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Category Archives: EQ

Hedge funds rush to get to grips with retail message boards | Financial Times

29 Friday Jan 2021

Posted by wmosconi in active versus passive debate, asset allocation, behavioral finance, beta, Black Swan, blended benchmark, bond market, Bond Mathematics, Bond Risks, bond yields, book deals, Brexit, business books, CAPE, Charlie Munger, cnbc, Consumer Finance, correlation, correlation coefficient, economics, enhanced indexing, EQ, EU, Fabozzi, Fama, Fed, Federal Reserve, Fiduciary, finance, finance theory, financial advice, financial advisor fees, financial advisory fees, financial markets, Financial Media, Financial News, financial services industry, Forward P/E Ratio, Frank Fabozzi, Geometric Returns, GIPS, Greenspan, gross returns, historical returns, Individual Investing, individual investors, interest rates, Internet Bubble, investing, investing advice, investing books, investing information, investing tips, investment advice, investment books, Irrational Exuberance, LIBOR, market timing, Markowitz, math, MBS, Modern Portfolio Theory, MPT, Nassim Taleb, Nobel Prize, P/E Ratio, passive investing, personal finance, portfolio, Post Brexit, probit, probit model, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risk tolerance, risks of bonds, risks of stocks, Robert Shiller, S&P 500, S&P 500 historical returns, S&P 500 Index, Schiller, Search for Yield, Sharpe, Shiller P/E Ratio, speculation, standard deviation, State Income Taxes, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Taleb, time series, time series data, types of bonds, Valuation, volatility, Warren Buffett, Yellen, yield, yield curve, yield curve inversion

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How to Become a Successful Long-Term Investor – Summary

30 Monday Sep 2019

Posted by wmosconi in asset allocation, behavioral finance, correlation, correlation coefficient, Dot Com Bubble, Emotional Intelligence, EQ, financial advice, Financial Advisor, financial goals, financial markets, financial planning, financial services industry, historical returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, market timing, math, personal finance, portfolio, risk, risk tolerance, risks of stocks, S&P 500, S&P 500 historical returns, S&P 500 Index, standard deviation, statistics, Stock Market Returns, stock prices, stocks, volatility

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asset allocation, behavioral finance, education, finance, historical stock returns, investing, investments, math, mathematics, performance, performance monitoring, portfolio, portfolio management, S&P 500, S&P 500 historical returns, S&P 500 Index, statistics, stock returns, stocks, success, successful long term investing, trading, uncertainty

The discussion of how to become a successful long-term investor in my three-part series is now finished.  However, the journey is an ongoing one that takes discipline, constant learning, and monitoring your emotional reactions to fluctuations in the financial markets.  I discussed the history of stock market returns of the S&P 500 Index (dividends reinvested) from 1957-2018, the concept of risk, and also the futility of trying to engage in “market timing”.  But you may be asking yourself, why didn’t you tell me what stocks, bonds, and other assets to buy to build my investment portfolio?  That is a valid question, and there is an extremely important reason why that gets at the very heart of my overall discussion.

The best way to answer the question posed above is with an analogy.  Now my international readers will have to indulge me with this example.  My favorite sport is football which is the most popular sport in the world.  Most people in the United States refer to it as soccer and only watch if the men’s or women’s teams are competing in the World Cup.  I could tell you all about the reasons why football clubs rarely use a 4-4-2 formation.  Or I could talk about how the 4-2-3-1 formation has evolved in the Bundesliga.  We also could discuss why goalies now need to be good with their feet in order to pass from the backline.  Finally, I might even be more specific and give my rationale for why Liverpool in the Premier League uses a 4-4-3 formation given their current squad for the 2019-2020 season.

My analogy above relates to long-term investing because I would argue that you should not invest a single dollar in the stock or bond markets without knowing about the history of returns, risks and volatility, and “market timing”.  Most Financial Advisors (FAs), Certified Financial Planners (CFPs), and Registered Investment Advisors (RIAs) jump right into the discussion of how to build an investment portfolio taking into account your financial goals and risk tolerance.  This conversation is directly related to the football analogy above.  Without a firm understanding of investing at a high level (or the general way football is played first), you are likely to fail in your resolve to stick with a long-term focus while investing.  For example, when you are asked if you can tolerate a 20% decline in the stock market, how should you answer?  I would say that, if you do not have some grasp of historical returns and the level of risk, you cannot properly answer.  Remember that we covered how often you will experience negative returns (including 20% declines) in the first article.  You need to understand the “composition of the forest before deciding how to deal with the trees”.

