Investment Psychology & Stock Declines

How to Use Volatility to Make Money

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Quiz!

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50%

How to Use Volatility to Make Money

Investment volatility is the investment’s movements up and down away from its average growth. It is commonly viewed as a negative, but for a disciplined long-term saver, it is typically a positive. A hypothetical example can demonstrate it. Let’s compare 2 portfolios with identical returns, and different volatility:

Portfolio 1

Portfolio 2

Year 1

0%

-50%

Year 2

0%

100%

Average

0%

0%

If you start with $100, both portfolios will be worth $100 after 2 years. Specifically, Portfolio 2 will go through the following values: (Year 1) $100 – 50% = $50. (Year 2) $50 + 100% = $100. The portfolios have identical average growth, but Portfolio 2 is far more volatile.

Let’s see the final balance if you add $100 in the beginning of each year:

Portfolio 1

Portfolio 2

Year 1

($100 + 0%) = $100

($100 – 50%) = $50

Year 2

($100 + $100) + 0% = $200

($50 + $100) + 100% = $300

Even though both portfolios have the same average growth, when adding to both portfolios identical amounts each year, the more volatile portfolio ended up 50% higher ($300 vs. $200).

How is this possible? The percentage going back up is greater than the original percentage going down. When a portfolio recovers from a 50% decline it goes up 100%. This is because the percentage going up is relative to a lower starting amount. While old money simply recovers, new money that was invested low goes up $100 – double the -$50 impact of the decline.

Notes:

  1. Some investors lose faith in their portfolio after declines, and hold off on investing (or even sell). If you do that, you can negate the entire benefit of volatility and even hurt your returns.
  2. Even with discipline, there is a special case that can lead to a negative effect. The case involves no up period after a down period, for example, only up years followed by only down years. This is not a concern for disciplined lifelong investors, because such a sequence is limited to one cycle or less.

Quiz Answer:

If you add annually to a portfolio that drops 50% in one year and recovers the next year, what penalty or benefit do you get when compared to a portfolio with the same returns (0%) and no volatility?

  1. -50%
  2. No impact.
  3. +50% [The Correct Answer]

Explanation: See this month’s article for an analysis of this scenario.

Disclosures Including Backtested Performance Data

The Secret to Getting Rich

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Quiz!

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%.
  2. Buy well established companies that are not going anywhere.
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand.

The Secret to Getting Rich

Have you ever heard a secret for getting rich? As an investment advisor, I hear such ideas frequently, and evaluate each of them with a critical eye. There is one thing in common with most, maybe all, ideas that work: they go against human nature, or deeply engrained human biases. If this sounds surprising, a few examples may help:

Good Action

Bias

Biased Action / Human Nature

Defer spending to invest, and enjoy compounded growth

Present Bias

Emphasize the present over the less tangible future

Invest in fast growing (and volatile) investment classes

Myopic Loss Aversion

Avoid declines, even temporary

Buy low: value stocks (low Price/Book), AND investments at a low point of the cycle (after years of declines)

Recency Bias

Prefer investments that did best in the recent 5-10 years

Diversify across countries

Home Bias

Buy familiar stocks that are close to home

Own small stocks

Familiarity Bias

Buy large stocks that are more familiar

Enjoy momentum

Disposition Effect

Sell too soon, after seeing a gain, and too late after seeing a loss

Buy small & unknown profitable companies

Familiarity Bias

Focus on known profitable companies over less known ones

A couple of notes about the list above:

  1. If some of the profitable actions listed in the first column seem natural to you, you are in luck, having strategies that are uncomfortable to others, but comfortable to you, letting you likely enjoy excess gains compared to the average investor.
  2. An issue that makes most of the above especially difficult is that they tend to show poor results for extended series of years. It requires a big commitment, to enjoy the long-term benefits.

If you hear of an idea for getting rich that is easy to implement, both technically and also in terms of human nature, you should be skeptical. The ideas that survive the test of time tend to be difficult or go against human nature. Otherwise, many people will pursue the investment, bidding up its price and hurting future returns.

