Behavioral Finance: Patience Is Its Own Reward

Here's a guest post courtesy of Marotta Asset Management. To me, the key is the last paragraph, but I thought I'd include the whole piece for those of you who want more. ;-)

To process financial information, our minds often attempt unwise shortcuts. By understanding behavioral finance, we can limit the information we use and keep our decisions balanced and on track.

Financial information on the Internet is excessive and changes daily. This overload leads to excessive trading, which in turn results in lower returns. Studies suggest that analysts who depend on all this overwhelming advice make poorer decisions even though they feel more confident about them.

Another reaction to information overload is paralysis. When investors have one attractive option, they tend to invest. When they have two or more appealing choices, they may fail to act because they are afraid of making a wrong decision and looking stupid. This regret aversion motivates them to go with the status quo, which is often more costly than either of the promising alternatives.

Over the long term, the U.S. stock markets go up an average of 11% annually, beating inflation by about 6.5%. But to earn this great typical return, studies in behavioral finance indicate that we must be able to tolerate the year-to-year volatility.

In each of the last five years, the stock markets were up. The three years before that (2000 to 2002), the markets were down. Many people worry about the timing of getting into or out of the markets: Will 2008 be an up year? What about 2009?

I will give you the forecast for the next ten years in the U.S. markets: up, down, up, up, down, up, down, up, up, up. These predictions are not in chronological order. This year could be one of the "up" years or one of the "down" years. It is a gamble, but unlike most gambling, the odds are in your favor. About seven of every ten years are up years, and they are usually stronger than the down years.

If you are an investor, the odds are in your favor. But not everyone who buys and sells stocks is an investor. Some people play the markets looking for short-term gains and follow hot tips or quickly timed movements. These people are speculators, not investors.

Compare an investor with an orchard manager who goes to a nursery to buy some peach trees. He buys the trees because he understands about growing and selling fruit. He knows how to care for the trees, harvest the peaches, and deliver them to market. He understands what is involved across the whole spectrum of his business: from nurturing the natural juicy fruit to savoring it baked in a delicious peach cobbler.

Speculators buy some peach trees when they see the nursery's supplies are dwindling. Then they stand in the parking lot hoping to resell the trees at a profit. Speculators do not care what they are buying or selling so long as the price moves quickly. So they never really buy peach trees. Speculators purchase snow blowers when the blizzard is forecast or generators as the hurricane gathers strength, or whatever else they think might show a short-term spike in price.

If the blizzard misses or the hurricane fizzles, speculators lose money. The possibility of more demand raises prices appropriately. If the likelihood increases, prices go up even higher. If the likelihood decreases, so do prices.

As soon as it is feasible, speculators sell quickly because they believe the spike is short lived and temporary. This tendency led to the investment truism "Buy on rumor and sell on news."

In other words, even if speculators are right, their profits depend on being faster to buy and faster to sell. For the speculator, speed is everything. Not so for investors.

Investors, like farmers, substitute seasons of patient labor and care for speed and market timing. They make their money off the gradual growth in the value of their investments. In contrast, salespeople must keep their merchandise moving because their product isn't getting any more valuable. They make their money off commissions on the transaction itself. For them, what is important is the speed and number of transactions. Brokers and those who sell "loaded funds" are salespeople, not peach farmers. Their livelihood depends on the number and rate of trades in an account. These incentives for speed can lead to abuses.

Frequent trading in an account for the purpose of gaining commissions is called "churning," measured by the turnover rate in an investment portfolio. Turnover is the percentage of an investment account's asset that are bought or sold during a year. Churning can be defined as a turnover rate of over 300%, meaning the entire portfolio value is bought or sold every four months.

An important criteria we use for equity mutual fund selection is a turnover ratio of under 50%. We advise you to be patient and try to ignore the market's ups and downs.

Studies show that mutual funds with a lower turnover rate perform better. Short-term trading has a cost and usually reduces performance. To make money, speculators usually must guess the highs and lows in the stock market within six weeks.

This investment philosophy does not depend on what the markets did in the last four months or what they will do in the next four months. We can't imagine a peach tree that would look good to buy and hold for only four months. Investing is like planting a peach tree: You have to wait for the fruits of your labor.

So don't worry too much about the timing of getting in and out of the market. Focus instead on having a diversified enough portfolio to weather any market--up or down. Once you have a brilliant investment strategy, a successful investor's greatest virtue is patience. As scientist and mathematician Georges-Louis Leclerc said, "Patience is genius"--and it is often the best defense against short-term noise that can ruin your long-term results.

Comments

[Big Winner]

I love the field of behavioral finance! If you search for "List of Cognitive Biases" you can find many of the ways the brain is not configured for making accurate decisions.

