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

26 Wednesday Apr 2017

Posted by 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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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.

The First Key to Successful Stock Investing is Understanding and Accepting Reality – Updated

16 Wednesday Mar 2016

Posted by in asset allocation, Average Returns, bonds, business, college finance, Consumer Finance, Education, Emotional Intelligence, finance, finance theory, financial advice, financial goals, financial markets, financial planning, financial services industry, Geometric Returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, math, personal finance, portfolio, risk, risk tolerance, statistics, stock market, Stock Market Returns, stock prices, stocks, Uncategorized, volatility

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This particular topic is so important that I decided to revisit it again. The discussion below adds further refinements and creates an even stronger tie to behavioral finance (i.e. how emotions affect investment decisions).  Additionally, for those of you who desire more in-depth coverage of the math and statistics presented, I have included that at the very end of this article.  Let’s delve deeper into this topic and what is meant by “reality”.

The first key to successful stock investing has more to do with your emotions than a fundamental understanding of what causes stocks to move up or down. Emotions about money can be a powerful thing and cause people to behave in irrational ways.  One of the most common phrases passed on to investors as a piece of wisdom is to “buy low and sell high”.  However, study after study has shown that most individual investors fail to heed that advice.  Why does this happen?  Well, I would submit the real cause is behavioral and based upon incomplete information.

Most individual investors are told when they start investing in stocks via mutual funds and/or ETFs to expect an annual return of 8% to 9% per year. You will find that many financial calculators to help you plan for retirement on the Internet have that as one of the inputs to calculate the growth of your portfolio over time.  While that information is not too far off the mark based upon historical returns of the S&P 500 stock index, the actual annual returns of stocks do not cooperate to the constant frustration and consternation of so many investors.

That brings us to the first key to successful stock investing:  The actual yearly returns of stocks very rarely equal the average expected.  The most common term for this phenomenon is referred to as volatility.  Stocks tend to bounce around quite a bit from year to year.  Volatility combines with the natural instinct of people to extrapolate from the recent past, and investing becomes a very difficult task.  I will get deeper into the numbers at the very end of the post for those readers who like to more fully understand the concepts I discuss.  I do need talk in general about annual stock returns at this point to expand upon the first key.

Below I have provided a chart of the annual returns of the S&P 500 index for every year in the 21st century:

 

Year % Return
2001 -11.90%
2002 -22.10%
2003 28.70%
2004 10.90%
2005 4.90%
2006 15.80%
2007 5.50%
2008 -37.00%
2009 26.50%
2010 15.10%
2011 2.10%
2012 16.00%
2013 32.40%
2014 13.70%
2015 1.40%

 

What is the first thing you notice when looking at the yearly returns in the table? First, you might notice that they really jump around a lot.  More importantly, none of the years has a return that is between 8% and 9%.  The closest year is 2004 with a return of 10.9%.  If the only piece of information you have is to expect the historical average over time, the lack of consistency can be extraordinarily frustrating and scary.  In fact, individual investors (and sometimes professional investors too) commonly look back at the last couple of years and expect those actual returns to continue into the future.  Therein lies the problem.  Investors tend to be gleeful when returns have been really good and very fearful when returns have been very low.  Since the average never comes around very often, investors will forget what returns to expect over the long run and will “buy high and sell low”.  It is common to sell stocks after a prolonged downturn and wait until it is “safe” to buy stocks again which is how the sound advice gets turned around.

I will not get too heavy into math and statistics, but I wanted to provide you will some useful information to at least be prepared when you venture out to invest by yourself or by using a financial professional. I looked back at all the returns of the S&P 500 index since 1928 (note the index had lesser numbers of stocks in the past until 1957).  The actual annual return of the index was between 7% and 11% only 5 out of the 88 years or 5.7%.  That statistic means that your annual return in stocks will be around the average once every 17 years.  The 50-year average annual return for the S&P 500 index (1966-2015) was approximately 9.8%.  Actual returns were negative 24 out of 88 years (27.9% of the time) and greater than 15% 42 out of 88 years (48.8% of the time).  How does relate to the first key of stock investing that I mentioned earlier (“The actual yearly returns of stocks very rarely equal the average expected”)?