Here are the links to the three articles to have an understanding of first prior to jumping into the mix of long-term investing strategy and building an actual portfolio of investments.

Part 1 – Understanding Historical Stock Market Returns:

https://latticeworkwealth.com/2019/09/23/successful-long-term-investing/

Part 2 – Understanding and Managing Risk:

https://latticeworkwealth.com/2019/09/25/successful-long-term-investor-risk/

Part 3 – Giving up on the Allure of “Market Timing”:

https://latticeworkwealth.com/2019/09/28/successful-long-term-investing-market-timing/

Once you have a firm grasp on these topics, you are ready to get your feet wet in the world of investing.

For those of you wanting a little bit of guidance because your intention is the manage your investments personally, I have written about this topic in the past.  I wrote a two-part series on how to build an investment portfolio and monitor the performance returns of that investment portfolio.  I have included the links below:

Part 1 – Building an Investment Portfolio:

https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/

Part 2 – Monitoring the Performance of an Investment Portfolio:

https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/

Those two articles above will provide you with some ways to go about creating your own investment portfolio without the assistance of a financial professional.  While it does contain a lot of information and suggestions, individual investors who are complete novices may find it easier and less confusing to seek out someone to guide them with investment selection, measuring risk tolerance, and understanding the goals of their financial plan.

In summary, I appreciate you taking the time to read my thoughts in regard to successful long-term investing.  As you can see successful investing has more to do with preparation, setting realistic expectations, and knowing how you personally respond to risk.  These topics need to be studied prior to investing money yourself or before going to seek out investment advice from a financial professional.  If you have any questions, comments, feedback, or disagreements, you can feel free to let me know.

What is Confirmation Bias? Why is it Dangerous for Individual Investors?

26 Wednesday Apr 2017

Posted by wmosconi in active versus passive debate, behavioral finance, confirmation bias, Emotional Intelligence, EQ, finance, finance theory, financial advice, financial markets, Financial Media, Financial News, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, passive investing, personal finance, stock market, stocks

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behavioral finance, confirmation bias, Emotional Intelligence, financial advice, financial markets, financial planning, individual investors, investing, investing advice, investing information, investing tips, investments, stock market, stocks

There are many dangers for individual investors to be aware of when investing.  More and more of these dangers and/or complications are being recognized in the field of behavioral finance.  Behavioral finance looks at the psychological and emotional factors that influence the decision-making process of investors.  Oftentimes researchers in this field try to figure out what causes normally rational people to act irrationally.  Unfortunately, it has proven over and over again that, when money is involved, the vast majority of people let their emotions/feelings interfere with their investment decision either slightly or in profound ways.  We do these things without even knowing it which makes it even harder to address and correct.  Keep in mind that Warren Buffett says that having control of one’s emotions is just as important (or even more so) than having a superior intellect that can select excellent, long-term investments.

Confirmation bias belongs in the realm of behavioral finance, but, as many of these issues, it really first has been examined in terms of psychology.  So, what is confirmation bias exactly?  The definition of confirmation bias is “the tendency to search for, interpret, favor, and recall information in a way that confirms one’s preexisting beliefs or hypotheses” (Plous, Scott (1993). The Psychology of Judgment and Decision Making. p. 233).  Keeping in mind that confirmation bias applies to many other areas, the primary focus in the remainder of this article will be how it manifests itself in relation to investing.  Now that we have the formal definition, let’s take a look deeper into this very real danger for individual investors.

Individual investors have the natural inclination to make a decision first and then look for information that supports that initial decision.  It also applies at an even higher level than that.  The way that individual investors think they should invest in general is almost predetermined.  The easiest thing to do is to talk to people with the same thought process about investing, search through the same supporting financial media news publications and websites, and listen to the same experts.  Over time, it gets very easy to just keep doing the same thing over and over again.  Plus, it takes an incredible amount of effort to step outside of one’s comfort zone and try to prove that he/she might in fact be incorrect.  Individual investors (and even professional investors, money managers and investment advisors) are not wired to attempt to confirm why they might be wrong.  At first glance, it seems like a totally foreign and nonsensical concept.