[Plamen]

Great summary on what investor really is.

The temptation to time the market is really strong some times, but I always keep at the back of my mind how much in transactions fees and taxes it will cost me to be an active trader.

On the other hand I support the idea of playing with the market with 5% of you investment resources if you defined them initially as expected loss. To start this however requires your 5% to be a significant number compared to the brokerage fees

[deer in the headlights]

Perhaps its because I've never had money in my life, I've had to work hard to save, but I find myself with cash (about half a million) in the bank but afraid to invest or buy a home or anything. I'm in my early thirties. I have zero debts and my wife and I earn a good wage but are forced to live in an expensive part of the country because of our jobs. Moving somewhere cheaper just isn't a real option right now.

Does any one have any hard quantitative advice on how best to save for retirement in our case? We're wondering if we're better off not buying a home until we can move somewhere much cheap (perhaps 10 years from now). We have no stocks, no bonds, no 401k, nothing like that.

Thoughts?

[Al Noyes]

This article hits what investing MEANS in the "bullseye" and how it is different than "speculating". Only one point wasn't covered what separates the two strategies but absolutely be done on both accounts. In school, teachers called it "homework" whereas "doing your due diligence" sounds more intellectual or sophisticated. Another way of wording it is, "Check it out for yourself rather than base any decisions on hearsay, which is, in fact, often little more than rumors."

This same principle holds true when INTERVIEWING a potential CPA or financial advisor or even insurance agent, Realtor, loan officer, etc. When it comes to one's own money, retirement, and investments, all of these ARE one's business. Also, a good friend or relative can LEAD one to or suggest a POTENTIAL good tax advisor, financial planner, etc. and is often the best place to begin. Simply because the professional might be good for a friend or relative or business acquaintance, however, should never mean that this individual AUTOMATICALLY receive one's business.

Think of it this way. A friend works at a particular company or agency and thinks that one might also do very well there. Does one basically SKIP the interview process just because a friend or someone else referred this individual to the company or agency? Does one automatically receive the job? And what is one's likelihood of one being able to PERFORM one's work without knowing SPECIFIC information about the job's duties and responsibilities?

Investing, however, isn't "some big mystery" once one is provided simple, easy to understand examples. If one has $100 then put this amount in a savings account, then one HAS made an investment that is safe. Imagine what might happen if, after the initial investment is repeated until that $100.00 (plus interest) continues growing until one has perhaps $5,000.00 then WITHDRAWS half of it and invests it into a short-term CD (Example: 6-month CD) at a slightly higher return on investment (initial amount plus interest) and continues the process. Both of these examples are investments and relatively safe. Anyone who believes that ANY bank or financial institution really KEEPS each individual's account balance in the bank might also think that the bank makes money by charging more interest than paying interest. In actuality, they make money through what is called "cash flow" based upon "how money 'flows' through" that particular bank or institution. The individual who invested $2,500.00 in short-term CD is essentially loaning one's OWN money to the bank or financial institution for a specific amount of time, agrees to allow the bank or financial institution to LOAN these same funds to someone else, calculate the risk (of receiving BACK this same amount PLUS interest), then loan this individual's money to the borrower. These same funds (or investments) are actually two different loans, one with the least amount of risk (often guaranteed or backed by the FDIC or similar institution) receives a lower return on investment while the bank or lending institution (both as a borrower and as a lender) receives the DIFFERENCE between the two loan amounts.

Unless one lives in a tent or a cave, one cannot avoid being "a real estate investor". If renting, then every rent payment is--or should be--building the OWNER's investment portfolio or increasing the equity. If owning whether having a closed-end loan or open-end loan or both OR PAID OFF (except for, of course, taxes, insurance, and maintanence), then one is "investing" in one's own place to live. In short, everyone is basically "investing" in one form or another whether it is time or money or both.

Hopefully, the comments made to this article might simply provide more general clarity. But this article is among the best that I have read in a long time on this subject.

[Al Noyes]

This article hits what investing MEANS in the "bullseye" and how it is different than "speculating". Only one point wasn't covered what separates the two strategies but absolutely be done on both accounts. In school, teachers called it "homework" whereas "doing your due diligence" sounds more intellectual or sophisticated. Another way of wording it is, "Check it out for yourself rather than base any decisions on hearsay, which is, in fact, often little more than rumors."

This same principle holds true when INTERVIEWING a potential CPA or financial advisor or even insurance agent, Realtor, loan officer, etc. When it comes to one's own money, retirement, and investments, all of these ARE one's business. Also, a good friend or relative can LEAD one to or suggest a POTENTIAL good tax advisor, financial planner, etc. and is often the best place to begin. Simply because the professional might be good for a friend or relative or business acquaintance, however, should never mean that this individual AUTOMATICALLY receive one's business.

