Paul Winkler: Welcome to “The Investor Coaching Show.” Paul Winkler here, talking money and investing because you don’t need to know everything, but certain things are really, really important.
I’m going to spend a little time on that just now. I think it’s really important to get into the types of things that I think you need to know. So let’s just walk through this.
What You Need to Know
When we look at the research on investors and investor returns, it’s pretty bad. The DALBAR company out of Boston actually does a lot of research on this. Morningstar does research on it.
A lot of different entities, such as universities, do research and have done research on investor returns. Investor returns and investment returns are two very, very different things.
So we look at investor returns and we go, “Wow, they’re a lot lower than what the investment vehicles are that we see people in.” It really comes down to how they’re utilized.
We were having a conversation about this, as a matter of fact, with some people this week, some people that helped me out with my website — the things that we put out there, the information we put out there, the blog, the radio show and things like that — and we were having this conversation where they said, “What’s your philosophy, Paul?”
And I said, “Well, I like to give away a lot of information.” And I give away a lot of information because number one, this stuff’s out there. You can go to university research sites and things like that and find a lot of the information that I’m teaching here.
But the reality of it is it’s not digestible.
A lot of it’s way too complicated and just confuses people, and confused people don’t do anything.
They just freeze, right?
So the idea is to give information out there, but partly because when somebody listens to how I teach and the things that I teach, they go, “You know what? That makes way more sense and not only that, but it lines up with how I believe.”
I had one guy actually put it this way. He said, “The day I heard you talking about how most people think that having to predict the future is what the financial person’s job is or the investor’s job is and it’s like looking in a crystal ball — that was the day I was convinced that this made sense to me.”
Also just if you look at how markets work and how investments work, it’s so logical that as time goes on, it starts to seep into you and you go, “This makes more sense than anything I’ve ever heard before.”
People respond. They buy my book. They come in for the meetings in our offices and things like that.
But I just want you to get what it is that you need to know. So I’m going to spend a little time on that.
Fight, Flight, Freeze
Why is it that investors get bad returns? I jokingly sometimes say to people, “You don’t know how many people that had $100,000 in the 1970s that aren’t sitting on 40, 50 million today.”
I do that, just kind of bait them because you look at markets, and a lot of different markets around the world have done that well or better over time. But most people haven’t gotten those returns.
It really comes down to our instincts and our emotions and how they play against us and cause us to do the wrong thing.
After I get scared, what do I do? I freeze. You look at how your brain works: fight, flight, freeze, right?
And what happens when markets are a little bit scary and things are a little bit weird out there? You’re hearing bad information. You’re hearing that things are kind of difficult out here. Maybe what’s happening in government is a little bit unnerving and upsetting.
I might choose flight. That might be what happens in that part of your brain. It’s either fight, flight or freeze — the emotional part of your brain.
That might be the first thing that happens is flight. I run to CDs. I run to things that I think are safe.
In reality, you look back at history and you say, “Well, gosh, that is one of the riskiest things when it comes to inflation,” because the dollar just keeps going down in value. It’s not really tied to anything and you think, well, that’s pretty precarious, don’t you think?
I mean, if the dollar isn’t actually tied to a gold standard, it’s not even tied to anything anymore. I’m putting all my trust that the dollar is going to hold value and it’s the very government that it’s backed by that I don’t trust. And you go, “Well, wait a minute. That doesn’t make any sense, does it?”
So number one, I might do that.
I might think I can fight and I go, “Well, you know what? The reality is I can’t fight. I’m too small to fight the system.” So that part of your brain that says fight, that’s not going to kick in.
Freeze is sticking the money in cash. Or I flee or run, and that’s another thing that I might do. I just might run.
Well, let me come back to freeze for a second because I need to build this up a little bit more because this is what a lot of people are doing. Freeze is where you just don’t do anything. I’m scared. I’m afraid I’m going to make a mistake.
So I don’t do anything until things look better. The problem with markets is, what happens? When everything looks better, markets will be way higher by that point and it’ll be too late for you to do anything.
Fear of the Future
So we got to get into what’s going on here. It really comes down to a seven-step cycle that we go through psychologically, and it starts with a fear of the future, which I’ve been just talking about. I’m afraid of what might be coming, what’s happening, how things are panning out around the world. I’m afraid of the wars and the governmental actions and things like that.