So, what are the types of problems that can occur when individual investor does not acknowledge confirmation bias?  There is a long list here are a few to ponder.  First, a big mistake can be thinking that what has happened in the recent past will continue into the future indefinitely.  This danger is especially evident during a bull market.  It can be easy to get carried away and see how much money one made and then keep pouring money in (more than you can really risk).  The converse is true when it comes to a bear market.  After stocks have gone down for a number of months or longer, it is very easy to just give up on investing in the stock market because it seems like things will never turn around.  Second, the danger creeps in when investing by not challenging one’s assumptions.  Even if an individual investor knows at a subconscious level that an incorrect decision was made, there can be a desperate search for any shred of evidence that one can justify nonaction.  Third, there are times when listening to the investment advice of a particular expert can be “addictive”.  By this I mean that it is natural to continue to listen only to the views of that person, especially when he/she made a bold prediction about the stock market that came true.  It can be simple to forget that market timing is extremely difficult and that person could be totally wrong in terms of his/her next prediction.  Lastly, it can feel good to be part of the crowd and not think differently (or at least examine other issues).  There is safety in numbers essentially and, if your investment decision does turn out to be wrong, you can at a minimum take solace in the fact that “everyone else was doing it”.

There are a number of steps that individual investors can take to counteract the dangers of confirmation bias.  First and foremost, the fact that you are aware of the potential trap of confirmation bias is half the battle.  Periodically ask yourself if you have looked for alternative viewpoints and evidence.  Second, you can make a list of why you made a particular investment decision in the first place.  But, more importantly, you should write down what types of events could occur to make you change your mind because your investment thesis was not correct.  It is very powerful to have a written record to start with.  This recommendation actually comes from a reporter at The Wall Street Journal named Jason Zweig.  Mr. Zweig has been writing about the financial markets for decades now and still has a weekly article in the paper (usually in the weekend edition) called The Intelligent Investor.  I really urge you to take a look at this interview with him back in 2009 about confirmation bias.  Here is the link:

http://www.wsj.com/video/when-investing-consider-your-confirmation-bias/B768E62A-AA01-4B37-905F-F3EDA5C72B78.html

Third, you should make it a habit on a regular basis, maybe monthly, to go to various financial market and investing websites that do not mesh with your general investment philosophy.  You can peruse through a few articles that you might find totally different than you interpret a situation.  I urge you to read them with an open mind though and try to be objective.  Lastly, you can bounce an idea off a close friend or advisor and see what they think about your rationale.  It is far easier for them to be objective.  If you do not have anyone to consult with, I would urge you to pose the question in an investing forum.  However, you need to phrase the question in the manner that will address your possible confirmation bias.  It is very common to ask question in a positive manner like “Why should you invest in technology companies?”.  The better way to phrase it at the outset is to use language like “What are some of the reasons why you should not buy gold?”.

Now keep in mind that the advice on confirmation bias also applies to the articles I have posted on my website.  You will note that two of the main themes are using a passive investing approach to invest and striving to keep investment fees as low as possible.  I urge you to go and seek out information about why you may want to choose an active investing strategy as an individual investor.  Look for the reasons why and situations where you might have to pay additional investment fees depending on your particular circumstances.  It is very healthy and beneficial to seek out other information, and I always encourage individual investors to do so.  The one thing that I firmly hold onto is that I would avoid financial websites or sources that say I am right and the other guys are all wrong.  Things are rarely ever so “black and white”, especially in the world of financial markets and investing.

Four Important Lessons for Individual Investors from the Brexit Vote

10 Sunday Jul 2016

Posted by wmosconi in Alan Greenspan, Black Swan, bond market, Brexit, Brexit Vote, Emotional Intelligence, EQ, EU, European Union, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Greenspan, Individual Investing, individual investors, Internet Bubble, investing, investing advice, investing information, investing tips, investment advice, investments, Irrational Exuberance, Nassim Taleb, personal finance, portfolio, Post Brexit, PostBrexit, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Stock Market Returns, Stock Market Valuation, Taleb, Uncategorized, Valuation, volatility, Warren Buffett

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The vote by the United Kingdom (UK) to leave the European Union (EU) caught the majority of individual investors by surprise.  In fact, the so-called Brexit was not foreseen by many of the most sophisticated professional investors and money managers all around the world.  The election results sent shockwaves through the financial markets on the Friday and Monday following the Brexit vote.  The most notable effect was the devaluation of the pound to its lowest level since 1985.  Over the course of Tuesday through Friday, the US and European stock markets gained back nearly all their losses from the two days after the Brexit vote.  This fast-moving volatility has left individual investors feeling confused, frustrated, bewildered, and a bit scared.  However, the Brexit vote results offer individual investors a unique set of key lessons to learn and understand.

