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You, the Capital Markets and Your Brexit Fears

One of our responsibilities as a financial adviser is to help put market news in its proper perspective, especially when the media is reporting particularly steep, UK market declines like we’ve seen during the past few days.

If you are okay with ignoring the current headlines and going about your business according to the investment portfolio recommended to you, feel free to continue as you were. Unless you would like to revisit your own risk tolerances or individual financial goals.

If, on the other hand, you are wondering whether you should adjust your investments in light of the unknown Brexit implications, we’d like to offer some context on why withstanding today’s bad market news can actually translate into good news for you and your investments, at least in the long run.

Remember those other articles we have published about your willingness, ability and need to tolerate market risks in pursuit of expected rewards? This week’s market performance serves as an excellent illustration of just what that risk feels like when it happens. It hurts, it can be scary and it’s not any fun at all. But if these sorts of realized risks never occurred, sometimes severely, the market could not be expected to deliver long-term premium returns to those who are willing to ride out the pain.

And yet, withstand the risk we must do – together – because it’s exactly this type of market risk that you have deliberately built into your portfolio, and globally diversified among stocks and bonds alike, in pursuit of achieving the expected returns defined within your investment portfolio.

While we don’t let breaking financial and economic news overly influence our long-term advice, we do find the information fascinating. It also continues to contribute to our ongoing understanding of how markets operate over time.

By ignoring current headlines and the temptation to react to the bad news with active trades you will find that:

  1. By the time you’re aware of good or bad news, the rest of the market knows it too, and already has incorporated it into existing prices.
  2. It’s unexpected news that alters future pricing, and by definition, the unexpected is impossible to predict.
  3. Any trades, whether they work or not, cost real money.

Rather than try to play an expensive game based on information over which we have little control, we continue to focus on investing according to market factors that we can expect to control, such as:

  1. Minimizing costs
  2. Forming an investment plan to guide your way – and sticking with that plan
  3. Capturing returns available by participating in expected long-term market growth
  4. Maintaining diversified holdings to dampen market risks

In short, if current news is getting you down, let us know. We’ll be happy to talk over the particulars with you and answer any questions you may have. Remember, stick to your long-range plans – or work with us to deliberately revisit them if those plans no longer meet your personal goals.

Our Mixed Up, Messed Up Relationship with Investment Risk

“What the imagination can’t conjure, reality delivers with a shrug.”

– Trumbo (movie voice-over)

Whether it’s the recent destruction wrought by Canada’s Fort McMurray oil sands wildfire, a potential June “Brexit” from the European Union, or uncertainty surrounding this year’s US presidential election, there is plenty of risk to go around as we swing into another busy summer.

Is investing riskier than usual these days? In our experience, probably not. If there is such a thing as “normal” in this world of ours, risk is certainly built into the definition. Besides, investors often love and hate risk in a mixed up, messed up relationship. How so? Let us count the ways.

One: We Underestimate Risk.

It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens. That’s why it’s possible to live in a world where there are song lyrics romanticizing a horse named Wildfire. When the real inferno unfolds, we quickly realize how unromantic it is.

In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”

Unfortunately, we can’t have it both ways. When the risk comes home to roost, if you panic and sell, it’s usually at a substantial loss. If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that?

Two: We Overestimate Risk.

On the flip side, we also see investors overestimate risk and its sibling, uncertainty. We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.

This summer already is destined to deliver plenty of uncertain outcomes. On the political front, there are the especially stark contrasts found among the US presidential candidates. For better or worse, whichever candidate prevails is likely to set the tone for the country if not the world. The “stay or go” uncertainty surrounding the June 23 Brexit vote could also impact financial markets in significant ways. Then there are the usual suspects, such as oil prices, continued Middle Eastern unrest and so on and so forth.

We don’t mean to downplay the real influence world events can have on your personal and financial well-being. But the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability. So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your individual investments.

Three: We Misunderstand Risk.

Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action – and fast.

Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, you’re usually best off disregarding both the good and bad news that is unfolding in real time. This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the kind we’ve been describing so far – the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimize their impact on your investments by diversifying your holdings widely and globally. That way, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings.