So when I have a fear of the future, what do I want to do? Well, it would be really nice if I could predict the future. That’d be really great.
If I could predict the future, then I could protect myself from whatever’s coming.
And you’ll see no end to the ads out there, the people, the talking heads telling you what’s going to happen in the future, where things are going, what you could do to protect yourself because maybe they’ll look at a pattern that has happened in the past and say, “Hey, this pattern has happened in the past and every time this happens.”
I’m thinking of a particular one that was talked about years ago, the Hindenburg Omen. The Hindenburg Omen basically said, “Not every time, but 70-something percent of the time, when this happens, this happens.” I did a video on it and I said, “This is just data mining,” and I ended up being completely right about it.
The person who said it and talked about it just didn’t talk about it anymore, and that’s how they do it. Now if the prediction doesn’t work out, just don’t talk about it anymore. Then nobody even thinks about the fact that you made that prediction. You were wrong and you can go on and make the next prediction.
So that’s one thing. We have that fear of the future. We try to predict the future.
Predicting the Future
Well, how do I predict the future? How do I know what is going to do well in the future? How do I figure this out?
Well, looking at the past too, maybe I don’t have that ability to predict the future. But I can look at the past and I can say, “Well, last time this happened, this is what ended up occurring after the fact.”
If we look at the person who figured out that real estate was going to go into a crash, then we can say, “Hey, what does that person think is going to happen this time?”
Or we can look at the person who predicted that we were having a tech bubble — that tech stocks were overvalued and they were poised to crash. And then of course, we also listen to the technical information coming out of these people and if they’re talking above our heads, then that’s a sign that they really know what they’re talking about.
There’s the Dunning-Kruger effect that I’ve talked about before, where people will talk above your head and fool you into thinking that they actually know more than they do. But that’s what people do. We find that people will try to impress you because they want you to think that they’re really, really smart.
Everybody wants to be thought of as being really well-engaged, well-informed and intelligent because we’re all about connection. We all want people to like us. So that’s why people will go out there and do that. But they’re also trying to sell things.
So this is what happens, what pulls people into this prediction about the future.
We look at past performance and we look for somebody that’s done well in the past.
But what do we know about how markets work? What do they do? They go up and they go down. So they go up and they go down and investment managers will do really, really well, and then all of a sudden they’ll go for a long dry spell.
So when we’re investing based on past performance, what is happening? We’re buying quite often high. We’re breaking a rule of investing — and more about that in a second.
Emotion-Based Decisions
So then what happens is that I look at past performance and I look for somebody and then I get overloaded with information. Everybody’s telling me about their track record and I get so overloaded that again, I get into that freeze mode where I don’t even know what to do. I just freeze up and I don’t do anything or maybe greed kicks in. So when I’m overloaded, emotions start to take over.
My emotions tell me that I need to act quickly or I’m going to miss out.
FOMO, fear of missing out. Or my emotions tell me, “Don’t do anything. Just stick it all under your mattress because you don’t trust anybody.”
Which, that’s often what people end up doing, especially during market downturns or when markets are a little bit iffy. They just kind of freeze and they stick things in something they think is safe.
And then another thing might be I just go, “I don’t know what to do. I don’t know who to trust,” and then blindly trust.
“So who are you working with?” They talk to a friend of theirs. “Hey, so who’s your financial advisor?” And the person says, “Oh, they’re really, really nice.”
Now do they have any way of knowing whether the advisor is doing what they ought to be doing? Not really. Typically not. They have no way of knowing.
There’s a question I ask them and I’m going to get into that in a second — the questions I think you ought to be able to answer and what some of the answers are.
But this is one of the questions: How do you really know things are going the way they ought to be going? Because what do markets do? They go up and they go down.
Just because something’s going up doesn’t mean everything is okay. The question is: Is it going up as much as it should be going up based on what’s happening? Just because it goes down doesn’t mean things are terrible because markets go up and they go down. So that’s not the issue.
So most of the time when you get a referral, let’s say, for somebody telling you, “Hey, go use my advisor,” they don’t have a clue.
And by the way, you can know. There is something that you can know and you can know whether things are going the way they ought to be going and I’ll talk about that more in just a second. So that’s another part of it.
