Your Money and Your Mind – Part III: We Have Met the Enemy….

Following the first two parts of my three part series, today I’m introducing the final installment of Your Money and Your Mind.  To review the overarching perspective around this series:  it’s been my experience that when most people think about the topic of money, it usually can be distilled down to two central considerations:  1) how to make it and 2) how to allocate it.

For this reason, I think it is critically important in my work with clients to address three aspects of their mindset on money as described in my series on the topic.  In Part I (http://knwm-llc.com/your-money-and-your-mind-1/), I reviewed what I think is a critical shift in perspective as it relates to cash-flow, the life-blood of every family’s financial life.  In Part II (http://knwm-llc.com/your-money-and-your-mind-2/), I introduced what I think are helpful tools (“The Factors”) to help you make an informed decisions on just how much today’s spending is impacting your future.  Finally, in Part III (today) I’ll touch on the mindset needed to successfully invest those assets over a long time horizon.  In a nutshell, we need to protect ourselves from ourselves as it relates to the emotion-driven buying and selling of investments.

So most of you probably recognize in the title the first portion of a well-known quote with the full quote being “We have met the enemy and they are us.”  Before getting into the wisdom of this quote, I found it interesting that this wasn’t Plato or Socrates or Shakespeare that came up with this.  According to Wikipedia, this is actually a twist on U.S. Naval Commodore Oliver Hazard Perry’s words after the famous naval battle against the British in Lake Erie (War of 1812), “We have met the enemy and they are ours”.  The actual first usage of this “twisted” quote was by none other than that Oracle of Wisdom, “Pogo” the comic strip character written by Walt Kelly in the 1970’s.  Without getting too deeply into the context, basically he was contributing his drawing with the quote for an anti-pollution poster for Earth Day in 1970.

Setting that historical footnote aside, I still believe the quote is very relevant today as I believe it perfectly captures the biggest problem we all face as investors:  ourselves.  Now there are many, many studies out there on behavioral finance and how both positive and negative emotions can be tracked as chemical reactions in the brain.  However, it’s probably tough for most of us to relate to medical studies as much as we do to real-life scenarios. In that light, I think it’s helpful to apply recent studies and statistics (see below) to demonstrate just how much we shoot ourselves in the foot when it comes to investing.

So what’s the common denominator of the primary culprit in all three of these studies?  Feeble attempts at market timing or buying high and selling low.

Let’s start with buying high and selling low. The first piece of evidence I’ll cite is one from DALBAR Inc, which recently published a 20-year study of the typical investor since 1984.  The shocking takeaway is that while the S&P 500 returned an average of 9.22% per year since 1984, the typical investor only realized actual results of about 5.02% per year.  While 400 basis points may not seem too big, over the course of 20 years, the difference in retirement account value is nothing short of staggering.  As noted in the accompanying graph, starting with a $500,000 portfolio at age 45, this difference in returns year after year would compound to a difference of $1,585,805 or more than double (119%)!  Of course this chart is showing theoretical returns based on the study and is not indicative of future performance or a formal recommendation from me (the 9.2% assumes 100% equities).  The chart is simply an illustration to show the startling difference yielded by under-performance, whatever your asset allocation strategy.

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Source: Kure Net Worth Management and DALBAR Inc.

Taking it one step further, another study citing the difficulty in market timing conducted by Utpal Bhattacharya of the Kelly School of Business (Indiana University) who analyzed ETF trading activity from a large brokerage firm between 2005 and 2010.  This was noted in a recent Wall Street Journal article by Mark Hulbert (Do ETFs Push People Into Becoming Market Timers? February 28, 2014).  On key statistic that came to light was that on average, the stock market tended to fall about 4% in the month following sales (not bad).  However also in a one month period, following purchases the market tended to fall around 18% (not good).  Over a 12-month period things get uglier.  Following sales, the market tends to rise about 10% but following purchases, the market tends to drop about 2%.

Finally, let’s turn to the difficulty in market timing.  For this, I’ll cite is a study published by Dimensional Fund Advisors again using the S&P 500 which shows just how difficult it is to “time the market” by knowing when to be “in the market” (buy) and when to be “out of the market” (sell).  The conclusion?  Between January 1, 1970 and December 31, 2011 the annualized compound return of the S&P500 Index was 9.8%.  However there’s a significant impact from missing just a few of what I estimate are about 10,250 trading days in that time period.  How big?

  • Miss the best single day:  Performance drops from 9.8% to 9.51%
  • Miss the best five  days: Performance drops to 8.68%
  • Miss the best twenty-five  days: Performance drops to 6.11%

So if an investor were unlucky and missed only 25 of the best days out of 10,250 (that would be 0.24% of all days), their performance would be crushed. To add insult to injury, the investor would have spent lots of time researching and lots of money trading for this underperformance.  You can use the chart from the first study to eye-ball the impact which again, would be substantial.

OK – enough with the flurry of statistics.  What does this mean to your families as you invest?

Certainly, I am unabashedly making the case for families to employ a financial advisor to help stay the course over the inevitable financial roller-coaster ride.  Putting aside the merits of my own practice (which can’t possibly fit into one book, let alone this article – just kidding), I believe financial advisors and more specifically, fee-only financial advisors, provide one thing that is absolutely impossible for you to provide for yourself, no matter how educated you are or how closely you watch your finances and investments.  What is that? An objective perspective.  In fact, a recent study from Vanguard (sorry one more study) found that investment advisors on average provide “about 3%” better annual returns to their clients vs. not using an advisor at all.  What I found most interesting however is the biggest portion of this out-performance (about half or 1.5%) was attributed to behavioral guidance…..not the ability to pick stocks, nor the ability to time the market.

By definition, it is just about impossible for you to provide objectivity for yourself and it is therefore impossible NOT to get emotional about the ups and downs of your investments.  As a colleague of mine likes to say “there are plenty of strategies out there but that they are like diets. It’s easy to find one…the problem is sticking to one.” In short, stopping that knee jerk reaction when watching that sharply dropping (or increasing) stock chart is where we can avoid those big mistakes and ensure we are not our own worst enemy.

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