Does Being Human Hurt Your Investment Results? Part III of III

Thanks to a commentary by my friend and fellow financial coach, Fred Taylor, we’ve been talking about how being human and being emotional is a great threat to our success with our investments. I ended the last post with a list of five basic statements that can help protect us from making poor, emotion-based investment decisions. Now let’s talk about each one.

1. Compound interest is what will make you rich. And it takes time. Warren Buffett is a great investor, but what makes him rich is that he’s been a great investor for two-thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most of us don’t start saving in meaningful amounts until a decade or two before retirement. That severely limits the power of compounding. There’s no way to fix the issue (starting to save too late) retroactively. This is a good reminder of how important it is to teach our children and grandchildren to start saving as soon as possible.

2. The single largest variable that affects investment returns is valuations—and you have no idea what they’ll do. Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That’s really all there is to it.

The dividend yield we know: As of this writing, it’s 2 percent. A reasonable guess of future earnings growth is 5 percent per year. What about the change in earnings multiples? That’s totally unknowable.

Earnings multiples reflect people’s feelings about the future. And there’s just no way to know what people are going to think about the future in the future. How could you?

If someone said, “I think most people will be in a 10 percent better mood in the year 2023,” we’d call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

3. Simple is usually better than smart. Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97 percent return by the end of 2012. That’s great! And they didn’t need to know a thing about portfolio management or technical analysis, or suffer through a single segment of Jim Cramer’s “The Lightning Round” on Mad Money.

Meanwhile, the average equity market neutral hedge fund lost 4.7 percent of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96 percent total return — still short of an index fund.

Investing is not like a computer. Simple and basic can be more powerful than complex and cutting-edge. And investing isn’t like golf. With investing, the amateurs have a pretty good chance of humbling the pros.

4. The odds of the stock market experiencing high volatility are 100 percent. Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time —every single time—there’s even a hint of volatility, the same cry is heard from the investing public: “What is going on?!”

Nine times out of 10, the correct answer is that nothing is going on. This is just what stocks do. Since 1900, the S&P 500 has returned about 6 percent per year, but the average difference between any year’s highest close and lowest close is 23 percent. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring. Someone once asked J.P. Morgan what the market will do. “It will fluctuate,” he allegedly said. Truer words have never been spoken.

5. The industry is dominated by cranks, charlatans, and salespeople. I’m sorry. I hate to say this about the great industry that I’m a part of. The vast majority of financial products are sold by people whose primary (often only) interest in your wealth is the amount of fees they can suck out of you.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention she or he will receive, even though shocking predictions make any pundit more likely to be wrong.

This is perhaps the most important theory in finance. Until we understand and live by it, we stand a high chance of being bamboozled and misled.
I know I’ve thrown a lot at you. Seriously think about what this means to your future and your investments. I wish you health and wealth.

Gene Offredi, CFP, RFC, Summit Investor Coach LLC, Guilford. Call 203.453.1017. Or visit  HYPERLINK "http://www.summitinvestorcoach.com/" my website or  HYPERLINK "http://www.summitinvestorcoach.com/blog/" blog.