Now that you realize how difficult it is to follow the good advice for growing your money, should you give up? No. Here are some ideas:

  1. Think of tangible examples for the tradeoffs. For example, would you give up spending $10,000/year for the next 20 years, in return for $38,700/year for the following 20 years (assuming 7% real growth), or one lump sum of $521,000 in 20 years? Think about a specific dream you can fulfill with these amounts.
  2. Get the longest data you can, for the asset classes of your investments (e.g. US large stocks, International value stocks, real estate in various locations), and get a sense for the length of cycles. If some past cycles reached 15 years, never use the past 5-10 years to conclude that there is a new normal.
  3. After a long tough stretch, when the media may be most discouraging, try to identify the recent peak or bottom. If the peak was a good number of years back, or the bottom was fairly recent, you should become more optimistic. If you see low valuations (low Price/Book for stocks or high affordability for real estate), it should further support your optimism.

Quiz Answer:

Which of the following investment strategies are based on biases, and can lead to poor performance? (May be multiple answers)

  1. Buy investments that exhibited rapid growth of 15% in the past 5 years, relative to their long-term average of 5%. [Correct Answer]
  2. Buy well established companies that are not going anywhere. [Correct Answer]
  3. Buy obscure small companies that you don’t understand.
  4. Buy companies you clearly understand. [Correct Answer]

Explanations:

  1. Recency Bias. An investment that did exceptionally well (relative to its average) for 5 years may be overvalued, and is at an elevated risk.
  2. Familiarity Bias. Well established companies tend to be well known, and you may pay a premium for the comfort of the familiar, well established name.
  3. As long as you stay diversified, and stick with small companies throughout the cycle, you are likely to get a return premium for holding these less familiar and less comfortable investments.
  4. Familiarity Bias. See #2.
Disclosures Including Backtested Performance Data

Can you Guess the Top Performing Country Last Year?

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Quiz!

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66%

Can you Guess the Top Performing Country Last Year?

As an Investment Advisor, a fiduciary that is responsible for the life’s savings of entire families, you would expect to count on me to follow the economic news closely and be ready to react to any new developments. Do I do this? I do the exact opposite – I separate my investment decisions from economic news. If I were to depend on the news for investment decisions, I could hurt your life’s savings badly.

A recent example from 2016 can demonstrate this counterintuitive point. Brazil spent the entire year in a devastating recession – the worst on record (over more than 100 years). Unemployment climbed throughout the year from 9% to 11.9%. The president was impeached and there were numerous corruption scandals. Predicting this year could have made you a fortune by shorting (making money when stocks decline) Brazilian stocks in 2016, right? Not so fast. The Brazilian stock market gained +66% in 2016. Not only did it not decline – it was the top performing country for the year.

How is it possible to get stellar returns during the worst economic decline on record? The answer is simple – ignoring prices. The consensus view was for a long and deep economic decline, which would hurt Brazilian companies. In reaction, people sold Brazilian stocks to avoid the declines. The problem was that people kept selling these stocks without regard to prices. Why is this a problem? Say that in normal times a basket of Brazilian stocks is worth $100. Now comes a big recession, and the new realistic value is, say, $80. You would expect rational people to sell until the price reaches $80. But many investors see a struggling economy and sell with disregard to the price. Others cannot imagine a turnaround and sell to reflect a multi-year depression. So, the continued selling brought the basket to a much lower value, say $40. This reflects an unusually bad expectation – far worse than reality. Now comes additional moderately negative news, lowering the realistic value from $80 to $75. With the news being far less negative than expected, people become more positive, and are more likely to accept a value closer to reality. They are ready to correct some of the excess decline, leading to a surge from $40 to, say, $66.40 (a gain of 66%), all while the economy is doing poorly. While the numbers in this example where made up, the mechanism explains what could have led to the surge of Brazilian stocks.

As of 9/30/2016, Brazil represented 6.82% of emerging markets, while the allocation to it in the emerging market portion of QAM’s portfolios was 9.19%. This emphasis reflects the deep value focus (a focus on low priced stocks) of these portfolios, something that often leads to outperformance compared to the general market during recovery years.