Well, it should be much easier to see at this point. If you are investing in stocks to achieve the average return quoted in so many sources of 8% to 9%, it is definitely a long-term proposition and can be a bumpy ride.  The average return works out in the end, but you need to have a solid plan, either by yourself or with the guidance financial professional, to ensure that you stick to the long-term financial plan to reach the financial goals that you have set.  Knowing beforehand should greatly assist you in controlling your emotions.  I recommend trying to anticipate what you do when the actual return you achieve by investing in stocks is well below or quite high above the average in your portfolio.  Having this information provides a much better way to truly understand and your risk tolerance when it comes to deciding what percentage of your monies to allocate to stocks in my opinion.

When you look back at the performance returns for stocks, it makes more sense why investors do what they do from the standpoint of behavioral finance. That is how emotions affect (all too often negatively) investment decisions.  If an individual investor is told at the outset that he or she can expect returns of 8% or 9% per year, the actual annual returns of stocks can be quite troubling.  Having that information only leads to a general disadvantage.  When stock returns are negative and nowhere near the average, individual investors tend to panic and sell stocks.  When stock returns are quite higher than the average, individual investors tend to be more euphoric and buy even more stocks.  This affect is magnified when there are a number of consecutive years with one of those two trends.  If stock returns are essentially unchanged, most individual investors become disengaged and really do not even see the point of investing in stocks at all.

I believe it is extremely important to know upfront that stocks are likely to hit the average return once every 17 years. That statistic alone is a real shocker!  It lets individual investors truly see how “unusual” the average return really is.  Plus, there is a better explanation for fear and greed.  Stock market returns will be negative once every 4 years.  Keep in mind this does not even include stock returns that are below the average yet still positive.  Lastly, every other year the stock market returns will be above the average (in my case I was measuring above the average with the definition of that being a stock market return greater than 11%).  It is no wonder why individual investors get greedy when it looks like investing in the stock market is so easy after seeing such great returns.  Conversely, the occurrence of negative returns is so regular that it is only natural for individual investors to panic.  Since the average only comes around approximately once every two decades, that is why confusion abounds and investors abandon their long-term financial plans.

I will readily admit sticking to a long-term financial plan is not easy to do in practice during powerful bull or bear markets, but I think it helps to know upfront what actual stock returns look like and prepare yourself emotionally in additional to the intellectual side of investing.  Now I always mention that statistics can be misleading, conveniently picked to make a point, or not indicative of the future.  Nevertheless, I have tried to present the information fairly and in general terms.

Additional Information on Stock Market Returns (Discussion of Math and Statistics):

Please note that this information may be skipped by individual investors that are scared off by math in general or have no desire to dive deeper into the minutiae. One of the first things to be aware of is what expected returns for stocks are.  An expected return is what the most likely outcome would be in any particular year.  Expected returns provide misleading results when there is a high degree of variability in the entire dataset.  In the case of stock market returns, there is an incredible amount of variability.  The industry term for variability, which is the statistical term, is volatility.  Due to the fact that the expected return almost never happens, it would be wise for the financial services industry to truly and better define volatility.  Most individual investors do not know that there is far more of a range of possible outcomes for stock market returns.  Individual investors associate hearing average returns with some volatility from Financial Advisors or financial media in the same way as the classic “bell curve”.  As discussed in further detail above, the outcomes do not even come close to approximating the “bell curve”.

One important thing to be aware of when it comes to actual performance returns of an individual’s investment portfolio is that average/expected values are not very important. In fact, they really lead to a distorted way of looking at investing.  Average/expected values are based on arithmetic returns, where the overall growth in one’s investment portfolio is tied to geometric returns.  The concept of geometric returns is overlooked or not fully explained to individual investors.  Here is the perfect example of how it comes into play.  Let’s say you own one share of a $100 stock.  It goes down 50% in the first year and then up 50% in the second year.  How much money do you have at the end of the second year?  You have the original $100, right?

