Wednesday, October 5, 2011

Stepping into the New Normal

1 - The third quarter of 2011 has mercifully come to a close. The U.S. stock market (as measured by the Russell 3000) fell more than 15% during the months of July through September. Other ownership asset classes performed poorly as well, while bonds came close to breaking even--and in some cases even managed a small gain. As is usually the case, things are not quite as bad as they may seem, despite what you may hear on TV. We are preparing quarterly client reports and will be sending them out later this week.

2 - One of the interesting speakers at the recent FPA Charlotte Symposium was Rod Greenshields of Russell Investments. His talk, entitled "Investors Behaving Badly," explored the reasons that cause smart investors to make not-so-smart decisions. My report on the session is below:

Investors Behaving Badly  
An executive summary of Rod Greenshields' talk at the FPA Charlotte Symposium 

At the Financial Planning Association of Charlotte's annual two-day symposium last week, Rod Greenshields of Russell Investments gave a timely presentation entitled "Investors Behaving Badly." Here are some of the highlights from the notes I took during the talk:

Investors consistently underperform the markets. The problem is in their decision making.
  • Human beings are wired to detect patterns even when they don't exist. We are psychologically wired for a world of limited and poor information. Example:  a simple coin flip. If I flip a coin five times and get 5 heads in a row, what do I expect next? Of course I expect tails. But in reality, the chance of tails is still only 50/50. I want to make a pattern where there isn't one.
  • Another example is the lottery, which Greenshields calls "a tax on the mathematically challenged." The odds of winning the PowerBall are 1 in 80 million. Although you're much less likely to win than you are to die from flesh eating bacteria, a dog bite, or a lightning strike,  people still keep playing, expecting their chances to improve with each ticket purchased.
  • Over short periods of time, great strategies can deliver losing results; that doesn't mean that we should abandon the strategy. Even rats and pigeons understand this concept better than humans do. Studies have been performed using a simple system whereby the subject can push a red button or a green button. The red button results in a reward 80% of the time, the green button only 20% of the time. The rats and pigeons learn quickly to simply select the red button every time, thereby "winning" 80% of the time. The humans, on the other hand, try to guess which button will give the next reward, reducing their success rate to around 64%.
  • Consider the problem of soccer goalies and penalty kicks. Goalies almost always dive for the ball because they don't want to look stupid standing still, but they stop the ball much more often when they do stay still.
  • Despite what many people think, a long-term investment study shows that it doesn't make a tremendous amount of difference whether you invest at the bottom of the market, six months before the bottom, or six months after. Your long-term rate of return is about the same.
Greenshields gave the advisors in attendance the following suggestions as to how to improve investor behavior:
  • The first thing to do, according to Greenshields, is to clarify some definitions. Define what "success" means. In reality, it means achieving your goals. There are plenty of books purporting to tell investors how to "beat the market."  Likewise, CNBC and other news outlets create a lot of drama with which to fill their air time. But you need to resist letting these strangers define success for you. In other words, successful investing is not the same as beating the market.
  • Here's another important term to define: Risk. While we may be tempted to define risk as the short-term loss of principal, a bigger-picture definition is more meaningful and realistic: running out of money before running out of life. Surveys indicate that 61% of baby boomers are more afraid of running out of money than of dying. That brings the concept of risk down to a very concrete and personal level.
  • The speaker recommended setting up systems that make it easier to make good decisions, and he used the concept of a diversified portfolio as an example. Greenshields recommends a portfolio based on a rigorously diversified investment approach. As asset classes and percentage allocations have evolved over time, the concept and practice of diversification has changed.  (As you might suspect, I very much agreed with this part of the presentation.)
  • An investor should look at their advisor as a personal trainer for his or her financial life. He emphasized the familiar (and true) precept that meaningful financial planning involves making sure the client is advancing toward his/her goals.
As he closed, he made the important point that staying the course is not the same as doing nothing. And he illustrated it with a quote by Edward Gibbon: "The winds and waves are always on the side of the ablest navigators."

3 - As mentioned last week, Juliet and Bonnie spent two days last week in a TD Ameritrade Operations Workshop in Washington, DC. They learned a lot, and Juliet reports that the trip was very much worthwhile. They even found time to visit some national landmarks, including the Washington Monument. On the day they were there, the National Park Service affixed a contraption to the top of the obelisk by which some intrepid inspectors rappelled down the four sides of the structure, inspecting the monument for damage caused by the recent earthquake.

4 - We plan to begin implementing our new portfolio models this month. If you're a client who didn't attend one of our portfolio resetting workshops and haven't taken the time to view the DVD of the presentation, this would be a good time to do so. We want clients to be fully informed and to have an opportunity to discuss the changes with us.

Enjoy this beautiful fall week!


Risks in Chasing Yields

Three reasons to be wary of chasing dividend yield for income
Rod Greenshields of Russell Investments discusses why "not invading principal" involves hidden risks that many investors don't recognize.

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