When should you invest it? Should it all go in as soon as you get it [lump sum] or should you space it out over 6-12 months [dollar-cost averaging]?

This is a classic behavioral finance question, and of course it would be easy if you knew where the market was headed, but since we don’t, things quickly get messy.

The industry answer is what I call the Spreadsheet Answer. The argument goes like this: because historically the market goes up, you should invest it all as soon as you have it. Every day you sit on cash, you are losing out on the opportunity [or potential] for the higher returns. This assumes that you plan on leaving the money invested for a very long time and that you are the rare individual that calmly makes rational decisions based on Spreadsheet Answers.

The second and far more reasonable way to look at it is the Sleep-Factor Answer. It is time that we realize unless you see Warren Buffet in the mirror, emotions play a much larger role than we care to admit. We are not rational beings that can live with Spreadsheet Answers. In the real world, real people do not make rational decisions all the time. We feel real pain and fear when we see large declines in our investments. If you recognize that reality, it makes managing your behavior a much more important factor in this decision.

Think about this for a minute: you are sitting there with $1,000,000! Now you have to decide not only how to invest it, you have to decide when…

The risk with investing it all now is that when you face the first decline it will be far more difficult than you think to stay the course. With buy and hold investing, it is not the buy part that is hard, it is the hold. Experience has proven that most of us just want out when things get scary. This is an emotional issue, and throwing more facts at emotion does not work. So to argue that the stock market historically goes up over long periods of time…blah, blah, blah….When you invested $1,000,000, opened your statement, and you have $800,000, all you know is that it is causing you pain and you want the pain to stop.

I am not saying it is smart, but I am saying it normal. Since it is normal, we should plan on it. If we plan on it, we would ease into the market over a period of months to minimize the chance of making the big behavior mistake of buying high and selling low.

[This post was inspired by a question that I addressed for The New York Times.]

Investors have a bad habit of treating the stock market like a Monopoly^® game. These same investors then forget that they are playing with real money instead of play money until it’s too late. You’ll do yourself, and your investments, a favor if you go to the movies instead.

When you try to make investing entertaining, you start making decisions that aren’t based on what’s best for the long term but rather on what perks up your day. And because you’re human, it’s easy to get caught up in the roller coaster of emotions. First, there’s the rush of making the deal, followed by the edge of your seat anticipation, waiting to see what happens. You’ve only got two options: 1) the excitement of winning or 2) the depression of losing.

What’s next? Starting the cycle all over again with only one difference: it’s harder to duplicate the same excitement, so you push harder, making the risk of losses greater every time you go around the board. Again, we aren’t dealing with play money. This is the real thing, and you’ve worked too long and too hard to throw it away. Trust me. Go to the movies.

For more information about how this behavior, and other’s like it, affect your investor return, check out the Behavior Gap Snapshot.

For as long as I have been in the business, using the word guarantee meant one of two things:

[1] The investment police were going to come through the ceiling tiles, because no investment is guaranteed.

or

[2] You were selling expensive insurance.

Sure there are ways to guarantee or insure your investment portfolio. You could use an annuity with a living benefit [please don't accuse me of promoting annuities; I don't sell annuities, this is just an example].

You could use options^[1] to protect your portfolio.

You could use a stop loss^[2] that follows the market up. I’m sure there are other ways, but they all have at least two things in common:

One, they will cost you, and two, most financial advisors view that cost as far too expensive.

But what is a guarantee worth?

What is your home owner’s insurance worth if you knew your house was going to burn down once every 5 years?

We know that the market is going to get killed on a fairly regular, but totally unpredictable, basis. We know that the cost of getting killed is huge. We know that it takes a long time to dig out from being killed. We also know that if we could avoid being killed, it would be a huge benefit to us financially, not to mention emotionally.

What we don’t know is if the benefit would outweigh the cost…

Annuities and living benefits have a particularly bad reputation^[3], and it might be well deserved, but try telling that to the client-to-be that I met with the other day that has a guaranteed benefit, base valued about the same place as it was at the market high. What about another lady I know that would be living in her son’s basement if she had followed my advice to asset allocate and buy and hold. Instead, she bought a annuity with a living benefit, takes home the income she needs, and has a guarantee [only as good as the insurance company]^[4] that she will have the income she needs for life, even after the market fell.

I also know people that have made a habit of buying put options every year to protect their portfolios. Their portfolios are worth close to what they were at the market top, and they didn’t lose ten years of their lives from the stress. Try telling them that it was too expensive…

So again, I ask, what is a guarantee worth?