Not even close. You end up with $75.  Why?  At the end of the first year, your stock is worth $50 ($100 + $100*-50%) after decreasing 50%.  Since you begin the second year with only that $50, that is why you end up having $75 ($50 + $50 * 50%).  The average annual return is 0% ((-50% + 50%) divided by 2)) for the two-year period.  Whereas your geometric return is negative 13.4%.  Essentially that number shows what happened to the value of your portfolio over the entire timeframe and incorporates the ending value.  Think of it as having $100 + $100 * -13.4% or $86.60 at the end of year one and then $86.60 + $86.60 * -13.4%) or $75.  Note that you never actually have $86.60 as the portfolio’s value at any time, but the geometric return tells you how much money you actually earned (or lost) over the entire period and how much money you end up with, otherwise known as the terminal value of your portfolio.  The geometric return will ALWAYS differ from the arithmetic return when a negative return is introduced as one of the outcomes.  As an individual investor, your primary concern is the terminal value of your portfolio.  That is the dollar value you see on your brokerage statement and is the actual amount of money you have.

Financial professionals forget to focus on geometric returns or even bring them up to clients. This omission is important to individual investors because negative returns have an outsized effect on the terminal value of an investment portfolio.  For example, in the example above, it is quite clear that losing 50% and then gaining 50% do not “cancel each other out”.  The negative percent weighs down the final value of the portfolio.  That is why it is extremely important to use the geometric return of the portfolio.  This result is due to the fact that the compounding of interest is not linear.  It is a geometric equation which is why the geometric mean comes into play.  Without going fully into the explanation of those equations, the main takeaway for investors when it comes to annual returns is that negative returns have more of an effect than positive returns.

Taken together, it is important to utilize the concept of multi-year geometric averages. Individual investors never want to simply add up the annual returns of a series of years and then divided by the number of years.  That result will overstate the amount of money in the investment portfolio at the end of the period.  The preferred approach is to use the geometric average which is referred to as the annualized average return.  That percentage is the number most relevant to investors.  Additionally, longer timeframes of these returns are best to look at given the extreme amount of volatility in yearly stock market returns.  It gives a better picture of how the stock market has moved.

When looking at the stock market returns for the S&P 500 index over five-year periods using the period 2001-2015, they yield surprising yet informative results. The five-year returns from 2001-2005, 2006-2010, and 2011-2015 were 0.54%, 2.30%, and 12.57%, respectively.  Valuable information comes from looking at extended periods of time using the same time increment.  The overall return during 2001-2015 was 5.01%.  The effect of these longer timeframes smooths the stock market return data, but even then the stock market returns vary quite a bit.  Note that the overall return from the entire historical period of the S&P 500 index is roughly 9.50%.  These three selected chunks show two periods of underperformance and one year of outperformance.  The reason stock market returns tend to hover around the historical average is due to the fact that these returns are tied to the overall growth the economy (most commonly Gross Domestic Product – GDP) and corporate profits.  In the meantime though, stock market returns can vary a lot from this expected return.  However, they are unlikely to do so for incredibly long periods of time.

By incorporating the understanding of volatility and geometric returns into your understanding of the “reality” of stock market returns, you will be able to better refine your own risk tolerance and how to craft your long-term financial plan. A better grasp of these concepts makes one far less likely to react emotionally to the market, either with too much fear or too much greed.

The Top 5 Most Read Articles in my Investing Blog During 2015

29 Tuesday Dec 2015

Posted by in asset allocation, bond market, bonds, Consumer Finance, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, passive investing, personal finance, portfolio, 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, statistics, stock market, stock prices, stocks, Yellen

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The most popular articles read over the past year included some writings from a couple of years ago and were also on a myriad of topics. The listing of articles below represents the most frequent viewings working downward.

  1. Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For.

 

This article has consistently drawn the most attention from readers of my investing blog. Individual investors have learned from me and many others that one of the most important components of being successful long-term investors is by keeping investment costs as low as possible.  This particular writing examines investing costs from a different perspective.  In general, the higher the investment costs an individual investor incurs, the higher the allocation to riskier investments he/she must have to reach his/her financial goals.

Link to the complete article: https://latticeworkwealth.com/2013/10/26/are-your-financial-advisors-fees-reasonable-are-you-actually-adding-more-risk-to-your-ability-to-reach-your-long-term-financial-goals-here-is-a-unique-way-to-look-at-what-clients-pay-for/

2. Are Your Financial Advisor’s Fees Reasonable? Here is a Unique Way to Look at What Clients Pay For.

 

This article is closely followed by the previous one in terms of popularity and forms the basis for that discussion actually. The general concept contained in this writing is that most asset managers now charge investors a fee for managing their investments based upon Assets under Management (AUM).  The fee is typically 1% but can be 2% or higher.  The investment costs to the individual investor per year are the total balance in his/her brokerage account multiplied by the fee which is commonly 1%.  However, the 1% grossly misrepresents the actual investment costs because the individual investor starts off with the total balance in his/her brokerage account.  The better way to express the fees charged per year is to divide the AUM percentage by the growth in the portfolio over the year.  That percentage answer will be quite a bit higher.

