Our Wonderfully Modern Investor Brains

It has been decades since behavioral economics took hold as a science of investor actions. Designed to study the irrational decisions that we all are apparently hard-wired to make, the field grew into a respectable and well-quoted discipline. Which is fine. We know we have incredibly limited potential to redesign ourselves, despite the pushing and prodding in one direction, the look-in-the-mirror study of our own foibles and the instructions on how to improve this very human lot in life. But we muster on. And this is why, even despite the improved access to our 401(k) plans does our retirement still suffer.

Studies done quite recently suggested that most folks will simply accept the status quo if given a confusing situation. Investing is just such a case-study in chaos, less so for the experienced investor, but even for that group, a churning pool of information keeps them struggling to keep up. But the behavioralists  insisted that auto-enrollment in a retirement plan would create great strides for the plan and even greater rewards for those who may have - and still do have the option of - opting out.

Auto-enrollment we have found out is a trip through the wardrobe. We may all have taken the first step. But what awaits us on the other side, in almost every instance, is our irrational mind. And in almost every instance as well, a less-than-wonderful 401(k) plan. But more on the plan later. Let's just focus on what we have done recently as we embrace our biases, follow our illusions and believe in the fallacies.

There have been several alarms ringing on Wall Street and those who invest in mutual funds have turned a deaf ear. Herd mentality, the primitive instinct to follow the herd because doubt in the face of danger can present death was considered a valuable possession. Somewhere along the line though, things changed.

In our wonderful modern brains, this instinct has evolved into a trait, or so say the behavioralists, the makes us run towards the danger because everyone else is. What once once a survival instinct is now a suicidal tendency, at least in the world of investing. (Look at it this way: It would be similar to seeing a crash on the highway and deciding that driving your car into the pile would be in everyone's best interest, including your own.) Evidence of this is beginning to crop up and our big "modern" brains are at fault.

There are three types of mutual funds or mutual fund investment strategies that have shown a tendency to attract these kinds of investors: emerging markets, commodities and a category I'd be willing to wager you didn't realized existed, floating rate funds. (Amy Or of Marketwatch.com describes them as "Unlike fixed-rate loans, floating-rate loans can capture rising interest rates and are deemed a good inflation hedge" and with some uncertainty about when if sooner-not-later, interest rates begin to rise, these funds will be able to capture the change in market conditions.

Recent herd-like inflows of over $14B suggest that the usually high load fees and the underperformance of late matter little. It is where, these investors believe they should be. But because, as so often is the case with herds like this, so many have heard the siren's call, the opportunity to make any more moves to the upside have been hampered. That means a lot of people will eventually follow the herd off the cliff, ost of whom bought at the top.

When they aren't betting on debt, they are looking at commodities. These funds, focused on such tangibles as oil, silver and gold will to most of us, seem to be destined to go higher. And if you bought into this sector recently, you have  high hopes that it wasn't at the top. But silver suggested it was, as did oil, and the drop in prices found those same people scrambling to get out. Most bought in with expanded exposure in their supposedly well-balanced portfolios and are now paying the price for having believed that diversity was just another word for profit.

And emerging market investors are beginning to realize that perhaps they too have been failing to listen to the global heartbeat. Europe is not finished with its economic woes. Commodity prices may have fallen but they still remain uncomfortably high for countries looking to emerge and now, predictions of slowing growth at expanding powerhouses like China have begun to worry the savvy investor. You newbies are deeply embedded in the herd still.

You may have been auto-enrolled, but the walk through the wardrobe left you in the middle of the Serengeti. And you probably won't get the memo that you are in danger until it is too late. This thinking about getting you in, attempting to educate you, guide you, slip you into an ill-suited target date fund came by way of Thaler and Sunstein's book called Nudge: Improving Decisions About Health, Wealth and Happiness. In is not the same as knowing what to do or how to act when you arrive. The information tsunami hasn't lessened and may have even gained strength over the last several years and investors, particularly the neophytes, will still drown before they learn to swim.

How running with the herd once saved you only to become the complete opposite will remain a mystery. And getting people into these plans by using science to study our unpredictable-ness is still a good idea, even if it seems suspect. But once there, the status quo is good. But who says what the status quo is? You may never get a clear bead on the answer,  Until you realize the herd is leaving the room.