The four important lessons for individual investors from the Brexit vote are as follows:

  • 1)  There are very few seminal events in financial market history that affect the future path of stocks, bonds, and other assets.

 

The difficult thing to realize about the financial markets is that there are very few consequential events that make an inflection point or major change in the direction of the financial markets.  Even more frustrating than that, these consequential events are only known with the benefit of hindsight.  In other words, what seems like a monumental event today may or may not be considered one of those major events.  Given the fact that there are so few, there is a high probability that the seemingly major events of today will not fall into the seminal event category of financial market history.

What are some of the seminal events in financial market history?  Here is a list of some of the seminal events in chronological order:  the stock market crash in October 1987, the bursting of the bond bubble in 1994, the Asian contagion of 1997-1998, the bursting of the Internet bubble in March 2000, and the Great Recession of the financial crisis starting in September 2008.  There are many more examples previous to 1987, but these are events from recent financial market history that many individual investors will remember.  Keep in mind that in between all of these events are a string of other major events that turned out to be minor blips that caused only fleeting financial market volatility or none at all.

Furthermore, these seminal events are confusing to financial market participants in and of themselves.  For example, let’s take a closer look at the stock market crash of October 1987.  The US stock market dropped over 20% in one day, and things looked very dire.  If an individual investor with a portfolio of $100,000 had sold his/her stock mutual funds (primary investment vehicle used by individuals on the day of the crash, he/she would have a portfolio worth $80,000 approximately.  That type of individual investor was likely to be very fearful and stay out the of stock market for the remainder of 1987.  If an individual investor with a similar portfolio of $100,000 had keep his/her money in stocks on the day of the crash and for the rest of 1987, he/she would actually have roughly $102,000 at the end of 1987.  Why?  Well, there are not too many investors these days that remember how 1987 really turned out for the US stock market.  The S&P 500 index ended up about 2% for the year, so US stocks recovered all of the losses from the crash and a bit more.  Here’s a little fun exercise:  Ask your Financial Advisor or Financial Planner what the return of stocks was in 1987.  The vast majority will assume it was a horrible down year for performance returns.

Another excellent example is the bursting of the Internet bubble in March 2000.  The reason it is so interesting is that individual (and even professional) investors forget the history.  Alan Greenspan, the Chairman of the Federal Reserve during that time period, gave a famous speech where he coined the term, “irrational exuberance”.  Greenspan warned investors that the Internet and technology stocks were getting to valuations that were way out of line with historical norms for valuation of stocks.  What do individual investors forget?  Well, that famous speech was actually given in December 1996.  Yes, that is correct.  Greenspan warned of the Internet bubble, but it took nearly 3 ½ years before financial markets took a nosedive.  The main point here is that smart, rationale professional money managers and economists can know that financial market valuations are out of whack in terms of valuation at any given point in time.  (Note that this can also be stock market valuations that are too low).  However, these conditions can persist for far longer than anyone can imagine.  That is why individual investors should not be so quick to sell (or buy) major portions of their portfolio of stocks and bonds when these predictions or observations are make.

For a more in depth look at this concept, you can refer to a blog post I wrote three years ago on this very subject.  The link to that blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

  • 2)  Investors focus on valuations (no emotions) while traders and speculators focus on market sentiment (emotions) and valuation (no emotions).

The majority of professionals who talk to individual investors and provide advice will explain how important it is to keep emotions out of the equation when dealing with elevated market volatility.  When the financial markets are bouncing up and down by large amounts in the short term, it can be very difficult to keep a cool head and resist the urge to buy or sell stocks, bonds, or other assets.  The frenetic pace of market movements makes it seems as though an individual investor needs to do something, anything in response.  The standard advice is to keep one’s emotions in check focus on the long term, and stick to the financial plan.  What is usually missing from that advice is a more complete explanation why.

