Imagine that everything you have will benefit others. With proper financial planning and a thought-out system in place that works for you (not just short-term goals), this is possible.
Now imagine you can decide who and how to help. This too is possible and exactly what you do when you hire an investment advisor (or decide to invest yourself). Hiring the right advisor, someone whose values and goals are similar to yours, is an important first step. Determining who will get your wealth when you are gone is the most important long-term legacy you leave.
Unfortunately, the path to investment success is riddled with obstacles. The first one, and the most important one, is your own humanity. Because you are a human being, you are never rational. Instead, you rationalize or find reasons that validate why you took actions, after the fact! This is hard science.
This causes investors to leave serious money on the table when they unwittingly try to time markets. Even worse, unscrupulous “advisors” often sell investors unnecessary and expensive insurance, locking in losses when investors are most fearful. Studies done by the U.S., Australian and UK governments have found that conflicted advice costs investors at least 1 percent a year in returns. But far worse, investors’ own behavior (manifested in market timing) causes them half of the market return (in stocks or bonds)!
Goals are nice, but you can’t know when you achieve a goal until after it is done. Because goals are only achieved at various points in time, far superior are systems that control the process, or how. Having goals is not a path to happiness. Let’s instead focus on creating systems instead of setting goals.
We can tackle this in two quick steps:
- First, what are the features you need in your system?
- Second, do you need an advisor to help (and then what kind of advisor do you need)?
Here are three key elements of the system:
- Asset allocation is set based on a valid assessment of your risk tolerance and is then within acceptable range to your risk tolerance as it evolves over time.
- Asset allocation is tailored to current interest rate environment and fundamentals.
- When selecting investments, make sure to avoid unnecessary conflicts of interest.
Learn what to expect – and remind yourself.
Why You Need a System
You need a system (or advisor with a system) because you are human. You are literally never rational but instead always rationalize. What this means is that your decisions are based on how you feel instead of how you think. It means that you will find reasons for making the decision after the fact so that you can continue to feel good about those decisions.
This is the most important insight you can make in investing.
It means that you often forget your bad investments but remember fondly those that went well. Like all investors, you are likely to believe that you are an above-average investor. But not everyone can be above-average. This is a reason so many pundits advocate investing in indexes (Global View does not, at least most of the time.)
Before you can act on this, you need to do some work. This is not the kind of thing I can just tell you; you have to experience it. So, I am going to ask you to do an exercise with me.
Imagine this:
On the first day, I come with a gun in hand, taking money. You have two choices: You can either give me $3,000 or you can take a chance. If you take the chance, you might not have to give me anything if you win. But if you lose, you have to give me $4,000. The odds maker says you will lose four out of five times. So, now that I have this gun in your face, which choice will you make: Choice A (give me $3,000) or Choice B (play the game)?
Write this down.
The next day, I send a lovely young lady carrying flowers to give you money. She will either give you $3,000 or let you take a chance. This time, if you take a chance, you will get $4,000 if you win, but $0 if you lose. Again, the odds maker says you will win one out of five times. Choice C is $3,000 and Choice D is $4,000 or $0.
Unless you are an entrepreneur or have taken this test before, the odds are that you chose Choice B the first day and Choice C the second day. This is really just a game of expected value.
The first day, you were given a choice to take a sure loss, -$3,000 (A), or expected value of $4,000 x 80% or -$3,200 (B). Because it is better to lose less, Choice A is a better choice.
The second day you were given a choice to make a sure win of $3,000 (C) or expected win of $3,200 (D). Receiving $3,200 beat $3,000 so Choice D is the best.
The problem is that nearly everyone gets at least one of these wrong. In a study run by Nobel Prize winning Economist Daniel Kahnemann, 92 percent of people made Choice B (costing them $200), and 80 percent of people made Choice C (losing them $200). Successful investors do the math and go for the highest expected value. They know that the future is uncertain. We all know this, but probability does exist and we can use it to make better choices.
Because literally no one is ever truly rational, you need a system to beat this built-in “handicap” we call humanity.
Systems Vs. Goals
Systems are different than goals because they are a process that takes place over time, involving steps.
The first step is to get a reliable assessment of your risk tolerance. FinaMetrica, a company in Australia, has developed a test that will take you about 15 minutes to complete. This risk assessment uses a combination of psychology and statistics to create a valid test. A valid test is one that will hold steady over time and not change when the market is up or down.
It is mindboggling that hardly any investors are willing (until educated) to make an investment of 15 to 20 minutes to learn their true, valid risk tolerance. Instead, they take six-question risk assessments (an offering by the major brokerage firms online) that provide results that are invalid. Using these invalid tests when the market is going well, investors typically have a higher risk tolerance. But when it is not going well, investors typically have a lower risk tolerance.
Based on your results for the test provided by FinaMetrica, you will have a valid and accurate assessment of the degree of risk you can handle. This helps you decide how much of your risk budget to allocate to risk (like equities, real estate and commodities).
The next step in the process is to decide where to allocate the risk budget. Because there are basically two types of investments, low-risk (think bonds) and higher-risk (think equity), global economic fundamentals warrant where you should allocate risk.
Because conflicts of interest are so rampant and deleterious, it makes sense to give this substantial attention. Ignoring conflicts of interest can destroy your wealth.
Talk with a financial advisor and set up a plan before you lose more money.