Unavoidable Market Risks – At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (Its spending power may be eroded due to inflation, but that’s yet another kind of risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market-wide risk that cannot be “diversified away.”

Four: We Mistreat Risk.

It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.

In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you. Friend or foe, don’t be surprised when it routinely challenges your investment resolve.

Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards.

The Fiduciary Rule: A Historic Milestone

When a hard-won historic milestone is achieved, it’s usually front-page news: Apollo 11’s “one giant leap for mankind.” The fall of the Berlin Wall. Martin Luther King’s “I have a dream.” … Last week’s fiduciary ruling by the Department of Labor (DOL).

About that last one. If you heard the news, you probably spotted it in the business section or on a financial newsfeed. With the ruling, anyone offering you advice about your retirement assets will be legally required to do so according to your highest interests, regardless of any conflicting incentives or dual roles they may have.

That’s the DOL’s ruling in principle. In reality, it only applies to advice related to retirement account assets such as those held in your 401(k) or IRA. Also, the ruling was watered down by several last-minute compromises that might (1) limit how effectively it can be applied, and (2) dilute the strictest definition of an investor-adviser fiduciary relationship with unnecessary exceptions to the rule. This New York Times overview offers a helpful summary of the issues involved. The author concludes: “[T]he quality of the advice you receive can still vary based on the provider you are working with.”

In short, the DOL’s ruling won’t eliminate every bad thing that can happen to a good investor – not even close. Still, we believe in this small step, and applaud its aim to become a giant leap in the right direction. For all of its flaws, the rule appears to be generating improvements. In anticipation of it, several large financial firms have already begun adjusting conflicted business models, shifting toward more efficiently managed products and lowering inflated prices.

Why would we want to advance a rule whose mission is to level the playing field between those of us who have been serving our clients’ highest interests all along and those who are making obligatory adjustments to catch up?

Most of all, it’s the right thing to do. We always have, and always will believe in the strictest definition of fiduciary. This means we will always applaud improvements that better protect investors’ interests, even if they might make running our own business a little more challenging.

Besides, we are not afraid of the challenge. By design and intent, we are and will remain an independent, fee-only Registered Investment Advisor firm, dedicated to advising you on how to best manage your wealth – all of your wealth – according to your goals and challenges. We are and will remain dedicated to being transparent and caring and fiduciary. With or without any regulatory requirements, this is what we do; it’s who we are. It’s bred in our bones.

We prefer focusing on doing all we can for you across all of our actions, large and small, according to our long-standing mission. As the DOL rule begins to (hopefully) improve on the retirement planning advice that all investors receive, we welcome any questions you may have about its impact on your own interests.

Investing for Retirement Income: Straw, Sticks or Bricks? Part III

As we’ve discussed in the first two parts of this three-part series, we do not recommend turning to dividend-yielding stocks or high-yield (“junk”) bonds to buttress your retirement income, even in low-yield environments. So what do we recommend? Today we’ll answer that question by describing total-return investing.

Part III: Total-Return Investing for Solid Construction

If you think it through, there are three essential variables that determine the total return on nearly any given investment:

  1. Interest or dividends paid out or reinvested along the way
  2. The increase or decrease in underlying share value: how much you paid per share versus how much those shares are now worth
  3. The damage done by taxes and other expenses

Total-Return Investing, Defined

Instead of seeking to isolate and maximize interest or dividend income – i.e., only one of three possible sources for strengthening your retirement income – total-return investing looks for the best balance among all three, as they apply to your unique financial circumstances. Which strategy is expected to give you the highest total return for the amount of market risk you’re willing to bear? Which is expected to deliver the most bang for your buck, in whatever form it may come?

If you’re thinking this seems like nothing but common sense, you’re on the right track. Last we checked, money is money. In the end, who wouldn’t want to choose the outcome that is expected to yield the biggest pot given the necessary risks involved? Why would it matter whether that pot gets filled by dividends, interest, increased share value, or cost savings from tax-wise tactics?

In Total-return investing: An enduring solution for low yields,” Vanguard describes the strategy as follows: “Many investors focus on the yield or income generated from their investments as the foundation for what they have available to spend. … The challenge today, and going forward, is that yields for most investments are historically low. … We conclude that moving from an income or ‘yield’ focus to a total-return approach may be the better solution.”

