Investing 102: Why and when? Use your emotions to fuel your why, and time-frames to temper them
Feelings are little bundles of emotion that zip around our bodies. They are essential. They make life vibrant. They have a powerful influence on behavior. We are wise to pay attention to our emotional selves in matters of friendship or love. But in the realm of investing, we need to be very aware of the role that emotions play. As an investor, and a human, I do not try to ignore my emotional side. My emotions form the core of why I save and invest – I want to help my kids go to college, I want to travel with my wife, I want our future selves to be financially secure. My emotions are the backbone of my “why.”
But, investing involves many decisions of “how?” and “what?” I know that my emotional state can affect my decision-making. When my investments do well, I feel good. When they do poorly, I feel bad. Desire and fear, or their softer sides, want and worry, affect our behaviors and decisions. It is well documented that most investors when they try to actively beat the stock market, fail to do so. The seemingly simple emotions of want and worry play a crucial role. To temper my emotions, I follow an investment process, or a game plan, that I can follow regardless of how I am feeling. The culmination of the process is a document called an Investment Policy Statement, or IPS for short.
Investing is part art, part science. This blog post is a blend of both, starting with a discussion of how behavior can affect investment results (art). Then, how I use time-frames to help structure my investment process (science). It is the second in a six-part mini-series about my investment process.
Investing 101 – Why invest? Have a process and a plan (previous post)
Investing 102 – When? Manage your emotions through time-frame and liquidity (this post)
Investing 103 – What investments should you choose
Investing 201 – What If? Investment returns and risk
Investing 202 – Diversification and fees. Why do they matter? (future blog post)
Investing 301 – Create a comprehensive investing strategy. (future blog post)
Why talk about emotions? Shouldn’t this be about stocks or something?
I chose to start with emotions and behavior because that is the start of most conversations I have with people when we talk about investing. Usually, I hear something like:
“Isn’t it a crazy time to invest right now?” or
“It feels like a single Tweet could make me lose all of my money.” Or, less commonly,
“What do you think about such-and-such a fund? It’s been really hot lately. It sounds like a sure thing. I want in.”
Questions like these are either driven by or at least colored by, want and worry. It is normal to feel such emotions. So, I am going to talk about them.
Does behavior really lead to bad investing results?
Yes.
There is considerable research stating that the average investor when they try to actively beat the stock market, performs more poorly than the overall stock market. This also turns out to be true for most professional money managers as well! (source [1]). There is a myriad of reasons why. Many have to do with trying to time short term moves in the stock market. Whenever I hear the words, “The DOW will reach _____ by this time next year” I am tempted to listen. It is alluring to think that someone has insight into what will happen in the short term. The problem is that academic research has shown such short-term predictions to be no better at predicting the actual future than a coin flip or a monkey throwing a dart. It is like asking the TV weather person to predict the exact weather in Bellingham, WA one year from today. A weatherperson usually knows a lot about the weather. But, if they predicted that the weather would be exactly 68 degrees one year from today, or even if they said the temperature will be warmer or cooler than average, most of us would recognize it as rubbish. Predicting the actual weather that far in advance has too many variables to make for any sort of accuracy. (Which is why weather forecasters usually say a 40% chance of…) In the financial markets, there are also many variables, plus an additional layer of unpredictability – human psychology. Even so, the financial media is filled with short-term predictions. My hunch is that the media, and the messaging, matches that way the average investor thinks, and thus, behaves. If the behavior is buying in and out of the market (i.e. trying to time the market), then corrosive effects such as trading commissions or taxes can drag down investment performance.
When I first started investing over 15 years ago, I doubted whether behavior really affected results. I doubted whether bad market timing (essentially buying high, selling low) actually occurred in real people. But, I like to explore whether my opinions and gut-reactions have truth behind them. So, I did some research. I found many pieces of evidence that persuaded me of how real people’s behaviors does hinder their investment results. I submit two pieces of evidence for your consideration:
Evidence A. Peter Lynch was an investment manager who ran one of the most successful mutual funds in history (the Magellan fund). While the fund was available to the public, it earned an annualized return of nearly 22%, while the overall market returned “only” 16%. Wow, the fund over-performed the market. But, the average investor in the Magellan fund earned only 13%. Wow-wow. Like, double wow. Look at those numbers again. Although the fund earned 22%, the average investor in the fund earned 13%. What gives? It’s like a family road trip with my dad when I was a kid. My dad was notorious for stopping at every historical marker and waypoint along our route (he had a particular fondness for fish hatcheries). So, even though the speed limit was 60 mph, our average speed was more like 37 mph. It took us forever to get anywhere. I kind of liked it as a kid. But as an adult, when my wife starting joining in, she had to practice deep meditative breathing techniques every time my dad clicked the turn signal. Breath in, breath out. Don’t yell at this kind, but distracted man…
Arriving late on a road trip is one thing, but arriving underfunded at your goals is much worse. Why did average investors do worse than the underlying investment? Bad behavior. Lynch noted that cash into his funds increased after periods of good performance, and decreased after periods of poor performance. Essentially, the average investor bought high and sold low. Oops. That’s bad behavior. Easy to see in the rearview mirror, tough to notice at the moment.