So I make an emotion-based decision and I blindly trust because I don’t know what to look at. Or maybe inertia takes over and I don’t do anything because I’ve worked with this company for a long, long time and I’m loyal to a company that may be doing things that are just 180 degrees opposite of what I believe as far as how things should be done. But you don’t even know that that’s happening. More about that in a second as well.
These are the things that happen.
Breaking Rules of Investing
And then what ends up happening is the next step, which is I break the rules of investing now. So what are the rules of investing? Well, you’ve probably heard them since you were a kid.
Buy when prices are low. Sell high.
So after something does well and I go and buy it because it’s got a good track record, what am I doing? I’m buying after something’s done well or I’m buying high quite often and then all of a sudden it comes down and I go, “That was a terrible mistake.” Then I sell low and I’ve broken that rule of investing.
What’s another rule of investing? Diversify. Well, if I’m buying something that has done well and I’m buying this fund that’s done well and that fund that’s done well, then quite often what I end up doing is I end up buying a lot of funds that own the same stocks that happened to do well in the previous period in time — three, five and 10 years.
So I see people with portfolios and they go, “They got all the funds with the best 10-year track record.” And I look at it and go, “Yeah, and they all have the same stocks that just happened to have the best track record.” So you own the same stocks over and over again.
What rule of investing have I broken? Diversification. I have not diversified.
And then all of a sudden when that market crash comes or that area of the market that happened to have done best in the past 10 years comes crashing down, guess where you are?
Then you’re out of money and you’re going, “Well, I need to do something different.”
Well, it’s kind of too late to do that because you’ve already gone through the crash.
Do What’s Prudent
So many people did that with technology stocks.
I was on the radio going, until I was blue in the face, “You need to change. You need to change. When’s the best time to be prudent? When you figure out what prudent is.”
And for me to get people to actually make a decision and change things, it was like pulling teeth. It was really, really hard.
And then finally, 2004 was the best year in my initial years and all the initial years that I had running a business. That was my best year. But it was two years after the market upturn had happened before anybody really started to go, “Hey, maybe that Paul Winkler guy, maybe he knows what he’s talking about.” So it’s an area of frustration.
But it doesn’t have to be something that you do.
Once you know what prudent is, do it.
I mean, that’s just really what it gets down to. Once you’re convinced that there’s a more prudent way of doing things and that’s more what I’m going to be talking about.
Okay, so breaking the rules of investing. Buy bonds. What do I hold bonds for? They should be there for safety.
When I find out that my bonds are double B-rated bonds, they’re low-rated bonds and they have long durations — kind of think Silicon Valley Bank — then I recognize that maybe there’s a problem there. So the rules of investing get broken and then I end up with relative losses. You may not lose money. But you lose relatively to what you should have.
Back to the studies again of investors who have had lower returns — far lower than markets around the world — and they can’t figure out why. It’s because of this.
So there are questions that I think are absolutely critical for investors to get their minds wrapped around and I’m going to talk about those in just a second and get into a little bit of why these things are important. You don’t need to know everything.
But once you get your mind wrapped around just these basic questions, what ends up happening as an investor quite often is that you just go, “Hey, you know what? I’m more relaxed about this thing because I kind of get what I’m doing and why I’m doing it. I have an idea of what to expect.” And then all of a sudden you don’t worry about things as much.
So I think it’s really critical, and I’ll get into that more in just a second. What are the things that you need to get your head wrapped around?
So people go through this cycle around money. We’ve talked about it. Fear the future, want to predict the future. Look at past performance.
What’s Your Purpose?
You get overloaded with information. Everybody’s talking at you and you can’t hear a word they’re saying, and you go, “I don’t know who to listen to.” And that’s the reality of it.
What am I doing? Why am I doing this? How does this thing work? I don’t have to know everything, but then I don’t blindly trust anymore. I’m literally looking at things through the perspective of logic based on what I know to be true about investing and if it aligns with what I’m doing, way better.
We don’t want cognitive dissonance. Cognitive dissonance isn’t cool. Cognitive dissonance is where I believe something to be true, and I find out that I’m not doing what I believe to be true. I find out that somebody has put me in mutual funds based on their past performance, let’s say, or they put me in several different funds that had the same exact stocks in them.
And I look at the prospectus and I look at the turnover ratios, and I see there’s a lot of buying and selling going on. I know I should be buying and hanging on to things, but I find that the fund is changing stocks more often than some people change their underwear. I mean, that’s not good.