There are two general types of financial market participants:  investors and traders/speculators.  These two groups have vastly different goals and approaches to the financial markets.  Investors are focused on investing in stocks, bonds, and other assets in order to obtain returns over time from their investments.  The long term might be defined as five years.  Thus, day-to-day fluctuations in the financial markets mean very little to them.  On the flipside, traders/speculators are focused on making gains in stocks, bonds, and other assets in the short term in order to obtain returns.  The short term for this group might be hourly, the medium term might be daily, and the long term might be weekly.  With this particular group, they need to determine both the likely direction of the financial markets due to both market sentiment and valuation.

As you might imagine, the traders/speculators have to analyze emotions or the psychology of financial market participants.  Gauging market sentiment (general short term positioning of traders/speculators in stocks, bonds, and other assets in terms of their trend to buy or sell) is all about emotions.  Additionally, they must be able to combine that with proper valuations for stocks, bonds, and other assets.  Essentially they need to be correct twice.  On the other hand, investors are focused on the long term which corresponds to valuation.  Valuation over the long term is not driven by emotions.  There is a very famous saying by Ben Graham who taught one of the most well-known investors of all time, Warren Buffett.  Graham said, “In the short term the market is a voting machine, in the long term the market is a weighing machine.”  The takeaway from Graham’s quotation is that market sentiment (i.e. emotions) can drive the financial markets wildly over the short term.  However, after a period of years, financial markets always seem to follow the path back to what their true valuations are.  Since emotions are not part of that equation, individual investors should feel more comfortable ignoring or at least subduing their emotions whenever the financial markets exhibit high levels of volatility.

A related part of the story is the financial media (both TV and print) almost always provide information for traders/speculators.  To be perfectly honest, the financial media would not have much to talk about if long-term investing was the topic.  Essentially they would recommend analyzing one’s risk tolerance, define one’s financial goals, and then build a portfolio of financial assets to reach those goals over the long term.  Yes, true investing is very boring actually.  The financial media needs to have something more “exciting” to talk about in order to have viewers (readers) and the corresponding advertising dollars that come from that.  Therefore, the stories and article appearing in the financial media are geared toward traders/speculators.  Now if you are an investor, you can either ignore this bombardment of information or take it with the proverbial “grain of salt”.  Thus, you can keep your emotions in check when all the traders/speculators are wondering how to react to the market volatility right now each and every trading day or week.

For a more in depth discussion of managing one’s emotions as it relates to investors, you can refer to one of my older blog posts.  The link to that blog post is as follows:

https://latticeworkwealth.com/2015/06/11/two-steps-to-help-individual-investors-become-more-successful-at-investing/

  • 3)  The benefit of diversification can disappear or be reduced greatly whenever there are periods are elevated volatility.

The benefit of diversification is one of the hallmarks of the proper construction of an investment portfolio for individual investors.  The basic premise (which has been proven over very long periods of time) is that investing in different asset classes (e.g. stocks, bonds, real estate, precious metals, etc.) reduces the volatility in the value of an investment portfolio.  A closer look at diversification is necessary before relating the discussion back to the Brexit vote.  The benefit of diversification stems from correlations between asset classes.  What is correlation?  To keep things simple, a correlation of 1 means that two different assets are perfectly correlated.  So a correlation of 1 means that when one asset goes up, the other asset goes up too.  A correlation of -1 means that two assets are negatively correlated.  So a correlation of -1 means that when one asset goes up, the other asset goes down (exactly the opposite).  A correlation of 0 means that the two assets are not correlated at all.  So a correlation of 0 means that when one asset goes up, the other asset might go up, go down, or stay the same.  Having an investment portfolio that is properly diversified means that the investments in that portfolio have a combination of assets that have an array of correlations which dampens volatility.  Essentially the positively correlated assets can be balanced out by the negatively correlated assets over time which reduces the volatility of the balance in one’s brokerage statement or 401(k) plan.

