewide contest to see which group of economics students could grow the largest fantasy investment portfolio over a three month period. The rules were that participants could only place trades at the end of the day and could only buy stocks that were trading at more than a dollar, so I quickly convinced my group that the only way we were going to get enough stock price movement to have a chance to win was to go all-in on a single stock that was trading near a dollar that was scheduled to have an earnings announcement in the next couple of days. (PLEASE NOTE I ADVISE AGAINST THIS STRATEGY AND IN NO WAY RECOMMEND IT UNDER ANY CIRCUMSTANCES WHATSOEVER.) As luck would have it, the company whose stock we picked announced that they had beaten earnings expectations and were in talks to be bought out, so the stock soared. The problem was that two other groups of students in the state had done the same thing, and we were all tied in first. My group elected to sell the next day with the hopes that the stock would return to orbit, but the other two groups held on as the stock eked up a few more pennies, thus landing us in third. First place in the state won fame and fortune, and third place won a T-shirt, so we decided to roll the dice again with our all-in, single-stock strategy by buying shares in a company that had an upcoming earnings announcement. This time, the company we picked failed miserably compared to expectations, and some of their executives had decided to leave, so the stock fell like a lead balloon filled with lead balloons. Our strategy had hit us a home run once on the very first try, but as we tried it again and again for the rest of the contest, we lost and lost. We actually finished second to last in the state. I told you that long story because I wanted to share my powerful, first lesson in why diversified investing is better than non-diversified trading - singles and doubles over the long term are a lot better than one home run and a lot of strikeouts in the short term!

If you enjoy trading, that’s wonderful, but call it what it is: a risky hobby. If you’re trying to reach financial independence or if you are trying to maintain financial stability, I urge you to invest, not trade. Trading is sexier, and it may make you feel like you are actually doing something about your holdings more often, but the tax effectiveness, cost effectiveness, and diversification benefits of letting the market do its thing over time are hard to argue with.

 

Are you a stock picker says he? No. I’m an investment advisor says I!

 

-Tom