And then what happens is that’s when I get into a sense of unease — when I’m finding that I’m not doing what I know to be true. Okay.
So then I end up breaking the rules of investing. I’ve made an emotion-based decision. I’m getting performance losses. Then I end up back all over again in fear of the future.
So what are the things that people need to know? Well, number one, the first thing is I want to know what money is — what is the purpose that I use it for?
Money is just a tool to help you actually express what is valuable to you.
And so often people think it’s just more and more, more, more, more. And you could have millions and millions and millions of dollars and have absolutely no peace of mind around money because you don’t really know what its purpose is, except that just having more is better.
Once you really start to get focused on purpose, a lot of times you go, “Oh gosh, you know what? I don’t have this. I’ve got to keep getting and accumulating and accumulating more.” Because so often “more and more and more and more” thinking causes people to take risks and step out there and do things that are really imprudent.
I’ve known people who do that. They say, “I’m behind. I’m behind,” and they get into commodities training, they get into Forex training, they get into a lot of things that are just not good for them. And then what ends up happening is they end up with performance losses and they end up with not only just regular relative losses, but they lose money and lose their money altogether.
So first off get that down so you can kind of go, “Okay, what am I trying to accomplish here?” And it’s good for the financial advisor to know what’s really important to you as well so that they can give you better guidance.
Mental Biases and Blind Spots
What are the mental biases and blind spots that you’re likely going to face? For example, if I’m buying funds based on past performance or I’m buying things, looking at funds and going, “Well, that was really good,” recency bias is what we’re dealing with right there.
Or I’m looking around for information. I’m scared about what the market’s going to do, and then I’m looking around for information on what might happen next. If I have a bias and I think it’s going to go down, I’m going to look for any piece of information that’s scary, that’s negative to confirm what I actually believe is going to happen. That’s confirmation bias.
Then sometimes I’ll look for an expert. And there are biases regarding experts and people that I perceive to be experts. There are biases.
Sometimes it’s like, “I want to get the cheapest everything.”
And the reality of it is you don’t want to overpay for anything. But the very least expensive area of the market right now, as I speak, to manage large US growth stocks is actually selling for the highest price compared to earnings and book value.
So if you look at that and go, “Whoa, wait a minute, do I want to pay too much?” If you look at that and you go, “Well, I want to pay as little as I possibly can,” then you buy the thing that’s most expensive? You think about that. There’s a little cognitive dissonance for you.
So what are the mental biases and the blind spots? I only just gave a couple of them there.
But unless we know what might pull us the wrong direction, guess what? It’s going to pull us the wrong direction because we’re not even aware of it.
If you’re aware of the biases, then you have a fighting chance against them.
So that’s really, really important.
Investing in the Market
Now, another thing is, are you invested in the market? You might be able to answer that question fairly easily. “Yeah, I’m invested in the market, in stocks, bonds and fixed income investments,” but we’re mainly talking about stocks right here. Well, if I don’t know what I’m really invested in, I might be invested in markets that I shouldn’t be in.
But with markets in general, why do we invest in stocks? Because historically it has been the best protector against inflation because inflation is prices going up.
And you think about, well, prices of what? Well, prices of gas, prices of groceries, prices of home goods, prices of homes, prices of computers or whatever. Just name it.
Well, who sells all those things that I’m talking about? Who sells TVs and groceries and things that you use to build a home like lumber and flooring supplies and kitchen supplies and appliances and all of those things, and computers? Who sells that?
Well, you can name lots of companies, right? And those are the very entities that if you’re really well diversified, you own these companies. You own the companies that raise the prices so, hence, there’s the protection against inflation right there.
So being in the market is really important.
But then we want to look at some of the warning signs that we may not be managing money in an investing manner but more in a speculation manner.
I’m going to talk about that in just a second — talk about the three warning signs that I could be really speculating rather than investing.
So we’ve got this investor’s dilemma, this cycle that we go through where I fear the future, I want to predict the future and I look at the past to do it, which is a really bad way of doing things with markets.
It works maybe when you buy your car because cars that performed well in the past might perform well in the future or appliances or something like that, think consumer reports, but it doesn’t work really well with investing.
Because markets go up and down and something that has gone up, had good past performance then gone down is where you go, “Oops, that was a bad idea. That didn’t make a lot of sense.”