What does all this correlation stuff have to do with the Brexit vote?  Surprisingly, it has quite a bit to do with the Brexit vote.  Note that this discussion also applies to any situation/event that causes the financial markets to exhibit high levels of volatility.  During extreme volatility like investors witnessed after the Brexit vote, the correlations of most asset classes started to increase to 1.  Unfortunately for individual investors, that meant that diversification broke down in the short term.  Most all domestic and international stock markets went down dramatically over the course of the two trading days following the Brexit vote.  Therefore, individuals who had their stock investments allocated to various different domestic and international stocks or value and growth stocks all lost money.  When correlations converge upon 1 during extreme market shocks, there is really nowhere to “hide” over the short term.  In fact, the only two asset classes that did very well during this period were gold and government bonds.

What is the key takeaway for individual investors?  Individual investors need to realize that there is an enormous benefit to having a diversified portfolio.  However, diversification is associated with investing over the long term and thereby harnessing its benefit.  There are times of market stress, like the Brexit vote and aftermath, where diversification will not be present or helpful.  When those times come around, individual investors need to keep emotions out of the picture and stick to their long-term financial plans and investment portfolios.

  • 4)  The surprise Brexit vote provides the perfect opportunity for individual investors to evaluate their risk tolerances for exposure to various risky assets.

The two trading days after the surprise vote by the UK to leave the EU (Brexit) were very volatile and very tough to keep emotionally calm.  Individual investors were faced with a very unusual situation, and the urge to sell many, if not all of their investments was very real.  That reaction is perfectly understandable.  Now for the bad news, there will be another time when volatility is as great as or larger than the volatility that the Brexit vote just caused.  In fact, there will be many such periods over the coming years and decades for individual investors.  In spite of that bad news, the Brexit vote should be looked at as a learning experience and opportunity.  Since individual investors know that there will be another period of elevated volatility, they can revisit their personal risk tolerances.

It is extremely difficult to try to determine or capture one’s risk tolerance for downturns in the financial markets in the abstract or through hypothetical situations.  You or with the assistance of your financial professional normally asks the question of whether or not you would likely sell all of your stocks if the market went down 10%, 15%, 20%, or more.  How does an individual investor answer that question?  What is the right answer?  There is no right or wrong answer to that type of question.  Each individual investor is unique and has his/her own risk tolerance for fluctuations in his/her investment portfolio.  A better way to answer the question is to convert those percentages to actual dollar amounts.  For example, if an individual investor starts with $100,000, would he/she be okay with the investment portfolio decreasing to $90,000, $85,000, or $80,000 over the short term.  Note that the aforementioned dollar amounts sync up with the 10%, 15%, and 20% declines illustrated previously.

The opportunity from the Brexit vote is that individual investors have concrete examples of the volatility experienced in their investment portfolios.  It is far easier to analyze and determine one’s risk tolerance by looking at actual periods of market stress.  Depending on your stock investments, the total two-day losses might have been anywhere between 5% to 10%.  Let’s use a 10% decline for purposes of relating this actual volatility to one’s risk tolerance.  If an individual investor was invested 100% in stocks prior to the Brexit vote, he/she would have lost 10% in this scenario.  Let’s use hypothetical dollar amounts:  if the starting investment portfolio was $100,000, the ending investment portfolio was $90,000.  Now the vast majority of individuals do not have all of their money invested in stocks.  So let’s modify the example above to an individual investor who has 50% in stocks and 50% in cash.  In that particular scenario, the individual investor has $50,000 invested in stocks and $50,000 invested in cash.  If stocks go down by 10%, this individual investor will have an ending investment portfolio of $95,000.  Why?  The individual investor only losses 10% on $50,000 which is $5,000 not the full $10,000 loss experienced by the individual investor with a hypothetical portfolio of 100% in stocks.

The importance of the illustrations above and its relation to the Brexit vote is that one can quickly calculate the actual losses from a market decline with a good degree of accuracy.  So let’s say that you had 60% of your money invested in stocks prior to the Brexit vote.  If the overall stock market declines by 10%, your stock investments will only decline by 6% (60% * 10%) assuming the other 40% of your investment portfolio remained unchanged.  So let’s put this all together now.  If you look back at the stock market volatility caused by the Brexit vote, you need to adjust the overall stock market decline by the percentage amount you have invested in stocks.  That adjusted percentage loss will be close to the decline in your overall investment portfolio.  Now whatever that adjusted percentage amount is, ask yourself if you are comfortable with that percentage loss over the short term.  Or is that way too risky?  If the adjusted percentage is way too risky for you and makes you uncomfortable, that is perfectly fine.  The important piece of knowledge to learn is that you need to work with your financial professional or reexamine your investment portfolio yourself to reduce your exposure to stocks such that the adjusted percentage loss is reasonable for you to withstand.  Why?  Because there will be another market volatility event on the order of magnitude of the Brexit aftermath or even worse.

