The Compounding Effect Of Fear

 

During British colonial rule in India, the government began to worry about the number of deaths caused by wild animals and in particular, venomous snakes. The government of the day decided to solve the problem by offering a reward for every cobra brought in to be killed.

Indian citizens didn’t take long to take advantage of the system and began breeding cobras. By the time the incentive was withdrawn, there were more cobras than at the start.

 

WHAT IS FEARED BECOMES THE FOCUS, AND THEN OFTEN THE OUTCOME

The Great Depression was a traumatic time and left a lasting impact on many who lived through it. Understandably, they feared ever having to live like that again.

These people, nowadays mostly over 70 years old, have always been extremely frugal in their spending and conservative in their investing. Even those who are in their 80’s and have more capital, remain frugal – keeping their money “for a rainy day”.

The irony is that by so badly wanting to avoid losing money, they have consistently worried about it and by being so frugal and conservative, lived materially inferior lives (compared to what they could have lived).

 

PREVENTING FEAR BECOMING REALITY

So how do you prevent being the cause of your fear becoming your reality?

The British in India should probably have just accepted that cobras were a potential risk but statistically, not a very big one. Understanding more about cobra’s habits and the circumstances under which they became more dangerous would have reduced their anxiety – as education always does. And lastly, having a medical emergency plan to deal with bites.

Human beings are almost hardwired by the time they reach adulthood. It becomes very difficult to change, even when the desire is strong. Money, and their relationship with money, largely exacerbates this hard-wiring, especially when emotions are piqued.

A drop in the value of assets, and the corresponding emotional stress that is triggered is just such a time. For some investors during this time, they lose control in their panic to protect their lifestyle, and by their actions, they create their nightmare.

 

THE MORE LIKELY AN EMOTIONAL REACTION, THE MORE NECESSARY A PLAN OF ACTION

Just like the British, investors who are susceptible to these types of emotional responses, should first, accept the fact that prices will fluctuate, then gain more understanding about how often it happens, how long it takes to recover, how to reduce the impact, and finally, have a plan to deal with an emergency, no matter how remote.

The answer is not to pretend the fear doesn’t exist or that’s it’s totally unreasonable. Either would result in more anxiety and ultimately, worse decisions. It’s preferable to accept the concern and treat it with ‘respect’. But at the same time, it’s useful to keep it in perspective. There are no absolute guarantees, but gaining a realistic understanding of the probabilities and mapping out a worst-case scenario goes a long way to remove the possibility of poor decisions.

I have personally found that when I stopped killing spiders and bugs, I began to fear them less. We fear what we don’t understand.

 

Every Asset Needs a Purpose

I have a friend who is a very good golfer and at one time was the distribution manager for McGregor golf equipment. He absolutely loved the game and golf equipment, and we had a lot of fun as golf partners.

After going to a golf equipment convention in the USA, he came back with the option to take up a Mizuno agency. He was really keen to do it and convinced me that there was a gap in the market. His plan was that I should invest the capital for the stock, and we set up a business distributing Mizuno golf equipment.

The business struggled from day one and we persuaded ourselves that it was just teething problems. At one point I invested further as we changed strategy.

It took a while for me to be honest with myself, but when I finally did, I realised that the truth was that I was supporting a friend and trying to make a business out of a hobby. These conflicted and confusing objectives were costly.

 

It’s easy to confuse the purpose of assets
“In any If you don’t know the purpose of an asset, you can’t determine its required return and therefore the most appropriate and optimal strategies. It’s easy to get confused. As every asset or venture requires money, whether it satisfies an emotional purpose or not, the investor would ideally like at least a return of that money.

Psychologically, it’s very difficult to accept a loss in return for satisfying an emotion. It is equally difficult to accept an inferior return – so it’s often justified as something else.

Every asset should have a purpose, and the owner should know and understand its purpose. It’s okay to make a choice where a financial return is forfeited for a return in some other way. It’s not okay to have an expectation of a good financial return, as well as satisfy emotional needs.

 

Four broad categories
There are four broad categories of assets: lifestyle assets, investment assets, speculative assets, and business assets.  The simplest test of whether an asset is for lifestyle is whether the owner would dispose of it for an alternative if a better return was available. Few people would dispose of their homes to invest for a better return. A boat, car and farm land often fit into the same category.

Investment assets are assets from which market returns are expected. The decision is usually a probability-based one and the benchmark is the market index.

A speculative asset purchase is one based on an opinion rather than probabilities. There is an extra layer of risk, and a return over the market is required.