Evidence B. Warren Buffet is…Warren Buffet. He is probably the best investor of the modern era. Plus, he likes to share his wisdom. He quipped about the most important thing he had to learn as an investor:
The most important quality for an investor is temperament, not intellect.
I typically think of Warren Buffett as a pretty smart guy. Even he recognizes that his own emotions and behavior are more important than his brains. I would consider myself foolish if I failed to listen.
Use time-frames in your process to control emotions
When something is not directly in your control, and you know you might be affected, it is wise to develop a strategy, and discipline, to guard against the out-of-control. I am going to discuss one such strategy. I call it “batching.” This is just a fancy word for saying that some money is for one thing, and some are for another. Separate your money into batches. Give each batch a purpose, and a time frame. Grocery money is for next week, fun money is for next month, retirement money is for….a long time later. Even if you are already retired, some of your retirement money will likely be for….a long time later. Time frames are a pretty simple concept:
If you had $5 in your wallet, and your daughter needed it for lunch money tomorrow, you probably shouldn’t loan it to your dead-beat cousin even if he promises to pay you back $6. That $5 has a short-term time frame.
But, if that $5 was extra, beyond what you needed for this month’s happiness and health, you’d be wise to squirrel it away. And possibly, invest it. If you didn’t, there is a good chance, if you are like most of us, that you would spend the $5 on something you didn’t plan for, or even know you wanted. In this case, the $5 could have had a long-term time frame if it was saved before being spent.
Here are a couple of steps to batching your money.
Step 1. Take care of immediate concerns first.
- Do you have any high-interest debt? In general, you should pay this off, or have a strong plan to do so, before considering any other batches for your money.
- Do you have an emergency fund? You should have 2-6 months of expenses in a simple, easily accessible, savings account. This fund will keep you out of the high-interest debt cycle. A credit card is not an emergency fund.
Step 2. Identify your short-term and long-term goals.
- Create goals. Figure out how much they will cost, and when you will need to access the money.
Step 3. Batch your money by when you will need it (time-frame)
- Short-term money is money you will need in the next 3 years. This could be your emergency fund, savings for a down-payment on a home, or your living expenses (if you are retired and they are not covered by income). This money should not be invested. You can park it in a safe place, like a money market, or an online savings account.
- Intermediate-term money is money you will need for a known expenditure in the next 3-5 years. This could be for an upcoming travel adventure, paying for college, or maybe a new boat. IF possible, you should save up for these expenses rather than borrow to pay for them! This money should be thoughtfully managed, and how it is held will depend on the need. A safe, money market account, a CD, or certain types of bonds may be appropriate.
- Long-term money is money that you won’t need for at least 3 years, and the exact expenditure is unknown. This is money that may be appropriate for investment in the stock market or longer-term bonds.
Step 4. Choose an appropriate investment strategy for each batch of money (in the next blog post).
Time-frame, and why it matters.
The reason time-frame matters is for a reason called “Time of Recovery.” Most people know that when you choose an investment for a higher return, you also accept a higher degree of risk. Although the risk is formally a measure of the variability away from an expected return (the wiggles in a graph), most people only care about the risk of loss. With the money you know you will need soon, most people don’t want to risk that they have less when they need it.
But, for money that you won’t need for a long time, you have a long time for recovery. Historically, the US stock market has suffered several major losses. But, it has recovered each loss. Only twice in the last 100 years has it taken more than four years to recover. Examples:
- In 1929, during the Great Depression, it took eight years for the stock market to recover. However, it did re-collapse, and it wasn’t until 1944 that the market recovered to pre-1929 levels.
- In the dot-com bubble (2000-01), the stock market crashed and it took seven years to recover.
- In the “great recession” of 2008, the stock market dropped by about 50%. But, it had recovered within two years.
For a more interesting look, Matt Egan wrote a piece for CNN Money, where he calculated recovery times if the investor just kept putting money into the market ($1,000 bucks just before a crash, then $1,000 each year thereafter). This situation more accurately describes an unlucky, but a disciplined investor. See source [3] for the original post.
