DARE TO BE DULL

Peter Greenfinch's comment:

Allan Roth, in his contribution titled "Dare to be dull", shows a crucial side of applied psychology for investors, by stressing the danger of getting too excited, and of overtrading, when managing one's hard earned money.

The common sense lesson from Allan is that if you’re having too much fun or look too much for emotions, chances are that you are doing it wrong.

A notable contribution to the money management topic and the investor profiles topic.


"Dare to be dull"

by Allan S. Roth ,  WEALTH LOGIC, LLC, Colorado Springs (USA)

November 2006

Behavioral finance explains many errors we all make in believing that we are acting as logical beings attempting to maximize our wealth.   Many students of behavioral finance feel this combination of psychology and economics can be used to beat the market by taking advantage of investors’ mistakes.  I agree with this assertion in a theoretical world without costs and taxes.

"Active investing" & the mathematics of costs and taxes

In reality, there are management costs, trading costs, and taxes related to investing.  If one is to maximize returns using behavioral finance, one must beat the market by enough to overcome those costs and taxes.  Mental accounting may lead us to believe that we are doing this, but it is very unlikely mathematically.

Wealth Logic developed a Monte Carlo simulation model that compared a strategy of a relatively low cost (1.0% annually) active investing to an ultra low cost (0.25% annually).  When you add in trading costs (bid, ask, spreads) and tax inefficiency, you can see that there is over a 2% total differential between the two strategies.

Theoretical comparison of active portfolio with 1% annual fee to passive with 0.25% fee

Now even with the 2% differential shown on the left of the illustration, each active portfolio has a 42% chance of beating the low cost tax-efficient strategy for any one year.  Most active investors, however, use several money managers or mutual funds and the more they use and the longer they pursue this strategy, the worse the odds get.  For example, an investor in ten funds over 25 years has less than a 1% probability of beating the low cost tax-efficient strategy.

We tend to frame our returns in nominal terms even though it’s our REAL buying power that matters.  In the US, many experts are predicting long-run REAL returns of between 4 and 5 percent.  The average investor pays about 1.4% in fees and another 2% in taxes, which is even more than the chart above

Mental accounting: did you really win money in Las Vegas?

Thus, they will barely keep up with inflation.  Most will actually do far worse because they are likely to buy high and sell low as fear and greed cause them to do the wrong things.  Yet, by one survey, the average investor believes they beat the market by 3% annually because of mental accounting, proving that we are not very efficient learners.  I call this the Las Vegas effect because roughly two out of three people I ask who just got back from Las Vegas actually tell me they think they won at the tables.  Obviously, they didn’t build the casinos to give money away.

If you are investing directly in stocks, you can eliminate the fee and pay only trading costs and taxes.  I would caution, however, that you need a lot of money to eliminate non-systematic risk.  In addition, as noted by Brad Barber and Terrance Odean, the more you trade, the more likely you are to underperform.

 

 

 

 

 

 

 

 

 

 

 

 

Seems much smarter to miss the fun, using a ...dull strategy

A strategy to easily double ones REAL return is to buy ultra low cost and tax-efficient index funds or Exchange Traded Funds (ETFs).  By buying very broadly based funds, we can easily eliminate diversifiable risk.  By buying different asset classes like US stocks, non-US stocks, precious metals and mining stocks, REITs (real estate investment trusts), and bonds, we get asset classes that have lower correlations and, therefore, decrease risk.  By rebalancing those asset classes on a regular basis, we are again reducing risk.

The one key problem with this strategy is that it’s incredibly boring and dull, as it continues to mathematically guarantee beating the vast majority of investors.  Frankly, it makes for really bland cocktail party talk.  While rebalancing means you have to sell some of the hot asset classes and buy the ones that lost the most.  Behavioral finance shows most investors will be doing just the opposite.

So “Dare To Be Dull” essentially uses applied psychology to show investors that wealth maximization comes from the triumph of mathematics over emotion.  Its very dullness goes against all of our human instincts, and few will be daring enough to resist those instincts.  Resistance becomes especially daunting in light of the copious Wall Street marketing dollars spent to prey on, and exploit, our human emotions.

Though it’s emotionally unappealing, it results in doubling the real return over most investors.  Because of the power of compounding, that doubling of ones real return can easily result in achieving financial independence a decade or two earlier.

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