And yet, many investors continue to favor generating retirement cash-flow in ways that put them at higher risk for overspending on taxes, chipping away at their net worth and weakening the longevity of their portfolio.

We’re not saying you should entirely avoid dividend-yielding stocks or modestly higher-yielding bonds. With total-return investing, these securities often still play an important role. But they do so in the appropriate context of your wider portfolio management. Let’s take a look at that next.

 The Related Role of Portfolio Management

The tool for implementing total-return investing is portfolio-wide investment management. Decades of evidence-based inquiry informs us that there are three ways to manage your portfolio (the sum of your investment parts) to pursue higher expected returns; more stable preservation of existing assets; or, usually, a bit of both. The most powerful strategies in this pursuit include:

  1. Asset allocation – Tilting your investments toward or away from asset classes that are expected to deliver higher returns … but with higher risk to your wealth as the tradeoff
  2. Diversification – Managing for market risks by spreading your holdings across multiple asset classes in domestic and international markets alike
  3. Asset location – Minimizing taxes by placing tax-inefficient holdings in tax-favored accounts, and tax-efficient holdings in taxable accounts

By focusing on these key strategies as the horses that drive the proverbial cart, we can best manage a portfolio’s expected returns. This, in turn, helps us best position the portfolio to generate an efficient cash flow when the time comes.

Your Essential Take-Home

Bottom line, there is no such thing as a crystal ball that will guarantee financial success or a happily-ever-after retirement. But we believe that total-return investing offers the best odds for achieving your retirement-spending goals – more so than pursuing isolated tactics such as chasing dividends or high-yielding bonds without considering their portfolio-wide role.

With that in mind, the next time the market is huffing and puffing and threatening to blow your retirement down, we suggest you throw another log on the fire that fuels your total return investment strategy, shore up your solidly built portfolio, and depend on the structured strength to keep that wolf at bay. Better yet, be in touch with us to lend you a hand.

Investing for Retirement Income: Straw, Sticks or Bricks?

Part I: Dividend-Yielding Stocks – A Straw Strategy

If ever there were an appropriate analogy for how to invest for retirement, it would be the classic fable of The Three Little Pigs. As you may recall, those three little pigs tried three different structures to protect against the Big Bad Wolf. Similarly, there are at least three kinds of “building materials” that investors typically employ as they try to prevent today’s low interest rates from consuming their sources for retirement income:

  1. Dividend-yielding stocks
  2. High-yield bonds
  3. Total-return investing

In this three-part series, we’ll explore each of these common strategies and explain why the evidence supports building and preserving your retirement reserve through total-return investing. The approach may require a bit more prep work and a little extra explanation, but like solid brick, we believe it offers the most durable and dependable protection when those hungry wolves are huffing and puffing at your retirement-planning door.

Part I: Dividend-Yielding Stocks – A Straw Strategy

We understand why bulking up on dividend-yielding stocks can seem like a tempting way to enhance your retirement income, especially when interest rates are low. You buy into select stocks that have been spinning off dependable dividends at prescribed times. The dividend payments appear to leave your principal intact, while promising better income than a low-yielding short-term government bond has to offer.

Safe, easy money … or so the fable goes. Unfortunately, the reasoning doesn’t hold up as well upon evidence-based inspection. Let’s dive in and take a closer look at that income stream you’re hoping to generate from dividend-yielding stocks.

Dividends Don’t Grow on Trees.

It’s common for investors to mentally account for a dividend payout as if it’s found money that leaves their principal untouched. In reality, a company’s dividends have to come from somewhere. That “somewhere” is either the company’s profits or its capital reserves.

This push-pull relationship between stockholder dividends and company capital has been rigorously studied and empirically assessed. In the 1960s, Nobel laureates Merton Miller and Franco Modigliani published a landmark study on the subject, “Dividend Policy, Growth, and the Valuation of Shares.” In “Capital Ideas” (a recommended read on capital market history), Peter Bernstein explains one of the study’s key findings: “Stockholders like to receive cash dividends. But dividends paid today shrink the assets of the company and reduce its future earning power.”