So what we do is we end up breaking those rules and we end up doing emotion-based investing. And then we end up with performance losses and it just keeps going around and around. How do we get out of that?
There are 20 things that I ask people and I go, “These are things that you need to know.” So these things, one of them is the warning signs. The three warning signs.
Stock Picking
Now when we invest, do we jump in, jump out, jump in, jump out? Not a really good idea. And this is what, if you look at how money is managed on Wall Street, this is what you see all the time.
Tune in to the TV programs. They’re telling you about this stock, that stock.
What are the hot stocks? What are the companies that are really going gangbusters right now and why? And what companies aren’t doing well and why they’re not doing well?
What areas of the market are poised to rally? What countries are really doing well? You’ll see them report on Bitcoin and you’ll see them report on gold.
You’ll see them report on X, Y, Z stock. You’ll see what’s going on in Britain, what’s happening in Germany, what’s happening in France, the United States. And they’re constantly getting you to move around and think about different areas. That’s market timing.
Now, with individual stocks, trying to figure out which companies are going to do better is stock picking. And the problem that you’re running into here is this: What does every company want?
They want to use your money as cheaply as they possibly can.
So if you’re going out there and looking at which stocks to buy and you’re going, “I think I want to buy this particular company,” you’re intuitively saying that you want that company. Your intuition is telling you that that company is going to go what? Up. It’s going to go up a lot more.
Which means that they’re going to pay a lot of money to use your money. And if you’re buying a company you think a lot of, you think that they’re really great, do you think for a second that they really want to pay a whole lot to use your money or more than they should to use your money?
That doesn’t even make sense. So what I’m doing is I’m thinking somehow I’m going to beat the man somehow. I’m going to get one over on somebody else and I’m going to buy that stock.
And what we don’t recognize is that the vast majority of stocks out there, when we look at the trading that’s taking place, it’s trading between institutional managers, huge fund managers and pension managers.
When I buy a stock, I’m buying it off of somebody that’s probably even better informed than I am. And when I’m selling it, I’m selling it to somebody that’s better informed than I am. So what happens is I’m thinking, “I’m going to get one over on them.”
Remember the whole GameStop thing? That was a smaller thing than the general market because it was this shorting activity.
Remember that these people got hammered. So many of them got hammered when that stock came crashing down because it really wasn’t worth what they were paying for it. But that’s a whole other story.
Looking at Past Performance
So what happens here is that we have these warning signs.
I am looking at past performance. I’m buying often high rather than what I should do is buy low or I’m stock picking and I’m trying to pick which companies are going to do best in the future.
The reality of it is that I have no idea which company is going to do better. Even the insiders in the company don’t know.
There was an Oslo Stock Exchange study where they knew that there was a lot of insider activity going on in this particular exchange. They actually did research on how the insiders did versus the market. And it wasn’t pretty for the insiders. So you go, “Gosh, how did the insiders…”
I mean I’m talking about CEOs of companies. Even the CEOs of companies don’t even know what their stock is going to do. And if they trade on information that’s private — personal, that’s not out there, information that’s not public — they can get in huge trouble.
So when you watch them do the regular trades that are legal and you look at how they do versus markets, the data’s not pretty for them. Let’s just put it that way.
And there are studies where they have stock trading platforms. Remember one platform, they were actually doing studies on the trades that their customers were doing. They shut down the study because of the returns.
Because if they’re doing really well, the traders on the platform think, “Hey look, you know how to use our platform. Look how well our traders do. People that use our platform, look how well they’re doing.”
Well, they shut down the study. Why? Because it wasn’t so pretty. It was awful.
So those are warning signs: stock picking, market timing and using past performance.
Academic Understanding and Investment Philosophy
Now another question is, do you have an academic understanding of how markets work? What I loved about academics — and this is why I was so attracted to it — is I wanted information about investing in markets that came from people that didn’t have a dog in the fight.
Because so early in my career, what I would do is I’d go to these conferences and this person would tell me how they manage money. This person would tell me how they manage money and this person would tell me how they chose stocks. And this one would tell me how they determine the asset allocation, how they would change it over time — tactical asset allocation. And my head would be swimming.
Then I discovered that there’s a whole different world of academics —- Nobel Prize-winning research on multifactor market efficiency and how markets price things, and I started getting into all that. I was like, Oh man, thankfully there’s somebody that isn’t out there. And then they would explain and they would get into Gordon Growth formula, and they would get into how all these markets work … cost of capital, dividend yields and all those types of things, where returns actually came from, etc.