Keep in mind that I am not making a financial market prediction over the short term.  The important point is that the history of financial markets has shown that periods of elevated market volatility (i.e. lots of fluctuations up and down) keep occurring over time.  The Brexit vote provides a real-life example to determine if your risk tolerance is actually lower than you first imagined.  The next cause of market volatility may be a known market event similar to how the UK vote to leave the EU was.  The harder things to deal with are market volatility stemming from the unknown and unforeseeable.  These market volatility events are called “black swans” which is the term coined by Nassim Taleb in his book by the same name several years back.  A “black swan” can be a positive event for the market or a negative event for the market.  As it relates to individual investors and risk tolerance, the negative “black swan” is applicable.  Now the term “black swan” is improperly used today by many investment professionals.  A “black swan” is an event that by definition is unknown and cannot be predicted.  When it does occur though, there is a period of extreme market volatility afterward.  Thus, you can adjust your risk tolerance to be better prepared for future events that will cause market volatility, either known events like the Brexit vote or unforeseen events.  The Brexit vote aftermath should be embraced by individual investors as a golden opportunity to ensure that they are properly (or more precisely) measuring their risk tolerances.

Summary of Important Lessons for Individual Investor from the Brexit Vote:

  1.  There are very few monumental financial market events that should cause individual investors to feel inclined to immediately change their investment portfolios. Plus, they can only truly be identified by hindsight;
  2. Investors should focus on valuation of financial assets (no emotions here), traders/speculators worry about market sentiment (emotions) and valuation (no emotions here);
  3. The benefit of diversification can disappear or be greatly reduced during periods of extreme market volatility and financial market stress over the short term;
  4. The surprise Brexit vote offers individual investors a valuable opportunity to see if their risk tolerances are aligned with the possibilities of short-term market declines.  This real-life event can be used to redefine one’s risk tolerance to better withstand similar periods of market volatility that will inevitably occur in the future.

Two Steps to Help Individual Investors Become More Successful at Investing

11 Thursday Jun 2015

Posted by wmosconi in Consumer Finance, Emotional Intelligence, EQ, finance, financial advice, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investment advice, investments, personal finance

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consumer finance, Emotional Intelligence, EQ, finance, financial advice, financial markets, financial planning, individual investing, individual investors, investing, investing information, investment advice, investments, investors, personal finance

Navigating the complicated world of investing can seem very intimidating and so frustrating.  There are so many pieces of information coming from the financial media that seem to conflict with each other.  At times it seems as though the markets move up or down for no apparent reason.  What is an investor to do?  Well, one of the most important things to do is to work on your emotional intelligence (EQ).  Most people assume that you need to have an extremely high IQ to navigate the financial markets.  Now it doesn’t hurt to have a lot of intelligence, but it arguably more imperative to have a high EQ.  EQ, in its simplest terms as it relates to investing, is the ability to control one’s emotions during market volatility.  Extreme market moves either up or down tend to make investors act irrationally or in a panicked way.  Instead of the old saying of “buy low and sell high”, they do the exact opposite and “sell low and buy high”.  Therefore, I wanted to share two steps to help you utilize and develop your EQ to allow you to be a more successful investor.  You will note that the two steps are more akin to practices and definitely interrelated.

Step 1 – Learn how to ignore the “noise” about the financial markets on a daily, weekly, and even monthly basis at times.

What does “noise” mean in this context?  “Noise” relates to all the reporting by the financial media and market prognosticators about the short-term direction of the financial markets.  Every day you will hear market “experts” (money managers, economists, traders, CEOs, etc.) predict with a good deal of confidence that the markets will start to rise, start to fall, or stay unchanged.  How do these discussions with plenty of evidence and thought help you?  Well, every investor (even a novice) should notice something right away.  You know that these are the only three outcomes for the market to begin with.  It really does not help to hear the conflicting opinions on a daily basis.  Note that each day at least someone is saying one of the three outcomes for the financial markets.