Here’s how this MoneySense article, “The income illusion,” explained it: “[I]f a company pays you a $1,000 cash dividend, it must be worth $1,000 less than it was before. That’s why you’ll often see a company’s share price decline a few days before an announced dividend is paid.”

Dividend Income Incurs a Capital Price.

So, yes, you can find stocks or stock funds whose dividend payments are expected to provide a higher income stream than you can earn from an essentially risk-free government bond. But it’s important to be aware of the trade-offs involved.

As described above, rather than thinking about a stock’s dividends and its share value as mutually exclusive sources of return – income versus principal – it’s better to think of them as an interconnected seesaw of income and principal. The combined balance represents the holding’s total worth to you. (If you’re reading closely, you may notice that we’ve just foreshadowed our future discussion about adopting a total-return outlook in your investment strategy!)

“Safe” Stocks? Not so Fast.

In addition, dividend-yielding stocks may not be as sturdy or as appropriate as you might think for generating a reliable retirement cash flow. Even if those stocks have dependably delivered their dividends in the past, assuming they are as secure as a government bond is like assuming that a Big Bad Wolf is harmless because he hasn’t bitten you yet.

The evidence is clear, and it has been for decades: Stocks are a riskier investment than bonds. This in turn has contributed to their higher expected long-term returns, to compensate investors who agree to take on that extra risk.

Dividend stocks may offer a slightly more consistent cash flow than their non-dividend counterparts, but at the end of the day, they are still stocks, with the usual stock risks and expected returns. As this Monevator (not so) “brief guide to the point of bonds” describes, “The key to (most) bonds is they aim to pay you a fixed income until a certain date, at which point you get your initial money back. That is very different to equities, which offer no such certainty of income or capital returns.”

In “The Dividend-Fund Dilemma,” Wall Street Journal’s financial columnist Jason Zweig explains it similarly: “When you buy a Treasury, you collect interest and get your money back (not counting inflation) when the bond matures. When you buy a dividend-paying stock, you collect a quarterly payment – but that certainly doesn’t mean the stock price will be stable.”

Nor is there any guarantee that the dividends will flow forever. Zweig described a lesson that many investors learned the hard way during the Great Recession: “In 2007, 29% of the S&P 500’s dividend income came from banks and other financial stocks, according to Howard Silverblatt, senior index analyst at Standard & Poor’s. That didn’t end well. Many banks that had been paying steady income to shareholders suspended their dividends – or even went bust. Their investors suffered.”

Your Essential Take-Home

Our capital markets rarely offer a free ride. If you’re taking stock dividend income today, you’re likely paying for it in the form of lower share value moving forward. And if you’re invested in the stock market, you are exposing your nest egg to all the usual risks (and expected returns) that comes with that exposure. That’s how markets work.

The fixed income bond markets offer their share of risks as well, but in a different form, which tends to make them a better choice for helping you dampen your total risk exposure as you pursue expected market returns. Stretching for high-yield, higher-risk bond income begins to shift your bond holdings away from their most appropriate role in your total portfolio … which will be the subject of our next piece in this three-part series.

A Headline of Our Own

As the popular media scrambles to explain the unexplainable – what is going on in the markets at the moment and how long it’s going to last – we thought we’d share a headline of our own:

“The stock market is a giant distraction to the business of investing.”

So said Vanguard founder John Bogle in his 2007 classic, “The Little Book of Common Sense Investing.” These are timeless words to invest by, as is Bogle’s deeper explanation of them:

“The expectations market is about speculation. The real market is about investing. The only logical conclusion: the stock market is a giant distraction that causes investors to focus on transitory and volatile investment expectations rather than on what is really important – the gradual accumulation of the returns earned by corporate business.”

Similarly, Dan Wheeler is now retired from his 20-plus years as a Dimensional Fund Advisors director, but he still posts his pithy ponderings at Wheeler Writes. Shortly after last August’s market correction, he had this to say about the “talking heads” of the day:

“I never have liked the term ‘correction’ to explain a move in the market indices. By definition it implies that the market ‘got it wrong,’ being under or over valued. So looking at the market as I write this, I guess the past few days the market ‘over corrected’ and has now ‘corrected’ the ‘correction.’ You can see how this starts to become a bit silly, but it also shows how little credibility should be given to the ‘talking heads’ and journalist posing as ‘experts.’”