Quiz Answer:

Brazil is in the midst of a devastating recession – the worst on record, with GDP of -3.5% for 2016 following -3.8% for 2015. Can you guess the returns of Brazil’s stock market for 2016?

  1. -70%
  2. -62%
  3. -14%
  4. 0%
  5. +24%
  6. +66% [The Correct Answer]
Disclosures Including Backtested Performance Data

Volatility is not the best Measure of Investment Risk

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Quiz!

If the longest possible decline (peak-to-peak) for ET (Extended-Term Component) were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years
  2. 3 years
  3. 12 years
  4. More than 12 years

Look for the answer below and read this month’s article for a discussion.

Volatility is not the best Measure of Investment Risk

Volatility is the most common measure of investment risk.  There are a number of reasons:

  1. Some investors panic and sell at a low point.  Selling a high-growth high-volatility investment at a low point can negate the entire benefit of the high average growth.
  2. Some investors build concentrated portfolios, where volatility involves the risk of a loss that extends beyond a market cycle.
  3. When the horizon of the entire investment is shorter than a cycle of a volatile investment, volatility can lead to a permanent loss if it is fully sold at a lower point in the cycle.

What if you are a disciplined investor, saving for retirement (or being in retirement, with limited annual withdrawals), and are able to stick with your plan throughout the cycle?  In such a case, seeking low volatility at the price of lower average returns, can lead to higher overall risk, given the risk of outliving your money – the opposite of what is intended.  If you are going to stick with your plan throughout the cycle, a higher-growth diversified investment is less likely to leave you bankrupt as a result of regular retirement withdrawals.

Another factor is the position in the cycle.  While it is impossible to identify the precise peaks and bottoms of the cycle, there are certain factors that are not typical for peaks:

  1. Valuations are lower than usual.  The beginning of the worst declines tend to occur at very high valuations, not low.
  2. The investments are in the midst of a deep and long decline.  For example, if the recent peak was 9 years ago, and you are at a 28% decline, your risk level is much lower today.  And, to continue the example, if the total decline is 12 years long, you get a 39% gain in the remaining 3 years.

Quiz Answer:

If the longest possible decline (peak-to-peak) for ET were 12 years (a hypothetical assumption, which was chosen as a punitive example given current conditions), and you were to invest money in ET today, what would be the longest possible decline for this investment?

  1. Less than 3 years  [The Correct Answer]
  2. 3 years
  3. 12 years
  4. More than 12 years

Explanation:  Since we are over 9 years into the current decline, if 12 years were the longest decline, the remainder would be at most: 3 years.  With the portfolio currently 28% below the 10/31/2007 peak, not only would you recover any decline within 3 years – you would enjoy an addition gain of 39% (to revert the starting point of -28%).  This means that the longest decline to recovery of an investment made today would be substantially less than 3 years.

Disclosures Including Backtested Performance Data

Can You Make Money in a Down Market?

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Quiz!

What are the outcomes of consistently adding to a portfolio during declines of 20% + 20% followed by a 2 year recovery (25% + 25%), instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio.
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

Can You Make Money in a Down Market?

Imagine living through a long decline period. If you are retired and your entire life’s savings are invested in your portfolio according to your plan, you can relax knowing that your low withdrawal rate is likely to sustain your money for as long as you live.

If you are still in saving mode, or have money that was not put to work in your portfolio, you have choices. Let’s review two different options:

  1. You wait for the portfolio to recover to gain more comfort, and after it proved itself, you add more money to it. You don’t add money to a losing portfolio.
  2. You add all money available, whether it is savings from work, money invested elsewhere, equity in your home that you can borrow (subject to a risk assessment), or an inheritance.