Link to the complete article: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/

3)  Rebalancing Your Investment Portfolio – Summary

 

Earlier in the year, I compiled a three-part series that examined the concept of rebalancing one’s investment portfolio. Rebalancing is an excellent investing strategy to learn about and apply at the end of the year.  Rebalancing in its simplest definition is the periodic reallocation of the investment percentages in one’s investment portfolio back to an original model after a passage of time.  This summary of rebalancing provides a look at rebalancing that is helpful for novice individual investors through more advanced folks.

Link to the complete article: https://latticeworkwealth.com/2015/11/25/rebalancing-your-investment-portfolio-summary/

4)  How to Create an Investment Portfolio and Properly Measure your Performance: Part 2 of 2

 

While this article is the second part of a discussion on the creation of an investment portfolio, it is arguably the more important of the two because it looks at a topic too often not relayed to individual investors. This writing talks about the importance of measuring the performance of your investment portfolio’s investment returns.  The financial media tends to focus solely on comparing your portfolio to the performance of the S&P 500 Index.  That comparison is “apples to oranges” the vast majority of the time because most individual investors have many different types of investments in their portfolios.  Therefore, I show you how institutional investors measure the performance of their investment portfolios.  The concept is broken down into smaller parts so it is very understandable and usable for individual investors.

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

5)  How Can Investors Survive in a Rising Interest Rate Environment? – Updated

 

Although this particular article was first published a couple of years ago, the content is even more valuable today. The Federal Reserve increased the target range for the Federal Funds Rate by 0.25% on December 16, 2015 and has indicated that more interest rate increases are likely in the future.  Thus, we have entered a period in which interest rates are generally headed higher over the next several of years.  Most financial pundits will bemoan this type of environment because higher interest rates mean that the prices of most bonds go down.   It makes it harder to earn any investment returns from bonds.  However, there are a number of investments and investment strategies that benefit from an increasing interest rate environment.  This article examines six different things individual investors can do.

Link to the complete article: https://latticeworkwealth.com/2013/11/30/how-can-investors-survive-in-a-rising-interest-rate-environment-updated/

 

I hope you enjoy these popular articles from my investing blog. My goal is to keep on releasing more information in 2016 to assist individual investors in navigating the world of investing.  Thank you to all my readers in the United States and internationally!

Rebalancing Your Investment Portfolio – Summary

25 Wednesday Nov 2015

Posted by in asset allocation, bonds, Consumer Finance, Emotional Intelligence, finance, finance theory, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investments, personal finance, portfolio, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, Uncategorized

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With the end of the year fast approaching, it is an excellent time to discuss the concept of rebalancing one’s investment portfolio.  The simplest definition of rebalancing is the periodic reallocation of an investment portfolio back to the original percentages desired.  The fluctuations of the financial markets over time will inevitably alter the amount of exposure in one’s investment portfolio to different types of assets.  These changes may cause the portfolio to be suboptimal given an individual investor’s financial goals and tolerance for risk.  Knowing about rebalancing is so important because it is one of the most effective ways to eliminate, or at least reduce, the emotions surrounding investment decisions that affect even professional investors.  Additionally, numerous academic studies have concluded that 85% of the overall return of an investment portfolio comes from asset allocation.