Sources:

[1] Options Strategies: Protective Put, The Options Industrial Council

[2] Stop price, Wikipedia

[3] Long Derided, This Investment Now Looks Wise, Wall Street Journal

[4] Insurers Are Retooling Annuities, Wall Street Journal

Rule No. 1: Never Lose Money
Rule No. 2: Never Forget Rule #1

—Warren Buffet

If you have been around the investment industry much, you’ve probably heard that if you miss just a few of the best days it has a massive impact on your investment return. Back in January, Jason Zweig mentioned some updated research on this concept. Turns out that if you miss the 10 best days, only 10 days out of the last 109 years of trading, you wiped out 2/3 of the cumulative return of the Dow Jones.

The lesson has always been that since you don’t know the best 10 days, you have to stay fully invested so you don’t miss them. What stuck out in the Zweig article was the next line:

Conversely, had you sidestepped the market’s 10 worst days, you would have tripled the actual return of the Dow.

What?

I had never heard that side of the story! I wondered if it was just because I’ve always been a blind optimist, or if this other side is never talked about. Either way, the same conclusion has been made: since you never know when those bad days are coming, you should just stay fully invested. But I have been wondering if there isn’t another lesson here: losing money is far more painful [emotionally & financially] then making it.

Of course, there is no reliable way to completely sidestep the best or worst days, but there are ways to reduce your exposure to those “worst” days. You could lower your exposure to stocks. You could use some sort of insurance product. You could use a put option to protect your portfolio. I’m sure there are others. Traditionally, we have focused on the costs associated with a reduction of risk, but the last 12 months have helped many of us realize that the costs [emotional & financial] of unprotected equity exposure might far outweigh the benefits. It turns out that higher returns do not always lead to more money if it comes with greater risk.

This becomes even more obvious when you understand how hard it is to dig out from a major decline. Remember, if you are down 50% it takes a 100% return just to get even. There is a reason that never losing money is Mr. Buffet’s number one rule!

I want to be clear: I am not saying you should run out and buy insurance [for example]. I am saying that we have placed way too much emphasis on the return side of the equation and that if you are going to practice unprotected equity investing you need to better understand the risks!

The market is free, like sharks are fish.

Much of the investment advice given is based on the idea of free and efficient markets. But what if the markets are not really free? Can they still be efficient?

In other words:

Do markets have to be free to be efficient?

If markets are not free [I don't know any real person that believes they are right now] and therefore not efficient, should we be rethinking models that are built on those two assumptions?

Due to massive government intervention and outright fraud [some would argue that those are the same thing] there is no question we have something other then free markets. Every day there is some new allegation of insider trading, Goldman Sachs taking over the government, or a massive hedge fund stealing money.

I know the old saying that the last four words of any great investor are “this time it’s different,” but don’t you wonder what the impact of massive government intervention, fraud, globalism, and terrorism will have on the traditional buy and hold approach to investing?

I was a monk in the monastery of buy and hold investing, where you believe that the best you can do is buy a broad-based index and hold on through good times and bad. I always thought of it as an investment in the concept of free market capitalism. So asking these questions feels like I am changing religions, but it is almost impossible not to at least consider it. At this point, I have a duty to my clients to ask these questions.

So if traditional buy and hold investing is a bet on the concept of free market capitalism, what if the current version is not quite as free as the model assumed it would be?

In the past I have decided to have faith that we will work this one out, that somehow good people will make good decisions, and it will all work out. Is that what you have to have…faith?

If faith in the system is required, most real people seem to be losing faith…

I know that these recent posts have been short on solutions and long on questions. There is a reason for that: I use this blog as a forum to ask questions and generate discussion. I’ve had some great conversations here, on Twitter, and via email with many of you. I know that you are thinking about these issues as well, and it helps all of us to talk about it.

In terms of solutions, I have one that works for me and my clients, but arriving at it was a personal journey as are so many things. One thing I know for sure is that the journey is not over. Any really good advisor should never stop studying the landscape because it changes. So for now this is a place to discuss the landscape and not a place for defending maps that might be outdated.

Please let me know what is on your mind. As always, if you feel your question would be better handled in private, feel free to email me.

Normal distribution is an appropriate way to measure a natural phenomenon. For instance, let’s say we put 50,000 adult, American males in a football stadium. Using normal distribution, it would be appropriate to say that the height of those adult males would be distributed around 70 inches with a standard deviation of plus or minus two. Weight and height would be normally distributed, too, among the males in the stadium.

