Thursday, December 4, 2014

Avoid "The Folklore of Finance" ... A Self Help Approach to Personalized Goal Centered Investing

Unfortunately, basic financial literacy is a missing ingredient in the skill sets of far too many of our fellow Americans. That's not a good thing in a free market and free choice economy and, in fact, that lack of basic knowledge can be and often is a needlessly debilitating thing over one's lifetime.

Perhaps the most important thing to recognize is the difference between earnings and assets. Earnings won't result in wealth unless savings and investments are a fundamental piece of the personal financial equation. And debt and the interest charges thereon subtract from assets, so owning something doesn't equate to accumulating wealth either. It's the monetary value of the assets we 'own' less the amount of money we owe that determines our assets.

Second, we fail to acknowledge the harmful long term results of giving in to a 'get it now' short term focus by accumulating debt and a long term orientation which minimizes debt and delaying gratification. As humans it's our clear and strong tendency to want things now and not delay in acquiring (or settling for something less expensive and more affordable) them until later when we can afford to own those things. That makes us early debtors and not early savers and asset growers.

The third missing ingredient is the useful knowledge concerning the difference between average annual inflation beating rates of return realized from investing in stocks over the long haul compared to any other asset, including residences, bonds, and gold. For the next few decades, and unlike the past few, bonds won't be a good investment as interest rates can't fall much lower than their historically low current levels. That means bonds won't be winning investments, and certainly not 'safe' ones, despite conventional wisdom about their 'safety.' Thus, successful investing is really as simple as knowing the basic 1-2-3 rules of personal financial literacy.

After making the effort to (1) get a useful education (the pursuit of which never ends) and then land a good job (which isn't easy), (2) establish the habit of consistently saving a substantial portion of  earnings, and (3) regularly invest a healthy portion of those savings in blue chip, dividend paying stocks for the long term, our younger self is on his or her way to a healthy and comfortable financially stable adulthood. And it's all well worth the effort.

The Folklore of Finance: Beliefs That Contribute to Investors' Failure offers some sound advice to individual investors:

"After a nearly two-year study that aimed to answer the question, What does true investment success look like?, Suzanne Duncan, global head of research at State Street’s Center for Applied Research, and her team found that the way individual and professional investors made investment decisions was so skewed that achieving both high returns and long-term objectives was nearly impossible.

They came up with a label for the beliefs that contributed to this failure: the folklore of finance. "The study, . . . found that people were overconfident in their investing ability, unable to focus on their stated long-term goals when distracted by short-term noise in the markets, and had come to distrust their advisers and lose interest in receiving professional investing help. It also found that changing these behaviors in individual and professional investors was going to be very difficult.

The study begins by trying to explain two very real disconnects in investing.

The first is part of the debate over skill versus luck in investing. Investors generally seek returns that beat a benchmark, known as alpha in financial jargon. But the reality is that alpha barely exists today — at least alpha that is achieved through skill and not luck. . . . In 2006, the number of funds delivering true alpha was down to 0.6 percent, which is statistically equivalent to zero. . . .

Why this has happened is a paradox of our age: Investors have both greater skill and more information to make outstanding performance more challenging. (The study includes an online quiz to test investing expertise). Think of it as standing up at a baseball game. If you do it alone, you have a better view. If everyone stands, only the tallest have a chance of seeing better than if everyone was still seated. . . .

The solution to the mostly futile quest for alpha, though, is not to switch to being a passive investor alone — which would mean investing in index-tracking funds that would return whatever the index returned, for a very low fee. Ms. Duncan called that reaction too simplistic. She advocated for a system at firms that would challenge broadly accepted, herdlike opinions.

What should be more achievable is setting a financial goal and meeting it, but the study found that this is not happening either. Individuals failing to stick to their plan is nothing new, but in some cases individual investors do not even understand what the plan is: 73 percent of respondents to a State Street survey said they invested with long-term goals in mind, including retiring comfortably and leaving an inheritance, but only 12 percent of those investors said they were confident they were prepared to meet those goals.

“Investors are very short-term-oriented in the sense of how the markets are performing,” Ms. Duncan said. “It’s all relative returns. That takes away from their ability to stay the course.”

In other words, if investors could focus on their long-term goals and understand that it is not going to be a straight line to get there, they would have a greater chance of achieving those goals. . . . And the solution is often advisers who can spend more time finding out what their clients want to achieve and less on moving them among investments.

“It’s not very hard to help individuals realize what they want to do,” said Charles D. Ellis, founder of Greenwich Associates and a former chairman of Yale University’s investment committee. “It does take some time. You have to ask questions and find the answers that are acceptable.” These go beyond return expectations . . . . They go to the core of . . . what they want their own money to accomplish.

The State Street study . . . criticizes investment managers and advisers who are focused on short-term gains as a way of proving their worth. . . . “Career risk is much more profound than we anticipated,” Ms. Duncan said. “It’s difficult to change because it’s very much embedded in everything. It’s the culture, the fee structure, it’s based on assets under management, and they’re rewarded for this.”

Investors are starting to wise up to this game. A 2012 State Street study found that 65 percent of investors did not feel much loyalty to their investment adviser, while 93 percent of respondents to another State Street survey said they believed they would be better off investing on their own. . . .

But investors’ taking investment decisions into their own hands has not proved to be the solution either.

The study found they look to markers like past performance or how others are doing to measure their own investment success, a false comfort in the study’s parlance. Only 29 percent of investors defined investing success as reaching their long-term goals; most preferred short-term markers, like their portfolio’s return versus that of a benchmark.

Another disconnect revolves around time. Investors want to invest with a long time horizon yet react to short-term swings that derail the strategy. Think of investment return markers, like one, three and five years — hardly the time needed to get people from their first job to retirement."

Summing Up

Investing is a long term proposition. It need not be difficult. In fact, it can and should be both easy and productive.

And recognizing the difference between earnings and accumulated assets is imperative for successful long term oriented investors.

Building a base of assets by regularly saving and investing a part of each paycheck in blue chip stocks is the key to financial success and security over the long haul.

It's that simple, but it requires personal discipline and a commitment to keeping at least one eye firmly focused on the future.

That's my take.

Thanks. Bob.

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