Business assets have additional layers of risk and cost and therefore need additional reward. Besides the high risk of failure (statistics show that only 33 per cent of businesses survive 10 years) but also time and concentration risk, they therefore need a return above speculative assets.

 

Leads to unnecessary losses
Confusion is common and costly. For example, a business that’s actually a job – often small professional services ‘businesses’ have no value without the partners. The partners convince themselves that it’s a business with value. For example, an interior design business owned by one person that employs two. The owner charges fees based on time or project. It’s a job.

An investment property that is actually a lifestyle asset. I recently had a client who owns two apartments that are generating a very low yield. The justification given is that eventually each of the children will take over as the primary residences. So they are actually lifestyle assets.

A business and investment that’s actually lifestyle. Picture an aircraft business with commercial land that can’t be developed, and a manager who is a close family friend. The business isn’t making money and requires regular injections of capital. It’s a lifestyle asset.

 

A lack of clarity results in waste and unnecessary anxiety: trying to save face, a breakdown in relationships, and the loss of money are just some.

The second tranche of capital that I invested in the golf business was really to save face, and a friendship. In the end, I couldn’t save face and the friendship was damaged, as neither of us were happy when I ended the adventure. Understanding the type of asset I was investing in, from the beginning, would have avoided all the subsequent hard lessons learned.

 

Rules of Thumb are Sometimes Dumb

Justin Hooper conveys ‘the importance of personalising rules of thumb’

I was reading an article this week about how much retirees need relative to their previous earnings. According to the article, the right amount is 70-80% of pre-retirement income. It’s not the first time this number has been used – but is it correct, and where does it come from?

In my experience and the reading I’ve done, the estimated range is enormous. In one research report I read, respondents were asked to outline the lives they wanted in retirement irrespective of what they were earning. Turned out that on average they needed 130% of pre-retirement income. I suspect that the rule of thumb on how much one needs in retirement has come from how much most people have accumulated, not what kind of lives they really want.

Often, the conventional wisdom creates an incorrect target and ironically then becomes reality which reinforces the rule. It got me thinking about “rules of thumb” — which ones are valid, how to use them, and some that I have created.

Rules of thumb are meant to be broadly applicable, but when handed down as the wisdom of elders they can be very dangerous.

Don’t  just accept them
At a Christmas lunch one year, a young girl asked her mother why she cut the ends off the pork roll before putting it in the oven.

“That’s what my mother taught me to do,” mum said. “She’s here, so let’s go and ask her.”

“When I got married, we didn’t have much money and I had to use the same pan for everything,” grandma explained. “The pork roll was too big for my pan so I cut the ends off it.”

Rules of thumb emanate from the practical insights of others. Most (particularly older) people will have developed some during their lives and many are adopted from parents. They’re supposed to provide guidance; they’re not based on scientific study. They’re applicable broadly and can be useful, but there are always exceptions.

Hard to ignore when expounded by an ‘expert’
At one time in my career, I worked alongside an adviser who was previously an actuary. In my mind, my actuarial colleague had an aura of authority about him which meant that his rules of thumb were accepted without question – for a while. One of them was how much insurance people needed.

“Thirteen times their annual expenses,” he said. It took me a while to challenge this and when I did, I found very little substance behind the rule.

At another time in my career I briefly worked for a company who had as one of its directors a big finance media personality. The rules of thumb he expounded around retirement were also wrong (in my view, anyway). Retire at 55 and you need 17 times your annual expenditure, 15 times at 60 and 13 times at 65.

For these to be accurate, you would need to assume that you definitely don’t live beyond your life expectancy and the returns on your portfolio are better than average over your particular time horizon. And that’s another one that’s dangerous – planning to your life expectancy. There’s a 50% chance of living beyond your life expectancy, so planning cash flow to then has a 50% chance of failing

Question the rules
Rules of thumb cannot be implemented without question. Here are some that are worthwhile but nonetheless have flaws.

  • The 10% rule: Always save 10% of your salary. Doesn’t take into account when you started, what return you will get, and what kind of life you want at the end.
  • The 50/30/20 rule: 50% of your income goes to necessities, 30% to financial goals and 20% to choices. Depends on your stage of life. The ratios need to be adapted to different stages of life.
  • The 20/4/10 rule: When buying a vehicle, put down 20% as a deposit, pay it off in 4 years and don’t spend more than 10% on transportation costs. Don’t buy a vehicle you have to finance.
  • The 20% rule: ‘Put down a minimum of 20% as a deposit on a home’. Depends on your income relative to the cost of the home.
  • The Six-Month Emergency Fund Rule: ‘Have at least six times your monthly expenses in an emergency fund’
  • The amount of life insurance you need is five times your annual salary. Depends on the level of other assets and income.
  •  ‘100 less your age is the percentage of shares you should have in your portfolio.’ Depends on total assets relative to income required and emotional risk profile.
  • Here’s one that people in other countries apply and Sydneysiders will laugh at: “The cost of your home should be no more than 2.5 times annual income.” 