However, if we decided to measure wealth, and Bill Gates was in the stadium, it simply would not work to apply a normal distribution. It wouldn’t work to say he is an outlier. He would completely blow the distribution because he’s likely to have more wealth than everybody else in the stadium put together. So, normal distribution modeling or bell-shaped curves work for natural phenomenon. They do not work for economics, a man-made phenomenon and social science. It’s important to understand the distinction.

This analogy has its limitations. To be clear, I’m not saying that the efficient market theory is incorrect, that modern portfolio is dead, or that indexing/passive investing is the wrong way to invest.  I am simply saying that we should lean down to see for ourselves if the $20 is there. We ought to take the time, especially those of us that are managing money for other people.  We ought to take the time to question the underlying assumptions.  We must understand the underlying assumptions, then question and judge them against what really happened and make a decision for ourselves.

Those values were best uncovered by one simple discussion. I have used this discussion since the early days of my career and it happens in the first two minutes of the first meeting with a client-to-be. The very first thing we do is ask, “What’s important about money to you?” On more than one occasion, this question has caught clients off guard, but it is the most important thing that we do. Only by understanding what clients truly value can we then provide the framework for making smart decisions about money.

What might be important to one client may be completely unimportant to another. While it’s not our job to decide a clients’ values, it’s our job to understand them and help provide framework for making smart decisions about money within the context of what they view as important. In the end, we sometimes get so caught up in financial charts, the economy, diversification, and standard deviation we fail to stop and say, “What is this all for?” We need to put financial and investment decisions in the context of what clients feel is important.

Source:

[1] Values-Based Financial Planning: The Art of Creating and Inspiring Financial Strategy, Bill Bachrach

Why is that?

Part of the reason is that there is no name, industry, or designation for someone that provides ongoing financial advice. There are groups that do a great job, like NAPFA, fi360, and C.F.P Board, but there are plenty of great advisors that don’t belong to any of these groups.

For the most part, the Real Financial Planning industry is still secret. But it is crystal clear that people have had enough of the financial plan industry.

As the stock brokerage business and insurance sales industry started to decline, it started a race to become the primary advisor. Now even bank tellers have been trained to ask you about financial planning, with everyone trying to get to one place…the primary family advisor. I have been at industry conferences where selling plans was part of an overall strategy to gain an increasing “share of wallet.”

The result is predictable.

When you take salespeople and reward them for selling financial plans, they do it. All of this has created a focus on the product called a financial plan, at the expense of those of us engaged in the process of planning.

Putting a name on this process is challenging. I feel like I have had an identity crisis for a decade. I don’t know what to call myself. In fact, some of the best financial planners don’t even use the term “financial planning” to describe what they do. They have tried “advisor,” “wealth manager,” and even “family CFO.” These all get close, but putting a name on it is really tough.

It’s a bit like the Supreme Court’s original attempt to define obscenity. In 1964, Justice Potter Stewart said that he “would not today attempt to define it…” and then the famous quote:

But I know it when I see it.

People who have found a trusted family advisor that they are happy with will tell you that it is a great thing. It might sound old fashion, but they describe it by using words like trust. In the end, it is really about putting the interests of the client first, even (and especially) when it is in conflict with the advisors.

It is about being the kind of person that someone else would trust with her mother’s money…

So while it may be hard to define when it is done correctly, Real Financial Planning changes peoples lives.

Plans are of little importance, but planning is essential. — Winston Churchill

Plans are nothing; planning is everything. — Dwight D. Eisenhower

Everyone has a plan until they get punched in the face. –Mike Tyson

It is time that we recognize that Churchill and Eisenhower [and even Mike Tyson] were right.

We place way too much weight in plans; in fact, most plans are little more than guesses.

This applies to business plans and financial plans alike. The problem is that when you are making plans, someone has to be the assumer (sounds like some evil villain). And the assumer has to make some really important assumptions, forecasts or guesses—which will always be wrong.

You just don’t have the information that you need before the fact. This is true when you start a restaurant^[1], a business^[2], or when you are planning the rest of your financial life^[3].

Now here is the key: I did not say that financial planning is a joke. I did not say that financial planners are a joke. I said that plans are a joke. That is part of the reason that so many people have had such a bad experience with the financial plan industry. They end up with a two-inch-thick book that collects dust.

The game changer is when you understand that you need a planner, not a plan!

A planner that knows their value is in the ongoing advice they will provide as more information becomes available. The course corrections.

Sources:

[1] “My So-Called Business Plan,” The New York Times, Bruce Buschel

[2] “Let’s just call plans what they are: guesses,” Signal vs. Noise, Jason Fried

[3] “The Fallacy of Extrapolation,” The Tranquil Investor, Jack J. Calhoun