Posted by Robert on October 28, 2013
This is a guest post by Robert, who lives in Calgary and worked as a financial adviser before retiring at age 35. He is married, has three kids and has returned to school with the goal of eventually living and working overseas.
There has been a lot of talk among economists and investors about human biases under the heading Behavioural Economics. People aren’t nearly as rational as economists assumed in their early work at modelling transactions and decision-making. We have predictable tendencies to exaggerate losses, to overestimate our resiliency to risk and to be overconfident about our ability to predict the future.
Our biases make it more difficult for us to be successful investors. How many people, when the market drops, focus too much on their paper losses, panic and want to sell their investments? How many people, when the market crashes, sell at the bottom and swear off investing forever? I know from my experience working as a financial advisor that the (admittedly imprecise) answer is: too many. The money that many people pay for investment advice pays not only for advice on investment opportunities and asset allocation, but also babysitting to avoid selling investments at every market correction, and to avoid getting sucked into enticing investments that offer 17% guaranteed returns (seriously, I’ve seen this), but is simply too good to be true (and I’ve seen it go bankrupt).
So let’s be honest with ourselves. Saving money is hard. We’d prefer to have something now rather than delay our purchase into the unpredictable future. It’s harder for some people than for others. But as long as we’re being honest, there are ways to compensate for the difficulty. As an example, having the employer deduct a certain amount of savings from every paycheque. As an example, a friend was telling me yesterday at his work that most of his colleagues can only have 1% or 1.5% withheld for the company savings plan, despite 100% matching from the employer (free money!). It’s because they live paycheque to paycheque and $100 makes a difference. I wonder if they would be able to increase their savings by 0.5% every six months or every year, without feeling the pain. I also suggested to clients that every time they get a raise, half of it be redirected toward savings. Being realistic allows us to work around our biases.
Facing reality also means knowing that the stock market is going to be volatile and fluctuate, sometimes wildly. In my research, I have found very few good reasons to own a diversified portfolio of stocks and bonds. Sometimes stocks perform far better. Occasionally, bonds perform better, while being far safer. These two investments have different purposes, in response to different investment needs. The benefit to an individual investor of buying a portfolio that’s 60% stocks, 40% bonds is that the ride will be smoother, the individual will have less opportunity to experience “losses” and will be less likely to panic. But in some cases, that can be a very real benefit.
Being realistic and honest with yourself is likely the best way to manage investment risk. Expect a small return each year, expect bad years once in a while, and expect to have trouble saving as much as you’d like. Then find ways to compensate for those difficulties. How honest are you with yourself about your investments? What do you do to compensate for your biases?