Let’s continue with an example: Say you had 1M that declined for 2 years, and then recovered in 2 years. Also, say you had 100k to add per year. During the declining period, you choose between diverting to a portfolio that gained 10% per year and adding to the portfolio that simply declined and recovered with no new gains (as described in 1 & 2 above, respectively). Let’s see the financial impact of the 2 options:

1M Portfolio state Value of

original 1M

 Value of new investments
Option #1: Invest at 10% Option #2: Invest in portfolio
20% decline + saved 100k 800k 100k 100k
20% decline + saved 100k 640k 100k + 10% + 100k = 210k 100k – 20% + 100k = 180k
25% gain + saved 100k 800k 210k + 10% + 100k = 331k 180k + 25% + 100k = 325k
25% gain to full recovery 1M 331k + 10% = 364k 325k + 25% + 100k = 506k
Performance of deposits 364k / 300k – 1 = 21% 506k / 300k -1 = 69%

After 4 years, option #1 would result in 364k, while option #2 would result in 506k.

In option #1, your entire mental focus is on the wait for a recovery, to regain comfort with the portfolio. You have no good feelings about the portfolio until you fully regained the lost grounds. In the meantime, you feel good about growing your new savings at 10% per year, and are happy that you did at least one smart thing.

In option #2, you keep adding to the portfolio, ignoring its behavior. At first, you feel good buying low. As the decline continues, you are tempted to feel that you are throwing good money after bad, but you remind yourself that the portfolio is far more attractive the lower it gets, and the new money can enjoy this benefit. After one year of gains, you can already celebrate the impact on your recent deposit. So, instead of focusing on the remaining path to recovery, you can enjoy the hard dollars that you gained during the initial part of the recovery. By the full recovery, you enjoy far better results than 10% per year even though you added to a portfolio that had 0% returns from peak to the new peak.

Quiz Answer:

What are the outcomes of consistently adding to a portfolio during declines of 20% & 20% followed by a 2 year recovery, instead of using a stable 10%-per-year investment for the new money?

  1. You throw good money after bad – you lose money while feeling lousy.
  2. You lose money, but at least you stay conservative by sticking with your plan. Once there are new peaks, your entire investment will enjoy future growth.
  3. Not only you make money by buying low – you magically outperform the consistent 10% portfolio. [The Correct Answer]
  4. You make money by buying low, and with the new peak your entire investment will enjoy future growth.

The article above provides an explanation.

Disclosures Including Backtested Performance Data

Don’t Worry, Climb a Wall of Worry

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Quiz!

Starting in 3/2/2009, Extended-Term Component enjoyed gains while there were great concerns about the world economies. If anyone were to sell this investment for 6 months, what would be the missed gain, and what would have been the impact on the 10 year performance?

  1. 12% gain in 6 months = 1.1% lost per year over 10 years.
  2. 26% gain in 6 months = 2.3% lost per year over 10 years.
  3. 47% gain in 6 months = 3.9% lost per year over 10 years.
  4. 76% gain in 6 months = 5.8% lost per year over 10 years.
  5. 102% gain in 6 months = 7.3% lost per year over 10 years.

Don’t Worry, Climb a Wall of Worry

When stock prices go up in spite of many concerns, it is said that the stocks are climbing a wall of worry. How is it possible that stocks go up while there are many concerns? This is the result of stocks reacting to two things: (1) changes and not an absolute situation; (2) expectations and not just the current situation. A few examples:

– There was an expectation for a very low price of oil, but the price spiked by 35% in just over a month, given an expectation for limited supply and increased demand.

– There was an expectation for 4 interest rate increases in the US this year, and this expectation went down to 2.

– There were a number of stimulus actions in Europe and China.

The improved expectations did not eliminate the worries, but they presented a more positive outlook, leading to big gains in stocks.

While a climb on a wall of worry can happen at any level of valuations, it is more typical when valuations are very low, and that is when you need to pay special attention. You can expect surges from low valuations to involve a climb on a wall of worry, since deep bottoms occur due to a long list of concerns, and these concerns are typically removed gradually over months or years. Avoiding an investment when valuations are low is risky, and can result in a negative impact that can be felt for a decade or longer. A good example is the 6 months starting at 3/2/2009. During that time, Extended-Term Component gained 102%. Missing such a period would lower the 10-year performance by 7.3% per year.

Quiz Answer:

Starting in 3/2/2009, Extended-Term Component enjoyed gains while there were great concerns about the world economies. If anyone were to sell this investment for 6 months, what would be the missed gain, and what would have been the impact on the 10 year performance?