So, while we could indulge in incredible analyses of the latest economic news – China, oil, interest rates and so on – we won’t. We don’t want to distract you from the real task at hand.

Your job is to remember that these are the very kinds of intrinsic events that our evidence-based strategy is meant to help  look past, so you can achieve the kind of investment success that Bogle, Wheeler and countless others have described.

Our job is to remind you to remember. This is what you and we have prepared for together. Come what may, we’re here to help you stay on your way. Don’t hesitate to be in touch if we can continue this conversation in person.

Peek-A-Boo Markets

Have you ever noticed how a newborn’s favorite game is peek-a-boo? Now you see it. Now you don’t. What fun! But somehow, by the time we’re investors, we’ve grown disenchanted with the element of surprise – especially when the “now you don’t” periods last longer than we’d like. In 2015, global markets seemed particularly intent on playing peek-a-boo with us:

It might help to think of the market’s unfolding uncertainty as comparable to that big, blue baby blanket. Current conditions can, and often do obscure our view of the decades of solid evidence which we’ve used to construct personalized, globally diversified portfolios for our clients.

In fact, overemphasizing near-term performance is so common that there’s a name for it: “recency.” In “Beware the Recency Pitfall,” financial author Larry Swedroe describes how investors who succumb to recency in ever-noisy markets tend to fall straight into a “buy high, sell low” trap: “[C]hasing past performance can cause investors to buy asset classes after periods of strong recent performance, when valuations are relatively higher and expected returns are lower. It can also cause investors to sell asset classes after periods of weak recent performance, when valuations are relatively lower and expected returns are higher.”

This is one reason we believe in investing according to decades rather than months or even years of performance data. In a market that seems forever intent on playing hide-and-seek with us, we continue to believe that the best way to capture expected returns is to invest according to our own, evidence-based rules of engagement.

Don’t hesitate to be in touch with us whenever we can review your personal goals and risk tolerances – in the new year, or any time you’re seeking a clear view of where you stand today.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.

HHWM Investment Insights: Bringing the Evidence Home

Welcome to our final installment in Hiley Hunt Wealth Management’s Evidence-Based Investment Insights: Bringing the Evidence Home. We hope you’ve enjoyed reading our series as much as we’ve enjoyed sharing it with you. Here are the key take-home messages from each installment:

  1. You, the Market and the Prices You Pay – Understanding group intelligence and its effect on efficient market pricing is a first step toward more consistently buying low and selling high in free capital markets.
  1. Ignoring the Siren Song of Daily Market Pricing – Rather than trying to react to ever-changing conditions and cut-throat competition, invest your life savings according to factors over which you can expect to have some control.
  1. Myth of the Financial Guru – Avoid paying costly, speculative “experts” to pinch-hit your market moves for you. The evidence indicates that their ability to persistently beat the market is “rarer than rare.”
  1. The Full-Meal Deal of Diversification – In place of speculative investing, diversification is among your most important allies. To begin with, spreading your assets around dampens unnecessary risks while potentially improving overall expected returns.
  1. Managing the Market’s Risky Business – All risks are not created equal. Unrewarded “concentrated risk” (picking individual stocks) can and should be avoided by diversifying away from it. “Market risk” (holding swaths of the market) is expected to deliver long-term returns. Diversification helps manage the necessary risks involved.
  1. Get Along, Little Market – Diversification can also create a smoother ride through bumpy markets, which helps you stay on track toward your personal goals.
  1. What Drives Market Returns? – At their essence, market returns are compensation for providing the financial capital that feeds the human enterprise going on all around us.
  2. The Essence of Evidence-Based Investing – What separates solid evidence from flakey findings? Evidence-based insights demand scholarly rigor, including an objective outlook, robust peer review, and the ability to reproduce similar analyses under varying conditions.
  3. Factors That Figure in Your Evidence-Based Portfolio – Following where robust evidence-based inquiry has taken us so far during the past 60+ years, three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) have formed a backbone for evidence-based portfolio construction.
  4. What Has Evidence-Based Investing Done for Me Lately? – Building on our understanding of which market factors seem to matter the most, we continue to heed unfolding evidence on best investment practices.
  5. The Human Factor in Evidence-Based Investing – The most significant factor for investors may be the human factor. Behavioral finance helps us understand that our own, instinctive reactions to market events can easily trump any other market challenges we face.
  6. Behavioral Biases – What Makes Your Brain Trick? – Continuing our exploration of behavioral finance, we share a half-dozen deep-seated instincts that can trick you into making significant money-management mistakes. Here, perhaps more than anywhere else, an objective advisor can help you avoid mishaps that your own myopic vision might miss.