And it made so much sense that I was able to just go, “Okay, this makes sense,” and I can hang my hat on it. So that was it.
There are pieces of academia that go against some of the things that I believe in. This is where choosing an investment philosophy comes in.
That’s the next question.
Markets work, markets fail. Now, quite frankly, I look at the research on the markets failing and the academics that have come out in favor of that, and I’ll say it is not wholly convincing evidence that they come out with.
Price-Earnings Ratios as Predictors
I mean, I’ll give you one example. There was research about price-earnings ratios — looking at price-earnings ratios to determine future returns of markets. There was a little bit of academic research, albeit not terribly convincing to me because I looked at it as data mining that showed that buying stocks with low prices compared to earnings gave us higher returns.
Well, in my first book, what I did — because it was prior to writing my first book that I actually saw that data — I decided to do a little bit of research and I went back a long way and looked at price-earnings ratios just to determine whether it was a predictor of future returns.
Now think of it this way. If I have a stock selling for $10 and they have $1 of earnings, it’s one divided by 10. That’s a 10% earnings yield. Okay?
Now if I have a stock selling for twice that $20 and I get $1 of earnings, it’s only a 5% earnings yield. So what would I expect? I would expect the stock with the one over 10 to have a higher return because it has a higher earnings yield. Now, I only know the earnings expectations in that PE ratio for one year.
The thing is, when I own a stock, I might be getting earnings for the next 20, 30 years or however long I own the company and however long the company is around. So what I did is I said, “Okay, so with low price to earnings ratios, is that a low price? Does that portend higher returns in the future?”
It should, right? Based on this research, it should tell me that I’m going to get higher returns. Well, what happened is I went, did the research and I said, “Okay, so low price to earnings should have high returns in the future, and high price to earnings should have low returns in the future.” Should be the opposite.
Did a chart on it. Looked like somebody took a shotgun and shot it at my chart. They were all over the place.
There was no correlation. There was no trend. I didn’t see a trend line and I should have seen very distinctly that high prices give me low returns in the future, low prices give me high returns in the future.
There should have been a pattern if that academic research was good.
So again, it was another confirmation of what I believe — that markets were pretty doggone efficient and that wasn’t a good predictor of future returns. Just one example.
Market Returns
Can you consistently and predictably achieve market returns? Most people don’t recognize what market returns are.
So this is partly how I look at my portfolio and know whether everything is going okay. I look at my large US stock portion of my portfolio, the part of my portfolio that’s investing in big US companies. Is it matching the returns and has it matched reliably year after year the return of the S&P 500? Has my value portfolio, my large value, been right in line and matching market returns for large US value stocks or the Russell 1000 value?
Is my small cap portion of the portfolio giving me the return of the Russell 2000 value for small value? International large Europe, Australia far east value? So we can look at each part of the portfolio and look to see whether that fund is matching the returns of that.
Well, why is that important? Well, it depends on the asset category, (it’s typically in the 90 range) but around a 90% range over 15 years, the asset manager fails to match market returns. So if I’m capturing market returns, that puts me in rarefied territories.
So that’s the thing that I’m looking at in my matching market returns. If I’m underperforming, there’s a problem and that’s how I determine whether everything is going the way it ought to be going. That’s how I determine whether my portfolio is actually working.
So when it comes to your portfolio, do you know exactly what you’re doing and why? That’s another question.
Do I know this at all times? Do I have a definite understanding of how I chose to have this much money in that asset category?
Now this is way deeper than I can go here, but this is something I think is really, really important. Having a model that I can work off of and know whether I’m doing what I ought to be doing based on my model and whether things are going the way they ought to be going is super, super important. Do I have a way of measuring my portfolio volatility?
People don’t realize how important volatility is. I can have two portfolios with the same exact expected return, and one portfolio, I can end up running it in the ground because I took too much risk. And if I can’t measure risk, I can’t control it.
That’s why volatility and knowing how to measure it is so important.
You cannot control that which you can’t measure.
So I’m going to talk a little bit more about some of the things that I think you need to know, but this is really critical as you get closer to retirement, having a method of measuring portfolio volatility.