Notes on Investing: Baruch and Lessons Learned, Part three

In part one of this review on one of the greatest investors, Bernard Baruch, titled “Notes on Investing: Baruch and Lessons Learned“, we looked at what he has learned from his own mistakes, errors that we all make and of which numerous books have been written in anattempt to correct our own investor and totally human fallibilities on the subject. In part two, we looked at, among other things, the art of investing and getting a good night’s sleep.

• I can’t tell you how many times I get told that having several projects in the works is multi-tasking. It is not and Baruch more or less felt the same way about what and how to focus. His belief that traders tried to be too many different things at once, concentrate on too many things at the same time and in the end try and parse all of that information in something worth investing in, something profitable, was futile. If you are going to be an investor, you will need to, in his opinion do “one thing at a time, perfect it, and do it well.”
• In the days before behavioral finance took hold, in the days before efficient markets were thought to exist, value investors were trying to teach people how to invest.  They knew that that more you knew about the business you invested in, the better your understanding of the risks such an investment posed. To incur a loss in Baruch’s experiences as well as from what he witnessed in his cohorts, suggested that “they [knew] too little about the company’s management, earnings, prospects, and possibility for future growth.”  And Baruch, also guilty in the early days of investment career, fell into the same trap as many investor still do today.  ”They tend to trade beyond their financial capital capacity.”
• Baruch also knew that companies were dynamic entities and need to change over time to survive. It was how they changed that matter. “Successful speculation requires staying on top of changes in industries and companies that either create new industries or improve on existing industries.” These improvements needed to come with some chance of success. Unlike the speculation during the Internet bubble, where products were scarce and promises of profits abundant, the businesses you invest in need to have something tangible in place before they start exporting the next new thing. He believed that “The majority of your profits will come from these two…..The shrewdest traders throughout history all adapted the skill of reactionary change, as the market constantly presents new and different opportunities.”
• In recent years, the study of our emotional involvement has taken over for some previous thoughts on how we trade. And Baruch recognized these flaws early on, was able to tamp down his demons and become successful. It is no easy feat. He remarked, almost in passing: “Without control over your emotions, there is very little chance for profitable success in the stock market.”
• In the current atmosphere of the media and what seems to be instantaneous reactions to every detail of news, one thing has never changed. In the discussion about which wags the dog, it is not the markets that do the damage, but the reaction to the economic factors at play. “The market,” he suggested,  ”does not cause economic cycles but merely reflects them and the judgments of what traders believe business and the future will be like.”
• He believed in buy low sell high but also believed that no one could actually do it. “I made my money by selling too soon.” Market axioms aside, timing is not possible.
• perhaps one of his greatest observations of investor foibles involved when and why investors bought and sold. “It is much harder to sell stocks correctly than to buy them correctly.” Further suggesting, quite possibly from his park bench view of the world going past, that a “stock went up, the average investor would hold because he wants more gains – he’s exhibiting greed. If the stock declines, he also holds on and hopes the stock will come back so he can at least sell and break even – he’s hoping against hope.”
• Sitting, staring a a screen while you invest doesn’t make someone who loses any less a liar. What it does do is completely removes the blame from being laid at the feet of someone else. You invest and if you don’t do well, you have no one to blame. “Whatever failures I have known, whatever errors I have committed, whatever follies I have witnessed in private and public life have been the consequence of action without thought.”
• Baruch did not think that anyone was capable of predicting. But we do and we listen to folks who suggest that one this news or that, the market will go higher. They don’t know. You don’t know. To which he suggested that “Every man has a right to his opinion, but no man has a right to be wrong in his facts.”
• Once agin, Baruch is right on this point. But this is no easy task and I wonder if this is what Ben Graham meant when he said that there isn’t an investor in all of us, only in some of us. Baruch pointed out that the key to successful investing hinged on control: “Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions, and prejudices so you can separate them from what you see.”
• Baruch was haunted by his mistakes and took numerous hours to reflect on those missteps. We, on the other hand, beleiev we should stay in the game, or get back on the horse. Baruch knew that only by going on a sort of self-induced recess would he be able to understand where he’d been, the wrong turn he’d made and why he did what he did. Do you do the same? Are you willing to take money off the table to reflect on how well you did – or didn’t? If you knew, as Baruch knew all too well that “The main purpose of the stock market is to make fools of as many men as possible”, why would continue to fight a force that only thoughtful reflection and recollection will help you overcome?