My  rules of thumb
I’ve come up with a couple of my own that I use daily.

  • How much is enough? 20 times your annual expenditure, (assuming you have a maximum 35-year time horizon). Another way of looking at this is double your lifestyle assets — you need twice as much in investments as the value of your home.
  • Changing home. Every time you sell your home and buy another, it costs one year of work. Here’s my theory – the costs of selling a home are 4% stamp duty plus around 2% commission to the agent – all after tax. That’s equivalent to around 10% pre-tax, and for most people, their annual income is around 10% of the value of their home.

Personalise rules of thumb to make them useful
The value in having rules of thumb is that they provide a benchmark that’s easy to remember. And there’s no doubt that having a benchmark influences behaviour. At the same time, for it to be believable, it needs to be personalised. Take the basic rule and tweak it to suit your purposes. Then apply it.

 

The Science & Art of Investing

Sending a man-made satellite to the sun is far more predictable than investing.  The uncertainty brought about by the behaviour of investors makes investment outcomes imprecise but not necessarily less successful.

 

In May last year I was lucky to visit NASA in Silicon Valley, so I was particularly interested to see the details of its latest mission to the sun. Called the Parker Solar probe, it will take just under seven years to complete 24 orbits of the sun, reaching speeds of 700,000kph. It will need to be able to withstand temperatures more than 1300 degrees Celsius as it goes as close as 6.1 million kilometres from the sun’s surface — and its navigational instruments will use Venus to adjust its course and slow down.

I understand that at the end of the day, it’s all calculations. But it’s pretty impressive how the scientists can plan a venture like this to such precision.

Investing is also full of numbers, so one would think it should be at least as precise.  
Of course it’s not – if it were, everyone would make a fortune. The difference, of course, is significant. Investing is not a science; it’s a combination of science and art. Investing is more economics than physics, and economics is as much art as it is science because there is so much human behaviour in economics. Instruments of economics are never totally predictable – because human behaviour isn’t predictable.

The data is not always helpful
We have access to more information these days than ever but that doesn’t mean that we either understand it or can make sense of it. Sometimes, too much information is the same as no information.

Financial engineers are analysing the data extensively and ‘discovering’ risk factors that go a long way to explain returns. We are definitely more educated around how markets work and the relationship between various factors, but the data can also be manipulated to draw biased conclusions. As the saying goes: “If the data is interrogated hard enough, it will tell you what you want to know.

“A wealth of information creates a poverty of attention”
Even though we have internet search engines like Google, it’s still a struggle to find what you want.

Investment markets are based on the fundamental premise that the market participants care about the price. The ‘Efficient Market Hypothesis’ then argues that markets are considered ‘efficient’ if all available information is ‘in the price’. In other words, all market participants have access to all available information about the security, and they have considered it before determining their view of the price.
I wonder whether for the first time in history, a significant portion of market participants don’t care about the price. There is an unprecedented flow of funds into index funds and neither the investor nor the manager of index funds pays any attention to the price of the securities within the fund.

Intelligence and rationality aren’t necessarily linked…

Sir Isaac Newton, an English mathematician, astronomer, theologian, author and physicist not only identified an investment bubble after making money out of it, but managed to get out of it early enough to secure his profit.

However, after the price kept rising irrationally, he couldn’t help himself and got back in at three times what he had originally paid, only to lose it all and go bankrupt. He summed up his experience with, “I can calculate the movement of stars, but not the madness of men.

 

First, avoid bad decisions

Investing is not only about making money – it’s also about avoiding losing money.

Confidence is not always a good thing

Being confident is regarded as an admirable trait, but there are times when confidence can be bad for achieving outcomes.

We need to change how we give

Charitable giving isn’t just for times of disaster — families can form a plan that makes charitable giving possible on a regular basis, which has a great many benefits, for the family, and the community.

There’s a danger lurking in the royal commission

Legislation won’t prevent misconduct — only individuals paying attention and taking responsibility can prevent scandals.

Analysis: Short-term returns don’t come from a magic potion

Making decisions on a long-term investment — like your superannuation — should be made with long-term analysis.