Think of it this way. A friend works at a particular company or agency and thinks that one might also do very well there. Does one basically SKIP the interview process just because a friend or someone else referred this individual to the company or agency? Does one automatically receive the job? And what is one's likelihood of one being able to PERFORM one's work without knowing SPECIFIC information about the job's duties and responsibilities?

Investing, however, isn't "some big mystery" once one is provided simple, easy to understand examples. If one has $100 then put this amount in a savings account, then one HAS made an investment that is safe. Imagine what might happen if, after the initial investment is repeated until that $100.00 (plus interest) continues growing until one has perhaps $5,000.00 then WITHDRAWS half of it and invests it into a short-term CD (Example: 6-month CD) at a slightly higher return on investment (initial amount plus interest) and continues the process. Both of these examples are investments and relatively safe. Anyone who believes that ANY bank or financial institution really KEEPS each individual's account balance in the bank might also think that the bank makes money by charging more interest than paying interest. In actuality, they make money through what is called "cash flow" based upon "how money 'flows' through" that particular bank or institution. The individual who invested $2,500.00 in short-term CD is essentially loaning one's OWN money to the bank or financial institution for a specific amount of time, agrees to allow the bank or financial institution to LOAN these same funds to someone else, calculate the risk (of receiving BACK this same amount PLUS interest), then loan this individual's money to the borrower. These same funds (or investments) are actually two different loans, one with the least amount of risk (often guaranteed or backed by the FDIC or similar institution) receives a lower return on investment while the bank or lending institution (both as a borrower and as a lender) receives the DIFFERENCE between the two loan amounts.

Unless one lives in a tent or a cave, one cannot avoid being "a real estate investor". If renting, then every rent payment is--or should be--building the OWNER's investment portfolio or increasing the equity. If owning whether having a closed-end loan or open-end loan or both OR PAID OFF (except for, of course, taxes, insurance, and maintanence), then one is "investing" in one's own place to live. In short, everyone is basically "investing" in one form or another whether it is time or money or both.

Hopefully, the comments made to this article might simply provide more general clarity. But this article is among the best that I have read in a long time on this subject.

[Jake]

"Focus instead on having a diversified enough portfolio to weather any market--up or down."

Preferably one that focuses on emerging markets, small caps, and mining companies, right? And for goodness sake make sure you don't have any t-bills, they're the riskiest investment in the world.

Good post, but it still just reminds me about how bad those past Marrotta posts were. If only these guys followed their own advice consistantly!

[Matt H]

deer in the headlights: In some ways, your problem is a very good one to have. The part most people have the most trouble getting down is the frugality. But I think you're a little too far down the frugal/risk-averse end of the spectrum for your own good.

Since you're sitting on a big chunk of change, before making any significant moves, it would be prudent to educate yourself about investing. A good place to start would be The Intelligent Asset Allocator by William Bernstein. Another book of his, The Four Pillars of Investing, is also very good if you prefer something written for a less mathematical audience. A good book on financial planning is Spend 'Til The End by Laurence J. Kotlikoff and Scott Burns.

On the other hand, don't get carried away with the research and try to read every investing book you can get your hands on before you start making some changes. No matter what your level of risk aversion, you should take steps to capture any tax breaks or employer matching you can through 401(k) plans or IRAs. So if you or your wife have 401(k) plans available to you, take steps now to begin contributing part of your paychecks. As for all that cash you've amassed, I'd suggest going to a fee-only financial planner to help you figure out what best to do with it given tax laws and your goals in life.

You're probably very risk-averse, but you should realize that even holding cash you can't eliminate all your risk. Inflation has been outpacing the before-tax yield of FDIC-insured savings accounts lately, leaving a negative real return. That means each year, the purchasing power of your existing savings erodes. The worst part though is that you're still taxed on your nominal return, which means that even in good years you have little hope of staying ahead of inflation with savings accounts. It's almost as if the tax laws were specifically designed to discourage people from doing what you've been doing.

Neither I nor anyone else can tell you with any certainty what the best asset allocation is nor when or where is best to buy a home. These things simply cannot be known in advance.

But I think in your case, this is an example of where the perfect is the enemy of the good. Don't worry so much about making the perfect choice that you fail to at least pick some of the low-hanging fruit like starting a tax-advantaged retirement plan like an IRA or 401(k).

If a house is something that you want, start looking to find out what your money could buy you where you live. Don't worry so much about trying to buy at the absolute bottom of the market that it keeps you from buying a place you can be happy living in and could afford. Chances are, in the long run, owning a home rather than renting will make you much better off.