Successful investing is a fleeting, almost elusive thing. Seems as though there are millions of books and websites offering something, some rope to grasp, when it comes to investing. I even offer a few of my own. In the end, it will come down to how well you do and recognizing that if you don’t do well, you should push yourself away from the table. Investing is not for all of us. And at the same time, it is. We still need to invest for retirement. But using individual stocks is not the way most of us should pursue it.

Paul Petillo is the Managing Editor of Target2025.com/BlueCollarDollar.com

Retirement Planning: Are You Acting on Your Own?

Your ability to make the choice of which investment to purchase depends on who you listen to. You may think you are an independent thinker, willing and able to parse all information available to you in a way that complies with who you think you are. But psychological experiments prove otherwise. Faced with which investment in your 401(k) portfolio (we'll use this tax-deferred retirement account in part because most of us have access to them and only some of use them well) you will invest in what someone else has told you to invest in.

You may think you are acting independently. But experiments have shown that you will act against your own morals or perhaps better judgement) in many instances. Consider this: if you are a long-time reader of what I have written over the years, you have grown to disdain annuities and repel target date funds.

You know that I think annuities are a product that costs too much and despite the peace of mind it might offer you and yours, you could do better on your own in something just as conservative without involving an insurance company.

You know that I am not a fan of target date funds in part because they are not all created equally, do not have a good track record that suggests they can do as advertised and if they fail to do as advertised, you might have missed a decade or two of substantial portfolio gains because of it.

So as a non-fan of those two products (there are others but for the sake of this discussion, we'll keep to products you are most likely to confront at some point in your financial lives - target date funds in your 401(k) and annuities at the end of your career), you might think twice about what these offer and if they will do what they suggest they will or I have claimed they might.

Yale University psychologist Stanley Milgram measured the willingness of study participants to obey an authority figure who instructed them to perform acts that conflicted with their personal conscience. While some of his experiments seemed somewhat abusive, they drove home the point that once confronted by the voice of authority, you will not follow what you know is right.

Consider the Halloween experiment for a moment. A trick-or-treater is told by the person answering the door to take one piece of candy and after instructing them of that, leaves the room. 34% took more than one. But put a mirror with the candy and the number of children who took more than one piece despite being directed not to, dropped to 12%.

We are subject to influences even if the person who is influencing us is the person in the cubicle next door or the neighbor across the street. You have no idea whether either of these tow people are lying when they reveal their investment secrets - and most people understanding that fact do in part because there is no moral obligation to tell the whole truth (which might be that they have a great 401(k) balance but huge credit obligations). They speak with authority and looking for guidance, we gravitate towards their expertise.

Your level of intelligence has little to do with it. So what do you do knowing that you are susceptible to suggestions that may go against what you know might the opposite of what you think you stand for? Professor Milgram suggests the following (from Wikipedia):

The first is the theory of conformism, based on Solomon Asch conformity experiments, describing the fundamental relationship between the group of reference and the individual person. A subject who has neither ability nor expertise to make decisions, especially in a crisis, will leave decision making to the group and its hierarchy. The group is the person's behavioral model.
The second is the agentic state theory, wherein, per Milgram, "the essence of obedience consists in the fact that a person comes to view himself as the instrument for carrying out another person's wishes, and he therefore no longer sees himself as responsible for his actions. Once this critical shift of viewpoint has occurred in the person, all of the essential features of obedience follow".

Here is the difference between authoritarian expertise and common sense. If you are told by someone that such-and-such an investment is a good choice, that they have it and have been thrilled by the performance, their authoritarian tone will suggest that you need to do very little research because they have and they have given it their stamp of approval. You have absolutely no idea whether they are going to sell it tomorrow because whatever the investment was, it has run its course. And they have no obligation to tell you.