  1. 12% gain in 6 months = 1.1% lost per year over 10 years.
  2. 26% gain in 6 months = 2.3% lost per year over 10 years.
  3. 47% gain in 6 months = 3.9% lost per year over 10 years.
  4. 76% gain in 6 months = 5.8% lost per year over 10 years.
  5. 102% gain in 6 months = 7.3% lost per year over 10 years. [The Correct Answer]
Disclosures Including Backtested Performance Data

A Vanishing Value Premium?

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Quiz!

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year

A Vanishing Value Premium?

By Weston Wellington, Vice President, Dimensional Fund Advisors

Value stocks underperformed growth stocks by a material margin in the US last year. However, the magnitude and duration of the recent negative value premium are not unprecedented. This column reviews a previous period when challenging performance caused many to question the benefits of value investing. The subsequent results serve as a reminder about the importance of discipline.

Measured by the difference between the Russell 1000 Growth and Russell 1000 Value indices, value stocks delivered the weakest relative performance in seven years. Moreover, as of year-end 2015, value stocks returned less than growth stocks over the past one, three, five, 10, and 13 years.

Unsurprisingly, some investors with a value tilt to their portfolios are finding their patience sorely tested. We suspect at least a few will find these results sufficiently discouraging and may contemplate abandoning value stocks entirely.

Total Return for 12 Months Ending December 31, 2015

Russell 1000 Growth Index 5.67%
Russell 1000 Value Index −3.83%
Value minus Growth −9.49%

Before taking such a big step, let’s review a previous period when value strategies underperformed to gain some perspective.

As many growth stocks and technology-related firms soared in value in the mid- to late 1990s, value strategies delivered positive returns but fell far behind in the relative performance race. At year-end 1998, value stocks had underperformed growth stocks over the previous one, three, five, 10, 15, and 20 years. The inception of the Russell indices was January 1979, so all the available data (20 years) from the most widely followed benchmarks indicated superior performance for growth stocks. To some investors, it seemed foolish for money managers to hold “old economy” stocks like Caterpillar (−3.1% total return for 1998) while “new economy” stocks like Yahoo! Inc. appeared to be the wave of the future (743% total return for 1998).

Many value-oriented managers counseled patience, but for them the worst was yet to come. In 1999, growth stocks shone even brighter as value trailed by the largest calendar year margin in the history of the Russell indices—over 25%.

Total Return for 1999

Russell 1000 Growth Index 33.16%
Russell 1000 Value Index 7.36%
Value minus Growth −25.80%

In the first quarter of 2000, growth stocks bolted out of the gate and streaked to a 7% return while value stocks returned only 0.48%. As of March 31, 2000, value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years and by 1.49% per year since the inception of the Russell indices in 1979. A Wall Street Journal article appearing in January profiled a prominent value-oriented fund manager who regularly received angry letters and email messages; his fund shareholders ridiculed him for avoiding technology-related investments. Two months later he was replaced as portfolio manager amidst persistent shareholder redemptions.

With value stocks falling so far behind in the relative performance race, it seemed plausible that value stocks would need a lifetime to catch up, if they ever could.

It took less than a year.

By November 2000, value stocks had delivered modestly higher returns than growth stocks since index inception (21 years, 11 months). By month-end February 2001, value stocks had outperformed growth over the previous one, three, five, 10, and 20 years and since-inception periods.

The reversal was dramatic. Over the period April 2000 to November, value stocks outperformed growth stocks by 26.7% and by 39.7% from April 2000 to February 2001.

This type of result is not confined to the technology boom-and-bust experience of the late 1990s. Although less pronounced, a similar reversal took place following a lengthy period of value stock underperformance ending in December 1991.

We can find similar evidence with other premiums:

  • From January 1995 to December 1999, the annualized size premium was negative by approximately 963 basis points (bps), amounting to a cumulative total return difference of approximately 113%. Within the next 18 months, the entire cumulative difference had been made up.
  • From January 1995 to December 2001, the annualized size premium was positive by approximately 157 bps.

The moral of the story?

Prices are difficult to predict at either the individual security level or the asset class level, and dramatic changes in relative performance can take place in a short period of time.