Who should you believe?  What should you believe?  Now here is an important note about guest appearances that have had recent accurate predictions about the direction of the stock market.  The financial news networks will rarely bring on a guest that has been totally wrong and advised clients quite poorly in the recent past.  It is not advisable for either party to make the guest look bad.  What is the point here?  There is a bias when listening to a guest appearing on a news network because only the ones whose predictions came to fruition are brought back and asked for more ideas.  The moderator never points out the times when that same guest has been wrong in the past.  Thus, it can seem like every returning guest has the best possible advice to follow as it relates to investing.  Moreover, you should adjust your portfolio as he/she suggests.  Do not get caught in that trap!

The main point and reason for step one is that the sources for investing tend to be conflicting and seeming as though the individual investor must act right now.  There are actually very few times when the financial markets reach a point of inflection that truly warrants your attention.  For example, the October 1987 stock market crash, the 1994 bond crisis, the Asian contagion in 1997-1998, the Dot Com Bubble in the 1990’s that started to burst in April 2000, and the financial crisis of 2008-2009 most recently are events that individual investors should read about and learn what is happening.  Although I will though that the difficult part is knowing in real-time what these events are.  Hindsight is always 20/20 as they say.

For additional information, I strongly recommend that you read a blog post I posted a while back.  The discussion goes into far greater detail on this subject and will help you understand the nuances far better.  The link to this blog post is as follows:

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

After all the discussion above, what is the practice investors should develop?  Well, as difficult as it might be and foreign, I encourage/implore you to stop listening to financial news networks and reading financial newspapers (or Internet columns) on a daily or weekly basis.  Why?  Just as a simple truism, it is the easiest way not to succumb to the financial “noise”.  If you are not exposed to it, you will not act (or feel as though you have to act) on a regular basis.  I promise that as you use this technique you will become much more comfortable.  Your EQ will really start to develop and become more mature.  Now I am not recommending that you give up all together on the financial media and sources of information.  Individual investors should simply consult them less often.  Looking at summaries of monthly activity will give you a much more complete picture of what is going on in the financial markets.

Step 2 – Commit to Examining Your Brokerage Account Statements on a Quarterly Basis Only.

I will admit that this practice, and change in behavior, is the hardest for individual investors.  However, effective adherence to step one is only possible by following this recommendation.  Many individual investors look at their account balances on a weekly or even daily basis.  The financial markets can move up and down quite frequently in the short term.  If you constantly look at your portfolio, your EQ will be hard to control or even melt away.

The vast majority of individual investors have a long-term financial plan.  You should have determined your risk tolerance (how much market volatility you are comfortable with), set up an investment portfolio with exposure to different asset classes like stocks and bonds, and determined what financial goals you have for the future already.  By definition the plan is long term and should not be altered all the time.   Note that you will utilize your IQ to establish your investment portfolio and then harness your EQ to stick with it through the inevitable “bumps” in the road.  If you are only exposed to your account balance four times per year, you will be far more likely to make more rational decisions.  Investing is very emotional due to the fact that money is involved.  That is true and will never change.  With that being said, individual investors will have less chances to be affected by emotions using this practice; only four times per year.

What should an individual investor do each quarter?  The quarterly brokerage account statements should be examined every March, June, September, and December.  Take a look at the account balance as a whole and then how the different components of your investment portfolio performed.  Then open up the other two brokerage account statements in the quarter to simply see what the account balances were.  For example, if it was the first quarter, you would be opening January and February after you looked at March.  Now the important thing to remember is that only your terminal balance matters.  What does that mean?  It is merely a fancy way of saying that only the amount of money you have at the end of the quarter is important.  The manner in which your brokerage account balance got to be at the end of the quarter might be interesting to look at, but, at the end of the day, it does not mean much at all.  It is in the past.

These two steps will definitely assist you in becoming a more successful investor.  Note that I did not say a trader or speculator.  Investors by definition have a long-term orientation.  Traders and speculators deal in hours, days, weeks, or even minutes.  Individual investors should be focused on quarters, years, and even longer increments if a solid and well thought out financial plan is in place.

The decision and ways to reallocate one’s investment portfolio is a separate issue.  Over the course of time, it will become necessary to alter the exposure of an investor’s investment portfolio to different asset classes, sectors, or regions.  Those decisions involve the IQ again but having a well formed EQ will assist greatly in that exercise.  I will take a detailed look at account rebalancing in the next series of blog posts.

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