Recently, I published a three-part series of articles to define and explain the various nuances of rebalancing an individual investor’s investment portfolio.  The first article covers the definition of rebalancing in its entirety.  Furthermore, the article looks at an illustration of how rebalancing works in the real world.  It offers an introduction to this important investing tool.  The link to the complete article can be found here:

https://latticeworkwealth.com/2015/07/16/how-to-rebalance-your-investment-portfolio-part-1-of-3/

The second article discusses a unique way to get assistance with rebalancing an investment portfolio.  Many of the largest asset managers in the financial services industry, such as Vanguard, Fidelity, and T Rowe Price, offer life cycle or target date mutual funds.  These mutual funds have a predefined year that the individual investor intends to retire.  Moreover, the combination of assets in the mutual fund is structured to change over time and become less risky as the target date approaches.  Since these mutual funds report their holdings on a periodic basis, any individual investor is able to replicate the strategy for free.  Plus, another feature is that an individual investor can be more conservative or aggressive than his/her age warrants according to the mutual fund family’s calculations.  The individual investor is able to pick a target date closer than the endpoint (i.e. more conservative) or pick a target date later than the endpoint (i.e. more aggressive).  For a more comprehensive discussion of this facet of rebalancing an investment portfolio follow this link:

https://latticeworkwealth.com/2015/07/29/how-to-rebalance-your-investment-portfolio-part-2-of-3/

The third and final article discusses the most advanced feature of rebalancing utilized by a subset of individual investors.  The investing strategy is referred to as dynamic rebalancing in most investment circles.  Dynamic rebalancing follows the general tenets of rebalancing.  However, it allows the individual investor to exercise more flexibility during the rebalancing process of the investment portfolio.  Essentially the individual investor determines bands or ranges of acceptable exposures to asset classes or components within the investment portfolio.  For example, a lower bound and upper bound for the asset allocation percentage to stocks is set.  The individual investor is free to allocate monies to stocks no less than the lower bound and no more than the upper bound.  Note that the bands or ranges are normally fairly tight and applies to the subcomponents of the investment portfolio, such as small cap stocks, emerging market stocks, international bonds, and so forth.  To learn more about this fairly complex aspect of rebalancing follow this link:

https://latticeworkwealth.com/2015/11/21/how-to-rebalance-your-investment-portfolio-part-3-of-3/

The articles above capture the vast majority of information individual investors need to know about rebalancing an investment portfolio.  It is good to get a head start on learning about or reviewing this topic prior to the end of the year.  The reason is that most rebalancing plans utilize the end of the calendar year as the periodic adjustment timeframe.

How to Rebalance Your Investment Portfolio – Part 1 of 3

16 Thursday Jul 2015

Posted by in asset allocation, bonds, Consumer Finance, finance, financial advice, financial goals, financial markets, financial planning, Individual Investing, individual investors, investing, investing advice, investing tips, investments, personal finance, rebalancing, rebalancing investment portfolio, risk, risk tolerance, stock market, stocks

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The first and foremost decisions for an individual investor is to determine his or her financial goals, assess his or her risk tolerance, and then develop an investment portfolio to allow one to reach those financial goals. Financial goals might be saving for retirement, a child’s college education, disbursing income while in retirement, or most any other thing that requires money to be paid in the future. Risk tolerance involves an individual investor’s willingness to take on volatility and variability in the performance returns of financial or real assets. Some investors are fine with the sometimes wild gyrations of the stock market. They might be able to withstand a 20% decline in the value of their investment portfolio and still not panic and sell. Other investors are more risk averse and do not want to see so much volatility in their investment portfolios. However, they may know they need the growth in their investment portfolio, so they reduce their exposure to stocks. Lastly, some investors may be nearing their financial goal and need to ratchet down risk in order to have enough money by not losing principal. The final step is to construct an investment portfolio that brings the two together. The financial goals can be reached but within the parameters of the investor’s risk tolerance. Note that risk tolerance in a general sense refers to the volatility of assets in one’s investment portfolio. For instance, US Treasury bills are much less volatile than stocks.

Now the financial markets will change over time as prices go up and down. Therefore, the original allocation (percentages) to stocks, bonds, cash, or other assets in the investment portfolio will be different than the one after one year goes by. It would be markedly different after five or ten years go by. That is where rebalancing your investment portfolio comes in. In this first part of this three-part discussion, I will focus on the easiest way to rebalance an individual investor’s portfolio. In the next two parts, I will expand the notion of rebalancing. In its simplest definition, rebalancing one’s investment portfolio refers to the periodic changes made to bring the investment portfolio back to the original allocation to the various investment selections. Let’s explore why this should be done.

