“Behavioral finance” is a relatively new but increasingly influential part of the financial world. Where traditional economic/finance theory assumes that consumers and investors regularly maximize their opportunities, behavioral finance acknowledges that this is not always the case. If you’re interested, excellent books on the subject include Thinking, Fast and Slow by Daniel Kahneman; Misbehaving by Richard Thaler; Nudge by Thaler and Cass Sunstein; and Predictably Irrational by Dan Ariely.
We at Park Piedmont have always tried to provide real-world, practical advice for clients. And we read a recent behavioral finance book, The Psychology of Money by Morgan Housel, with interest. (Housel works for the Collaborative Fund, a venture capital firm, and previously wrote for the Wall Street Journal and Motley Fool.) It’s a very readable (i.e., short and mostly to the point) summary of many important ideas in the behavioral finance/investing field; the chapter on being “reasonable” as opposed to “rational”, starting on page 113, is a notable example. The book also reflects much of the advice we provide.
Here’s a summary of some of the key concepts, along with our perspective:
Play the Right Game – Yours: There are millions of financial opportunities available, and almost as many people trying to pitch them to investors. But many of these opportunities are designed for trading, i.e. getting in and getting out quickly, hopefully at a better price. Housel explicitly distinguishes between trading and investing, as we regularly do in our monthly comments: “Short-term traders operate in an area where the rules governing long-term investing –particularly around valuation—are ignored, because they’re irrelevant to the game being played” (p. 171).
The larger point is to focus always on your needs and goals, not those of the often short-term-focused finance industry. As Housel puts it: “Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are… Everything that’s unrelated to [your goals] – what the market did this year, or whether we’ll have a recession next year—is part of a game I’m not playing” (p. 173).
Enough: In addition to the idea of playing your own game, we often discuss the concept of “winning” the game, and the implications for clients’ portfolios. Housel introduces this topic with a story that John Bogle, the legendary founder of Vanguard, once told: “At a party given by a billionaire, Kurt Vonnegutinforms… Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, “Yes, but I have something he will never have… enough” (p. 37).
Determining what constitutes enough is of course different for each person and family. But once that level has been reached, we typically recommend that clients reduce their allocations to the risky parts of the markets (stocks in particular) because there’s no further need to take on the additional risk. As Housel puts it: “If you can meet all your long-term goals without having to take the added risk that comes from trying to outperform the market, then what’s the point of even trying? I can afford to not be the greatest investor in the world, but I can’t afford to be a bad one” (p. 219).
Time Is Your Friend: A long-term perspective is beneficial not only because it helps to avoid the pitfalls of short-term trading. It also provides time for compounding to occur. Compounding refers to the idea of earning returns on returns over time; $100,000 earning 5% a year becomes $105,000 after one year, and $110,250 (not just $110,000) after two years. Assuming decades of returns (some of which will of course be lower than 5%, but some of which will be higher), the impact can be enormous. Einstein is famously reputed to have said that “compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” According to Housel, “good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild” (p. 53).
We encourage clients to focus on the long-term period and goals that are relevant to each of them, and pursue market-tracking returns using low-cost index funds. We’ve written often about the benefits of indexing, and Housel provides several examples too, including the costs of buying and selling (p. 161), the frequent underperformance of actively-managed funds (pps. 195-6), and the added risk in trying to beat the market (p. 219).
Focus on What You Can Control: We’ve always considered indexing to be the most realistic way to benefit from long-term investing. But even given the low cost and tax efficiency of index funds and ETFs, your returns are still subject to the ups and downs of the markets. We can assume these markets will generate long-term returns going forward similar to the ones from the past 100 years or so, specifically about 6-8% for stocks and 3-4% for bonds, before taxes . But there’s no guarantee that these returns will recur, and even if they do, there can still be extended periods of underperformance in all markets. So we also recommend a focus on what you can control, which is the amount you save. As Housel describes it: “Investment returns can make you rich. But whether an investing strategy will work, and how long it will work for, and whether markets will cooperate, is always in doubt… Personal savings and frugality… are parts of the money equation that are more in your control and that have a 100% chance of being as effective in the future as they are today” (p. 104). He goes on to summarize his own investing strategy, which “doesn’t rely on picking the right sector, or timing the next recession. It relies on a high saving rate, patience, and optimism that the global economy will create value over the next several decades. I spend virtually all of my investing effort thinking about those three things – especially the first two, which I can control” (p. 220).
Focus on the Portfolio: Related to the indexing strategy is the idea of focusing on your overall portfolio, as opposed to a single account or investment. According to Housel: “You should always measure how you’ve done by looking at your full portfolio, rather than individual investments… Judging how you’ve done by focusing on individual investments makes winners look more brilliant than they were, and losers appear more regrettable than they should” (p.208).
In addition to indexing, we devote much of our work with clients to developing a well-diversified portfolio that will help accomplish each client’s specific goals. This high-level “asset allocation” is developed differently for each client, depending on the desired balance between income and capital preservation (the primary features of bonds) and capital appreciation (the primary feature of stocks). Once we develop an appropriate asset allocation, we then turn to “asset location”, which considers the amounts available to invest in the two main types of accounts. The first are “taxable” accounts, such as Individual, Joint, and Trust accounts, in which interest and dividend income are taxed when earned, and capital gains tax treatment is available when selling an investment. The second are “tax-deferred” accounts, such as IRAs, 401Ks, and other retirement plans, in which income tax is deferred until retirement, and all withdrawals during retirement are taxed at ordinary income tax rates (which are currently significantly higher than capital gains rates). Different investments are typically preferable in different accounts (e.g., stocks in taxable accounts and bonds in tax-deferred accounts), with the result that taxable accounts will often perform better, by design, when stock prices are rising, but worse when they’re falling. The portfolio perspective avoids these short-term distortions and helps investors to concentrate on the long-term returns that generate compounding over time.
Housel’s book does get repetitive at times, but we think there are enough good ideas in The Psychology of Money to merit a quick read. And if you do, please feel free to contact us to discuss it in greater detail. We’d love to hear your thoughts.