Measuring Risk Tolerance
We’re walking through kind of the psychological cycle — I say I need to call it a psychological cycle — that we go through that causes us to fail as investors. A lot of it is emotions, instincts and just things that we have a hard time getting away from.
We have a hard time getting away from our humanness, is the way I like to put it. We are human. It’s like the old Kansas song, “Hopelessly Human.”
But how do we get around this? It’s certain things that I think that you need to know. You don’t have to know everything, but the right things are certainly important to know. What are the right things?
Well, knowing how to measure volatility, I’ve talked a little bit about that. Making sure we’re matching market returns, understanding a little bit about how markets work, understanding academic research and our biases, our psychological biases and things like that. That’s really important.
Knowing our risk tolerance is important.
I referred to that just a little bit before the break, just knowing how many ups and downs that I can take. Because when I’m taking income from a portfolio, if it is too volatile, I have to sell more shares when the market goes down, and then when the market recovers, I don’t own those shares anymore and then I can’t recover with them.
Understanding how to measure the risk tolerance and know exactly where I should be is important for an investor so that they’re not taking more risks than they really should be taking. You have risk tolerance, right? You talk about that and risk management.
It’s like, how much risk can I take though? It’s like tolerance. A lot of times it gets a bad name with me. And the reason being that I’m not tolerant of risk at all after a market downturn.
What capacity do I have to take risk is something I think is a little bit more important because I can teach people how markets work and get them to tolerate market downturns. If you don’t expect something, or you don’t know what to expect, when something goes outside your expectation, then that’s what throws you for a loop and it ends up causing you to make really bad decisions.
And it’s probably well beyond what I could talk about here, but there is a difference between risk capacity and risk tolerance. Okay. So, that’s one thing.
Other Important Things to Know
Measure the quality and the maturities of the fixed income in your portfolio. We think about what bonds are for; they’re for safety. But a lot of times we don’t recognize that we end up with these really high-risk bonds in our portfolio, and we don’t even know that until it’s too late, until those markets come crashing down.
So, that’s something that I look at. What are the maturities? Because we want to know how much interest rate risk we’re taking. If interest rates go up, bond prices can come crashing down at the worst times because markets can go down and interest rates go up, and then all of a sudden our bonds go down with our stocks.
But also, am I investing in bonds with companies? Have I lent money to companies that may actually have a hard time paying back money during economic hardships — which would be a lot of times when stocks are going down? When they can’t pay back? What are their obligations when stocks are going down and everything’s going down together?
Another thing is, do you know where you stand on Markowitz’s Efficient Frontier? Markowitz was this guy who won the Nobel Prize in 1990 for economics for how to put together a portfolio to maximize expected return for a given level of risk.
A lot of people don’t have a clue where they sit on that frontier. And if you don’t know where you are on that, how can you fix it?
Does your current investing approach include ongoing coaching? Here’s the reality of it. There was this person I was talking to and talking about a little bit earlier. We had this conversation.
He goes, “Yeah, you give away a lot of information.” I said, “Yeah, I give away a lot.” He said, “Why?”
I said, “Number one, so people have somebody who is constantly engaged in what’s going on in markets and reminding people of what we’re doing, why we’re doing it and making changes on a daily. You rebalance a portfolio on a daily basis, and it’s just not something that people are going to do, number one.”
But here’s the more important part about it.
Because of our instincts and our emotions and just how we approach money, so often it takes somebody outside of us to help us.
It’s like working out in a gym. I mean, it’s way more complicated than working out in a gym.
Some people can be super disciplined about working out without anybody coaching them or anything like that, but that’s a lot simpler. But still, a lot of people need a coach at the gym to get them to do what they know they should do.
Because it’s easy. Move more, eat less. Losing weight is fairly easy. Doing it is a whole different deal, right?
And have an algorithm and a tested process for rebalancing a portfolio. When we rebalance a portfolio, when we’re managing a portfolio, there’s a lot of research on what the most cost-effective ways of doing that are.
How do we reduce commissions in the portfolio? That’s another thing. Implications and applications and diversification. How do we diversify?
Do we have an investment policy statement? I almost never see somebody with a blueprint for their investment portfolio.
Now having a clear-cut method for measuring success, I already talked about that. Identify cultural messages. A lot of the messages and beliefs we have about money come from our parents, come from unhealthy sources, friends and family. These are the things I think you need to know.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