While there is a sound economic rationale and empirical evidence to support our expectation that value stocks will outperform growth stocks and small caps will outperform large caps over longer periods, we know that value and small caps can underperform over any given period. Results from previous periods reinforce the importance of discipline in pursuing these premiums.

Quiz Answer

As of March 31, 2000, US value stocks had underperformed growth stocks by 5.61% per year for the previous 10 years. How many years did it take for value stocks to make up for these 10 years of underperformance?

  1. We are still waiting
  2. 10 years
  3. 5 years
  4. 3 years
  5. 1 year
  6. Less than 1 year [The Correct Answer]
Disclosures Including Backtested Performance Data

The Power of Low Valuations

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Quiz!

When a diversified stock portfolio has low valuations, as measured by Price/Book, which of the following is most likely?

  1. Investors are pessimistic about the investment, which could lead to poor performance.
  2. Investors are pessimistic about the investment, which could lead to unusually high performance.
  3. Investors are optimistic about the investment, which could lead to poor performance.
  4. Investors are optimistic about the investment, which could lead to unusually high performance.

Look for the answer below and read this month’s article for a discussion.

Article

Extended-Term Component, one of two stock portfolios offered by Quality Asset Management, exhibits high volatility along with high average returns. In recent years, the portfolio went through a slow period. At this point, it would be nice to have some indication of where we stand. There is one measure that is very helpful – the Price/Book (P/B), or price of the companies relative to their book value, or liquidation value. When breaking the timeline of returns to up and down periods, we observe a strong relationship between the returns in the upcoming period and the Price/Book at the start of the period (see charts below). Specifically, down periods started with a Price/Book of 1.38 to 2.04, while up periods started with a Price/Book of 0.69 to 0.75.

There is nice logic to this behavior. A Price/Book below 1, indicates that people are paying for the company less than its value by the books – a very low price. This is usually the result of very negative sentiment. Once the pessimism wanes, people go back to wanting to pay a premium for the companies relative to their book values. This leads to gains beyond the growth in the book values of the companies, explaining the dramatic gains of 84% to 580%, that were experienced in past up periods.

Up Periods for Extended-Term Component
Period Begin Period End Starting P/B Annualized Gain Total Gain
02-1999 12-1999 0.69 105% 84%
03-2003 10-2007 0.75 52% 580%
11-2008 04-2011 0.71 62% 214%
Down Periods for Extended-Term Component
Period Begin Period End Starting P/B Annualized Gain Total Gain
12-1999 03-2003 1.45 -14% -39%
10-2007 11-2008 2.04 -66% -68%
04-2011 07-2015 1.38 -8% -31%

Today, the P/B is equivalent to 0.79 (after adjusting for the profitability bias), close to the range that started the big up periods in the past. While the future can bring lower valuations or longer down periods, the data is strong enough to give some optimism for an up period in upcoming months or years. If we experience declines from this point, I would expect the gains to be greater.

Quiz Answer:

When a diversified stock portfolio has low valuations, as measured by Price/Book, which of the following is most likely?

  1. Investors are pessimistic about the investment, which could lead to poor performance.
  2. Investors are pessimistic about the investment, which could lead to unusually high performance. [The Correct Answer]
  3. Investors are optimistic about the investment, which could lead to poor performance.
  4. Investors are optimistic about the investment, which could lead to unusually high performance.

Explanation: A low Price/Book means that the price of the investment is low relative to the company’s book value. Investors are usually willing to pay a low price because they are pessimistic about the investment. Once the sentiment improves, investors are willing to pay more than the book value. This leads to unusually high performance, because the price goes up by compounding the price gains relative to the book value with the growth in the book value.

Disclosures Including Backtested Performance Data

When Emotions Should Play a Role with Money

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Money can be an emotional topic.  It can raise feelings of greed, fear, entitlement, or shame, among others.  It is important to have emotions impact money in one stage of the investment process:  when defining your goals.  Here are a few examples:

  1. You expect to have great emotional suffering when your portfolio declines.  This may lead you to have a greater allocation to low-volatility investments (CDs or bonds) than financially called for.  It can make sense when done in the planning phase, and not during a deep decline.
  2. You may be stuck in the rat race for too long, and decide to take actions to live within your means.  As a part of the solution, you are willing to accept short-term volatility for the ultimate goal of having sustainable spending relative to your assets.