Due to the natural ups and downs of the financial markets, an individual investor’s investment portfolio will change in composition. Remember that an investment portfolio is initially set up to allow the individual investor to reach his or his financial goals while still adhering to the amount of risk that he or she is willing to take. Well, after a year goes by, the chances are very good that the amount of money invested in stocks, bonds, cash, etc. will have changed. Thus, the investment portfolio may be more risky or less risky than intended. Moreover, the investment portfolio may not be on track to allow the individual investor to achieve his or her financial goals which is the overall goal to begin with. Additionally, rebalancing allows the individual investor to “sell high and buy low” in general. Stocks and bonds have a way of getting too expensive or too cheap as time goes by. However, the individual investor can sell the asset class that has gone up and use those funds to buy the asset class that has gone down. The technical term that you might hear is reversion to the mean. That means that over long periods of time, financial assets tend to produce an average rate of return. Hence, a rate of return much higher than the average for several years is normally followed by a period of lower returns than the average. Now let’s turn to an example with actual numbers to make things much clearer.

We can take the following scenario with various assumptions. They are as follows: the individual investor has a portfolio of $1 million at the beginning of the year, the asset allocation is 60% stocks ($600,000), 30% bonds ($300,000), and 10% cash ($100,000), during the year the stocks gain 10% ($60,000), the bonds lose 2% ($6,000) and the cash earns no interest, and, finally, the individual investor is committed to rebalancing the investment portfolio at the end of every year.

Here is the scenario:

1) Investment Portfolio at the Beginning of the Year
Type of Asset Dollar Amount Percentage
Stocks $             600,000 60.0%
Bonds                300,000 30.0%
Cash                100,000 10.0%
Total $         1,000,000 100.0%
2) Investment Portfolio at the End of the Year
Type of Asset Dollar Amount Percentage
Stocks $             660,000 62.6%
Bonds                294,000 27.9%
Cash                100,000 9.5%
Total $         1,054,000 100.0%
3) Investment Portfolio After Rebalancing
Type of Asset Dollar Amount Percentage
Stocks $             632,400 60.0%
Bonds                316,200 30.0%
Cash                105,400 10.0%
Total $         1,054,000 100.0%

As you will note above, the investment portfolio starts out with the intended asset allocation for this individual investor. However, at the end of the year in accordance with the rate of return assumptions, the investment portfolio is quite different. In fact, the percentages for each asset class have changed. In the scenario detailed above, the investment portfolio at the end of the year is more risky than at the start of the year. That is where the rebalancing comes into play. In order to get the investment portfolio back to the original asset allocation, stocks need to be sold and the proceeds invested in bonds and cash. It is fairly easy to come up with the necessary purchases and sales by multiplying the total balance at the end of the year by the desired percentage for the investment portfolio for each asset class. That step will show how much should be bought or sold in order to restore the investment portfolio to harmony.

Please note that the $1 million and asset allocation types and percentages were selected for the purposes of illustrating the concept of rebalancing. The scenario listed above will work with any investment portfolio dollar amount. In addition, there is no reason why more specific asset classes cannot be added to the investment portfolio to match your individual investment portfolio (e.g. large cap stocks, international stocks, emerging market bonds, etc.). As long as you have the desired percentages for your portfolio, you can go through the same process in the example above in order to rebalance your portfolio.

In summary, rebalancing on a periodic basis is a way to ensure that the individual investor is on track to achieve his or her financial goals while not taking on too much or too little risk to get there. It is a way to stay on the path to one’s financial plan. Normally individual investors will rebalance their investment portfolios once a year, typically at the end of the calendar year. However, there is no reason why the length and/or time of the year cannot be altered. For the purposes of simplicity, a hard and fast rule of each year at the end of the year is usually the best rule of thumb when it comes to rebalancing for most novice individual investors. One of the other benefits is that rebalancing allows individual investors to not try and time the market or stay with a certain type of investment too long. As a personal anecdote, I have an uncle who got caught up in the Internet Bubble of the late 1990s into 2001. He devoted more and more of his retirement portfolio to technology stocks. When the bubble burst, his investment portfolio was devastated. Unfortunately, he had to delay his retirement by nearly ten years due to this mishap. Adherence to a strict schedule and rebalancing plan acts a buffer against occurrences like this. It really helps to take much of the emotion, which most investors of all types struggle with, out of investing.

Two Steps to Help Individual Investors Become More Successful at Investing

11 Thursday Jun 2015

Posted by 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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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.