If a mutual fund suggests that it has a trillion dollars worth of investor dollars under its management, the perception is that there are a lot of people who trust the managers authority to do the right thing. But suppose that money - which we always think does the right thing even if the sell on the downside and buy on the upside - is doing only what the previous person has done. Think Ponzi. Think Madoff.

So what do you do? The morally correct choice is relatively simple when it comes to investments for retirement. You will one day retire and that means you are dreaming of a day when you will no longer work. You may live 20-30 years after that moment and you will need to finance that time. You will need to explore how you will spend that time and how you will pay for it.

You will need to put money away. I can say that you need to contribute the maximum amount the law allows to that 401(k) account, but you won't. You will feel bad because you haven't and in many cases simply work longer to make up the shortfall. But you know you need to invest more than you are.

Is Knowing How Much Important to Your Retirement Plan?

It no longer is how much you have.  Now it is whether what you have will be enough.  From the age of accumulation, the twenty or so years prior to this, when growth was rampant, portfolio values seem to take on an endles stream of gains, and the opportunity to retire seemed within everyone's grasp, we now have the age of decumulation.  This newer word in the retirement planning world applies to the simplest of concepts: how much will I need each month.

Decumulation, as described in a recent New York Times article by Jennifer Saranow Schultz, is the ability to pay for a "similar quality of life, keeping financial autonomy, leaving money to children, philanthropy, hanging on to money to cover health expenses or a combination of these options or others". It's not that we weren't focused on those things before, running simple calculations in our heads and using online calculators.  But with so many of us seeing portfolio declines that we hadn't expected, and entertaining the possibility that we would see them again, possibly at the very moment we retired, knowing exactly what we could expect has suddenly popped to the front and center of every discussion.

There is much more to consider than in the previous decades.  Without ever swelling balances, the predictions of what may happen have become much more difficult.  News reports suggesting that we will live longer, that the cost of health care in retirement will eat away at those balances, and the potential of declining cognitive abilities all need to be considered -even if we can't put a price tag on any of them.  Simply suggesting that we will work longer or even work in retirement if needed do not satisfy the question of decumulation with any accuracy.

Does that mean we will all need an annuity?  According to Eric Johnson, a professor of marketing at Columbia Business School, annuities are still a hard sell to retirees who do o=not want to hand over a huge chunk of their retirement portfolio to one firm in exchange for a steady check.  If their annuity is to cover your spouse in any way, the cost goes up while the monthly payout goes down.

What do we know about annuities aside from the hybrid investment, part-insurance, part mutual fund aspect of the purchase?  There is also the actuarial element - how long you will live is calculated into the payout and if you include your wife, with her potential to live longer than the husband, the payout drops even further.

There is a behavioral aspect to the purchase of an annuity, most often bought at retirement when the defined contribution plan pay the retiree in a lump sum.  What many economists who study this event have found is not really surprising.  People make their decision of whether to buy or not using the last six months of the stock market as their best indicator.

The mention of cognitive decline also worries financial professionals and the government as well.  The older you get, the less likely you will be able to make the right decisions with whatever remaining wealth you might have. This sort of problem can occur only ten-years after retirement and with anyone overseeing the decisions - which get more complicated - there is good chance that the wrong one will be made.

Annuities are a hard sell based on what experts call mental accounting.Once you begin thinking in terms of different baskets for your money, spending what is needed often becomes a question of selling more investments than might be prudent.  Your retirement budget will change with time.  Studies have begun to suggest that in the first years, liesure spending will be far higher than it willbe just ten-years after you retire.  Annuities don't address this, often giving retirees too little money in the beginning and too much when they don't often have the ability to spend it.

Some believe that a self-examination of what you see in the future - based on who and what you are now - might be helpful.  Others disagree suggesting that if that were the case, and everything about the future seems to be not-so-bright, retirees might take an opposite stance and spend it now.

The best solution, which seems to be gaining ground it building the purchase of annuity right into the person's 401(k) plan.  This would allow them to see exactly how much they would get if they retired.  This would induce them to invest more, learn to budget now and possibly enter into retirement with fewer financial burdens. It would also benefit women who retire allowing them to get a clearer picture of what they will get based on what they have invested for the future.