Once you are done defining your goals, emotions can harm your investment results.  Here are a few examples:

  1. Fear:  After a big market crash, the media is very negative about the economy and stocks, and you are ready to sell stocks low, or stop investing new savings.
  2. Greed:  After unusual gains in stocks, you decide to increase your stock allocation (buy high) beyond what you planned for originally.
  3. Familiarity Bias:  You fall in love with a company, believe in their product and business plan, and decide to invest in it, without looking at valuations (price relative to book value or earnings) and other information.

The solution is easy to describe and tough [psychologically] to implement:

  1. When developing the plan, view its impact on your entire life, and balance the various risks.  Accept that there is no safe investment – you simply choose which risk you can tolerate most.  Examples of risks to account for are: a need for money during a big decline, panic selling during a decline, outliving your money, and inflation.
  2. Once the plan is developed, be cautious of making changes without changes in your personal circumstances.  Unless you have very substantial assets relative to your expenses, and you don’t watch your investments frequently, you have to expect to feel uncomfortable with your investments at various points in life.  The difference between success and failure can be the action you took against your interests under the emotional stress of an uncomfortable period.
Disclosures Including Backtested Performance Data

Feel Wealthy or Be Wealthy?

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Did your income jump significantly at any point in your life?  If you are fortunate enough to experience that, you may face a tradeoff between feeling wealthy and being wealthy.

If you feel wealthy, you are likely to increase your spending significantly, which can make you less wealthy very quickly.  If this doesn’t make sense to you, Sports Illustrated estimated in 2009 that 78% of National Football League (NFL) players are either bankrupt or in serious financial trouble within two years of retirement.  This is a group of people who typically make several millions each year.  While this is an extreme example, you can get in trouble even without feeling adventurous or being irresponsible.

Say your income jumped from $100,000/year to $300,000/year.  You make the following adjustments to your annual expenses:  $1.5M house, with $72,000/year mortgage payments (30-year fixed loan with 4.5% interest), $18,000 property taxes, $15,000 repairs & improvements, $10,000 utilities + cleaning + gardening, $40,000 private schools for 2 children, $5,000 classes for the children, $20,000 food, $10,000 car payments, maintenance, gas & insurance, $10,000 travel & vacations, $10,000 various types of insurance, including medical & dental & medical bills for the family, $10,000 clothes, toys, household items, etc..  If you don’t have children, you may spend more on nice clothing, eating out, jewelry, hobbies, etc.

I didn’t include all categories of spending, and already consumed your entire net income of $220,000, with nothing left to save.  If you lose your job, you are left with high expenses and low savings.  Furthermore, you have no money left to help your children with higher education, or to fund your own retirement.  By feeling wealthy, and spending accordingly, your financial security dropped lower than before the big raise.

Instead, you can decide to not feel wealthy.  You increase your spending to $120,000 – a significant jump, but low enough to leave $100,000 to save.  Within a few years, you accumulate meaningful savings.  If you lose your job, your savings can carry you for a much longer period of unemployment.  In addition, finding a job to cover your $120,000 in spending will be much easier than replacing the $300,000 salary.  Here are some key ideas for making this work:

  1. Keep your focus on spending-to-assets, and strive to reach a sustainable ratio of 3%-4% per year.  While it would be impossible for most people to reach this rate for a long time (even with $300,000 or $600,000 in annual earnings), use any big jump in earnings to increase your spending modestly and your saving rate significantly.
  2. Never feel wealthy thanks to high income.  No matter how much you earn, you can end up with no financial security, and no wealth.  It can start with nicer cars, expensive jewelry, a nicer home, vacation home, full-time staff in each of your houses, yacht, private jet, private island, or private jumbo jet.
  3. Once you approach sustainable finances, you can increase your spending along with your assets, and enjoy the continued increase in standard of living without losing your peace of mind.
Disclosures Including Backtested Performance Data