The Messy Reality of Financial Decisions

My latest Research magazine column is now available online (my print copy just reached my desk too). I am especially pleased that Carl Richards allowed me to use his wonderful sketch (shown below) to illustrate it.

DecisionsEvidence

With sufficient education and proper training, we have the opportunity to deal with messy reality for the good of our clients. As critical thinking skills and the knowledge base to use them effectively are in extremely short supply generally, if you have them and exercise them, all the time, you will have a tremendous advantage. It takes a lot of work, work that is never completed but work that is ever so crucial. As my father used to tell me, it’s what you learn after you think you know everything that really counts.

The Messy Reality of Financial Decisions

Financial Advisers: How to Counsel Clients in a Hot IPO Market

cfa_logoLauren Foster of the CFA Institute has an excellent article up at Enterprising Investor about IPO investing. That I’m quoted is an added bonus. My friends Carl Richards and Michael Kitces show up too.

“For those who are convinced that any particular IPO will be ‘the one’ (after all, it might be), I encourage them to understand both the risks and the odds before they buy, and that they only buy with money they can afford to lose,” Seawright says. “It’s like going to Vegas. The lavishness of the casinos demonstrates that the odds favor the house. But, if you only play with money you can lose (perhaps out of your entertainment budget), it’s not quite so bad.”

I encourage you to read the entire article. 

Financial Advisers: How to Counsel Clients in a Hot IPO Market

Five Good Questions for Carl Richards

Carl Richards is a Certified Financial Planner™ and the founder of Prasada Capital Management, a fee-only firm he created to help clients with two objectives:  to avoid losing money and to enjoy their lives. He also explores how our relationships with money impact the quality of our lives at BehaviorGap.com. Carl is perhaps best known for his helpful illustrations of financial concepts, a sample of which may be seen below.  His sketches may be seen at BehaviorGap.com, as part of his weekly writing for The New York Times, and at Morningstar’s Advisor blog. He is also the author of a best-selling book, entitled The Behavior Gap. Carl earned a Bachelor of Science degree in Finance from the University of Utah.  What follow are what I hope are Five Good Questions for Carl Richards. 

Source: BehaviorGap.com

  1.  Your drawings help people understand what may be difficult concepts.  What do you think are the keys to an effective drawing?

Being an amateur! As is very apparent, I have no art background, but for some reason I found I learned things I didn’t know when I went through the process of trying to explain things using a Sharpie and a piece of paper. Limiting yourself to simple tools, like a whiteboard, pen and paper, or the back of a napkin forces you to get to the stuff that really matters. Having no artistic talent helps as well. Because I can’t draw a horse or a bird, I have to use simple lines, a box or a circle.

  2.  What have you found to be the most effective tool(s) for dealing with the “behavior gap” (the difference between what we should do and what we actually do)?

Asking questions. In our industry we have an obsession with having all the answers, but we spend very little time making sure we are asking the right questions to start with. If we can help people get clear about why they are doing the things they are doing, then, maybe we can help them make change.

  3.  You’re a powerful advocate for meaningful conversations about money.  How do you suggest people get started and go about having those conversations?

First recognize that is it okay to talk about money. Most of us were taught that money, sex, politics and religion were things you didn’t talk about in polite company. Of course we have gone way too far when it comes to sex, but we still have not learned to talk about money. Another key is to do what Stephen Covey suggested and learn to listen to understand and not judge. People want to know that we understand them before we give them advice. How can we prescribe before we take the time to diagnose?

   4.  You are careful to advocate life planning rather than just financial planning.  What does that mean?

I am not sure that life planning is the right term, but the reality is that the process of planning for our financial futures is about life. Almost every goal we have is funded by dollars. Security, health, safety, education, retirement are all make possible to some extent using money. So if we think that financial planning is a process of spreadsheets and calculators we are kidding ourselves. These things are about life. We are talking about people most important goals and dream and the things that keep them up at night.

  5.  As you emphasize, we need and may even want simplicity but we are attracted to complexity.  How do you suggest that people go about simplifying their financial lives?

Start by getting clear about where you are today and where you want to go, then give yourself permission to peruse the simplest path to make it happen. So often we think that because the problem feels complex to us, the solution must be complex, when more often it is the simplest solution that has the staying power to get us moving forward.

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The AdvisorOne version of this article is here.  The Five Good Questions series: 

When Bloggers Meet

I met Carl Richards in person for the first time yesterday and heard/saw him give a delightful presentation.  Great stuff.  Great guy. Look for him as part of the Five Good Questions series soon.  You should also (of course) read his terrific book and read him weekly in The New York Times.  Thanks, Carl.

The Power of “I Don’t Know”

In Bucks today, Carl Richards has an outstanding piece up that I heartily recommend.  Here’s a taste:

Of all the phrases in the financial planning world, “I don’t know” may well be the most powerful.

There are other phrases like “it depends” that are similar, but underlying them all is the fact that we are trying to make money decisions without a great deal of certainty. The reality is that we just don’t know what the next five, 10 or 20 years are going to look like.

Sure we can model it based on history, but that would just be a model. One of the most dangerous things I see in the investment and financial planning world is a false sense of precision.

In fact, I think there is a tremendous sense of freedom that comes with recognizing that we just don’t know what the future will look like. At that point, the process of financial planning becomes about making the best guess we can about that future. Then we consistently course correct as we go, before we get too far off track.

Read it all and thank me later.

The illustration used on the front page for this piece is also by Richards.  More information on his artwork is available here

Why ‘I Don’t Know’ Is Often Your Best Money Answer

If Investing = Faith, I’m Agnostic

If investing = faith (as the always engaging Bucks blog from The New York Times contends), this Christian is decidedly agnostic.