- Great Depression. The investor would have recovered his/her original investment within 7 years.
- Dot-com crash. The investor would have recovered his/her original investment within 5 years.
- Great Recession. The investor would have recovered his/her original investment in less than 2 years.
What is the take-away? If your time-frame is long, you will likely still come out ahead, especially if you contribute regularly towards your long-term goals.
A case study – Ava and Raj
In my last blog post, I introduced Ava and Raj, a happily married couple in their early 50s. They have two daughters – Sonia just graduated from college while Abby is going to start university next Fall. Ava and Raj are now turning their attention towards retirement. Ava is going to spend more time working in her job as a nurse practitioner, in fact, she is considering opening her own practice. Raj just received a nice raise from his work as an elementary school principal. They have some excess cash flows that they want to know what to do with. They know they should put their money to work, but, they are pretty nervous about the stock market. Just last week, they heard on CNN Money that “58% of fund managers think the market has peaked or will peak in 2018.” They decide to start on an Investment Process:
Step 1. They do not have any high-interest credit card debt. They have an emergency fund in their cash savings account.
Step 2. They identify some of their important financial goals.
- Help Abby pay for her schooling. They have tuition covered through a college savings plan. They also want to help her with some living expenses.
- Save for retirement. They want to retire at age 62.
- Save for a vacation home in Leavenworth, WA. They are avid trail runners and skiers. They hope to have a strong downpayment for the home saved in ten years.
Step 3. They batched their money by goal and time-frame.
Retirement accounts: Ava has a 401k with about $600,000 in it, while Raj has a 403b plan with $250,000. This is long-term money and is intended for retirement.
College savings accounts: They have a Dream Ahead 529 college savings account for Abby that is worth about $80,000. This is short/intermediate-term money. They have a pretty good sense of the cost of Abby’s schooling.
Cash accounts: They have about $50,000 in their bank savings account. They decide to assign $30,000 to their short-term emergency fund, $10,000 to help Abby with living expenses, and the other $10,000 as possible seed money for Ava’s new business. This is all short-term money.
Excess cash flows: They currently have an extra $2,000/month from their cash flows. They decide to split it evenly into more retirement savings ($1,000/month) and a new account for their future vacation property ($1,000/month). The retirement savings will become long-term, although the future vacation property, they may invest it conservatively.
Step 4. Choose appropriate investments.
In general, they will choose safe harbors (like high-yield savings accounts, money market accounts, CDs or bonds) for their short and intermediate-term investments. For their long-term money, they will design appropriate ways to invest. I will go into specific investments in my next post.
However, last week they had to make a quick decision in their college savings plan. They decided to rollover Abby’s GET units into the new Washington Dream Ahead college savings plan. Because they knew the money had a short-term time frame, they decided on a very safe investment. They opted to invest in a “static portfolio” with a “Cash preservation” allocation. The investment has a fairly low expected investment return (about 1.4%). Unfortunately, the fees in the plan are a bit high (about 0.4%) compared to other 529 plans around the US, but since they received a decent bump in value through the rollover they are content with the outcome. Plus, they like the low risk of the “Cash preservation” portfolio.
How can you use this post for yourself?
For do-it-yourselfers, follow the steps. Start a plan and a process for yourself. Write it down. Look at your notes again in the future. Measure your progress. Are you following your plan? Are you making decisions based on how you feel, or based on your plan? Keep track of your progress towards your goals.
For non-do-it-yourselfers, engage with a good financial planner/advisor to help you work through this process. I would encourage you to seek out a fee-only advisor, who takes his/her fiduciary responsibility to heart.
You’ve reached the end of this post! If you’d like to read more, you can continue this series about investing by visiting one of the following:
Investing 101 – Why invest? Have a process and a plan (previous post)
Investing 102 – When? Manage your emotions through time-frame and liquidity (this post)
Investing 103 – What investments should you choose
Investing 201 – What If? Investment returns and risk
Investing 202 – Diversification and fees. Why do they matter? (future blog post)
Investing 301 – Create a comprehensive investing strategy. (future blog post)
Or, you may be interested in:
How we (John and Liz) take our fiduciary responsibilities seriously, and why we think fee-only is the right way to work with clients About Us.
Or, you can read more of John’s writings about financial matters that matter, on the main blog page on Trail Financial Planning
References
[1] – https://www.thebalance.com/index-funds-vs-actively-managed-funds-2466445
[2] – https://www.cbsnews.com/news/lessons-from-a-great-fund-managers-record/
[3] – https://money.cnn.com/2015/02/26/investing/stock-market-crash-bubble-investing/index.html