Your (Final!) Take-Home

When we began our series, we promised to skip the technical jargon, replacing it with three key insights for becoming a more confident investor.

  1. Understand the Evidence. You don’t have to have an advanced degree in financial economics to invest wisely. You need only know and heed the insights available from those who do have advanced degrees in financial economics.
  2. Embrace Market Efficiencies. You don’t have to be smarter, faster or luckier than the rest of the market. You need only structure your portfolio to play with rather than against the market and its expected returns.
  3. Manage Your Behavioral Miscues. You don’t have to – and won’t be able to – eliminate every high and low emotion you experience as an investor. You need only be aware of how often your instincts will tempt you off-course, and manage your actions accordingly. (Hint: A professional advisor can add huge value here.)

How have we done so far in our goal to inform you, without overwhelming you? If we’ve succeeded in bringing our evidence-based investment ideas home for you, we would love to have the opportunity to continue the conversation with you in person. Give us a call today.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.

HHWM Investment Insights: Behavioral Biases – What Makes Your Brain Trick?

Welcome to the next installment in our series of Hiley Hunt Wealth Management’s Evidence-Based Investment Insights: Behavioral Biases – What Makes Your Brain Trick?

In our last piece, “The Human Factor in Evidence-Based Investing” we explored how our deep-seated “fight or flight” instincts generate an array of behavioral biases that trick us into making significant money-management mistakes. In this installment, we’ll familiarize you with a half-dozen of these more potent biases, and how you can avoid sabotaging your own best-laid, investment plans by recognizing the signs of a behavioral booby trap.

Behavioral Bias #1: Herd Mentality

Herd mentality is what happens to you when you see a market movement afoot and you conclude that you had best join the stampede. The herd may be hurtling toward what seems like a hot buying opportunity, such as a run on a stock or stock market sector. Or it may be fleeing a widely perceived risk, such as a country in economic turmoil. Either way, as we covered in “Ignoring the Siren Song of Daily Market Pricing,” following the herd puts you on a dangerous path toward buying high, selling low and incurring unnecessary expenses en route.

Behavioral Bias #2: Recency

Even without a herd to speed your way, your long-term plans are at risk when you succumb to the tendency to give recent information greater weight than the long-term evidence warrants. From our earlier piece, “What Drives Market Returns?” we know that stocks have historically delivered premium returns over bonds. And yet, whenever stock markets dip downward, we typically see recency at play, as droves of investors sell their stocks to seek “safe harbor” (or vice-versa when bull markets on a tear).

Behavioral Bias #3: Confirmation Bias

Confirmation bias is the tendency to favor evidence that supports our beliefs and gloss over that which refutes it. We’ll notice and watch news shows that support our belief structure; we’ll skip over those that would require us to radically change our views if we are proven wrong. Of all the behavioral biases on this and other lists, confirmation bias may be the greatest reason why the rigorous, peer-reviewed approach we described in “The Essence of Evidence-Based Investing” becomes so critical to objective decision-making. Without it, our minds want us to be right so badly, that they will rig the game for us, but against our best interests as investors.

Behavioral Bias #4: Overconfidence

Garrison Keillor made overconfidence famous in his monologue about Lake Wobegon, “where all the women are strong, all the men are good looking, and all the children are above average.” Keillor’s gentle jab actually reflects reams of data indicating that most people (especially men) believe that their acumen is above average. On a homespun radio show, impossible overconfidence is quaint. In investing, it’s dangerous. It tricks us into losing sight of the fact that investors cannot expect to consistently outsmart the collective wisdom of the market (as we described in “You, the Market and the Prices You Pay”), especially after the costs involved.