In Bucks yesterday, Carl Richards makes a plea for investors to “stay the course” based upon faith.

This act of faith is most evident when it comes to the stock market. …[T]he core question becomes this: do you still believe that stocks will continue to do better than bonds, and bonds will continue to do better than cash, just like they always have?

I do not necessarily accept the premise of the question in that bonds *have* outperformed stocks over significant periods of time. Moreover, we do not have anything like enough data to be terribly confident about any alleged trend going forward.  However, to the extent that this question is a valid one, my answer is “no” with respect to the short and intermediate terms and “I have no idea” with respect to the longer term. It is usually wrong to think so, but things may really be different this time.

Financial services advertising typically includes a disclaimer something like “Past performance is not indicative of future results” for very good reason.  If the 2008-2009 financial crisis taught us nothing else, it taught us that just because something has not happened or is highly unlikely to happen does not mean it cannot happen.  Therefore, assuming that something will not happen is extremely dangerous, especially when the consequences of being wrong are dire.   

United States domestic equities have returned nearly 10% per year on average over the past 100 years. These historical returns compare to slightly above 5% for bonds and a “risk-free” (Treasury bill) rate of slightly more than 3.5 percent. In the long run, then, stocks have been a great investment, at least to this point. Unfortunately, the long run may be much longer than an investor has. Owners of equities have been well rewarded over most substantial time periods, but not all.  As John Maynard Keynes famously put it, the market can stay irrational far longer than one can stay solvent.

Advocates to staying the course typically argue that downturns are opportunities to buy stocks on sale and I generally agree.  But even with this year’s struggles, U.S. markets still appear overvalued.

Source: Pension Consulting Alliance – Investment Market Risk Metrics

Moreover, projecting returns over the next ten years based upon present values suggests that equity investors will see nothing like average historical returns over the near to intermediate term (even though strong cyclical rallies – as in 3/09-3/11 – are to be expected).

Data courtesy of Robert Shiller, Yale University Department of Economics and his Irrational Exuberance

As emphasized above past performance is not indicative of future results – almost anything *could* happen – with the exception of the 1990s period dominated by the tech bubble, the stock market has never had a positive 10-year return that began from valuation levels like those seen at present.  Secular bear markets (like the one we have been in since 2000) can see dramatic swings but no real advance – what Time magazine, in 1977, called a “roller-coaster to nowhere.” John Hussman sagely calls the faith of the buy-and-hold-hope-all-the-time investor “hanging around, hoping to get lucky.”[1] 

Accordingly, even investors who perceive themselves as “in it for the long haul” need to be clear about how long that is.  Wade Pfau, a professor at the National Graduate Institute for Policy Studies in Japan, has shown that Americans who retired around the turn of the century are often in real danger if they are using their portfoilios to provide income using an alleged “safe withdrawal rate” (usually around 4 percent).  Indeed, for 2008 retirees, Pfau estimates a maximum sustainable withdrawal rate of only 1.5 percent.[2]  Blind faith in historical return levels for these investors is likely misguided.

That said, Bucks is right that “[o]ne of the biggest risks to investing in the stock market is getting scared out of it at the wrong time.”  As behavioral economics teaches, we all tend to buy when markets are high and sell when markets are low.[3]  Moreover, we all have a perfectly human – but erroneous – tendency to chase the most recent “hot” thing or to get out of the current “cold” thing in the market. If recent returns are good, we expect that trend to continue (and vice versa).  Even professional managers suffer this flaw. We also know that investors simply trade too much and hurt their investment performance accordingly. Attempts at market timing are not the answer.

Bucks purports to see an appropriate object for the faith it commends:

“Approaching investing based on the data from the past doesn’t require you to ignore the tough economic challenges we face. It just requires that we believe we will find a way through them.”

I agree that “a way through” can be found.  However, the key to discovering it is not by blindly clinging to the past as indicative of the future, especially if one’s “long-term” is ten years or less.  Richards claims that “investing based on the weighty evidence of history is the most prudent thing we can do.”  I agree that it’s foolish to ignore history.  But the history must be accurately recorded and wisely interpreted.  As Christianity teaches, faith without works is dead.


[1] See also, Lessons from a Lost Decade, The Likely Range of Market Returns in the Coming Decade, Valuing the S&P 500 Using Forward Operating Earnings, and No Margin of Safety, No Room for Error. Robert Shiller doesn’t like the investment universe much at all over the near and intermediate-term either – except for farmland.  Jeremy Grantham is extremely risk-averse right now too.

[2] Wade suggests that retirees would be well advised to consider the market value (and not just price) of a retirement portfolio when determining a withdrawal rate. He has shown that the amount of wealth remaining 10-years into retirement accounts for up to 80 percent of the variation in final outcome measures after 30-years (“sequence risk”). Therefore, retirees who are unlucky and retire into a down market and who have not provided adequate guaranteed income will need to try to readjust their spending downward and consider returning to work. In his view, since current dividend yields are low, earnings valuations are near historical highs, and nominal bond yields are low, current retirees should assume lower portfolio returns than normal for the near-to-intermediate term and should lower their withdrawal expectations accordingly to try to avoid plan failure. His recent paper entitled Can We Predict the Sustainable Withdrawal Rate for New Retirees? gives a solid framework for how to do that. A helpful summary of some of Wade’s work is available here.

[3]The Dalbar study annually finds, based upon mutual fund flows, that the average equity investor’s return on stocks is dramatically less than the return of the S&P 500 index.