Behavioral Bias #5: Loss Aversion

As a flip side to overconfidence, we also are endowed with an over-sized dose of loss aversion, which means we are significantly more pained by the thought of losing wealth than we are excited by the prospect of gaining it. As Jason Zweig of “Your Money and Your Brain” states, “Doing anything – or even thinking about doing anything – that could lead to an inescapable loss is extremely painful.”

One way that loss aversion plays out is when investors prefer to sit in cash or bonds during bear markets – or even when stocks are going up, but a correction seems overdue. The evidence clearly demonstrates that you are likely to end up with higher long-term returns by at least staying put, if not bulking up on stocks while they are “cheap.” And yet, even the potential for future loss can be a more compelling emotional stimulus than the likelihood of long-term returns.

Behavioral Bias #6: Sunken Costs

We investors also have a terrible time admitting defeat. When we buy an investment and it sinks lower, we tell ourselves we don’t want to sell until it’s at least back to what we paid. In a data-driven strategy (and life in general), the evidence is strong that this sort of sunken-cost logic leads people to throw good money after bad. By refusing to let go of past losses – or gains – that no longer suit your portfolio’s purposes, an otherwise solid investment strategy becomes clouded by emotional choices and debilitating distractions.

Your Take-Home

So there you have it. Six behavioral biases, with many more worth exploring in Zweig’s and others’ books on behavioral finance. We recommend you do take the time to learn more. First, it’s a fascinating field of inquiry. Second, it can help you become a more confident investor. As a bonus, the insights are likely to enhance other aspects of your life as well.

But be forewarned. Even once you are aware of your behavioral stumbling blocks, it can still be devilishly difficult to avoid tripping on them as they fire off lightning-fast reactions in your brain well before your logic has any say. That’s why we suggest working with an objective advisor, to help you see and avoid collisions with yourself that your own myopic vision might miss.

In the next and final installment of Hiley Hunt Wealth Management’s Evidence Based Investment Insights, we look forward to tying together the insights shared throughout the series. Of course there’s no need to stand on ceremony. If you have questions or ideas you’d like to explore right away, feel free to reach out to us today.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.

HHWM Investment Insights: The Human Factor in Evidence-Based Investing

Welcome to the next installment in our series of Hiley Hunt Wealth Management’s Evidence-Based Investment Insights: The Human Factor in Evidence-Based Investing

In our last piece, “What Has Evidence-Based Investing Done for Me Lately?” we wrapped up our conversation about ways to employ stock and bond market factors within a disciplined investment strategy, as well as how to extract the diamonds of promising new evidence-based insights from the larger piles of misinformation. We turn now to the final and arguably most significant factor in your evidence-based investment strategy: the human factor. In short, your own impulsive reactions to market events can easily trump any other market challenges you face.

Exploring the Human Factor

Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated instincts and emotions that spur us to leap long before we have time to look.

Rapid reflexes often serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think; his or her laughter elicits an instant outpouring of love (and oxytocin).

But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know that they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by ill-placed, “survival of the fittest” reactions.

Put another way by neurologist and financial theorist William J. Bernstein, MD, PhD, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.”

Behavioral Finance, Human Finance

To study the relationships between our heads and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens?

Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors themselves as well as what is happening inside our heads to generate them. To name a couple of the most obvious examples:

An Advisor’s Greatest Role: Managing the Human Factor

Beyond such market-timing instincts that lead you astray, your brain cooks up plenty of other insidious biases to overly influence your investment activities. To name a few, there’s confirmation bias, hindsight bias, recency, overconfidence, loss aversion, sunken costs and herd mentality.

Your Take-Home

Managing the human factor in investing is another way an evidence-based financial practitioner can add value. Zweig observes, “Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them.” By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too. In our next piece, we’ll explore some of the more potent behavioral foibles investors face.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.

HHWM Investment Insights: What Has Evidence-Based Investing Done for Me Lately?

Welcome to the next installment in our series of Hiley Hunt Wealth Management’s Evidence-Based Investment Insights: What Has Evidence-Based Investing Done for Me Lately?

In our last piece, “Factors That Figure in Your Evidence-Based Portfolio,” we introduced three key stock market factors (equity, value and small-cap) plus a couple more for bonds (term and credit) that have formed a backbone for evidence-based portfolio construction.

Continued inquiry has found additional market factors at play, with additional potential premiums (which also seem to result from accepting added market risk, avoiding ill-advised investor behaviors or both). In academic circles, the most prominent among these are profitability and momentum:

A Closer Look at Newer Factors

Before we get ahead of ourselves, let’s discuss a few caveats.

As a result, opinions vary on when, how or even if profitability, momentum and other newer factors should play a role in current portfolio construction. We would be happy to speak with you individually about our evolving approach. To help you assess whether they may make sense for you, let’s explore how to think about investment information.

Investment Information: A Double-Edged Sword

As time marches on, relentless questioning from scholars and practitioners alike has been essential to evidence-based investment theory and application, dispelling illusions and laying the foundation for the insights we now routinely harness.

Similar inquiry must continue to pave the way to future improvements. But one need only glance at daily headlines to notice a never-ending stream of ideas from competing, often conflicting voices of authority. While being informed is helpful, being overloaded by it can do as much harm as good to well-intended investors. Even when the news is solid (which is never a given), hyperactive reaction can strip away all the advantages of an enlightened investment approach.

Investment Reality: Choose Your Allies Carefully

So, how do you know what to heed and who to ignore? This is where we believe an evidence-based advisor relationship is critical to your wealth and your well-being. Calls to action that erupt overnight based on scant evidence and concentrated events are unlikely candidates for building into a durable investment discipline. As we outlined in, “The Essence of Evidence-Based Investing,” whenever we assess the validity of existing and emerging market insights, we ask pointed questions that can take years to resolve:

Your Take-Home

By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of misleading misinformation. We feel you are best served by heeding those who take a similar approach with their advice. Next, we turn to a factor we have mentioned but have yet to explore, even though it may be the most influential one of all: you and your financial behaviors.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.

HHWM Investment Insights: Factors That Figure in Your Evidence-Based Portfolio

Welcome to the next installment in our series of Hiley Hunt Wealth Management’s Evidence-Based Investment Insights: Factors That Figure in Your Evidence-Based Portfolio.

In our last piece, “The Essence of Evidence-Based Investing” we explored what we mean by “evidence-based investing.” Grounding your investment strategy in rational methodology strengthens your ability to stay on course toward your financial goals, as we:

  1. Assess existing factors’ capacities to offer expected returns and diversification benefits
  2. Understand why such factors exist, so we can most effectively apply them
  3. Explore additional factors that may complement our structured approach

Assessing the Evidence (So Far)

An accumulation of studies dating back to the 1950s through today has identified three stock market factors that have formed the backbone for evidence-based portfolio construction over the long-run:

  1. The equity premium – Stocks (equities) have returned more than bonds (fixed income), as we described in “What Drives Market Returns?”
  2. The small-cap premium – Small-company stocks have returned more than large-company stocks.
  3. The value premium – Value companies (with lower ratios between their stock price and various business metrics such as company earnings, sales and/or cash flow) have returned more than growth companies (with higher such ratios). These are stocks that, based on the empirical evidence, appear to be either undervalued or more fairly valued by the market, compared with their growth stock counterparts.

If you ever hear financial professionals talking about “three-factor modeling,” this is the trio involved. Similarly, academic inquiry has identified two primary factors driving fixed income (bond) returns:

  1. Term premium – Bonds with distant maturities or due dates have returned more than bonds that come due quickly.
  2. Credit premium – Bonds with lower credit ratings (such as “junk” bonds) have returned more than bonds with higher credit ratings (such as U.S. treasury bonds).

 

Understanding the Evidence

Scholars and practitioners alike strive to determine not only that various return factors exist, but why they exist. This helps us determine whether a factor is likely to persist (so we can build it into a long-term portfolio) or is more likely to disappear upon discovery.

Explanations for why persistent factors linger often fall into two broad categories: risk-related and behavioral.

A Tale of Risks and Expected Rewards

It appears that persistent premium returns are often explained by accepting market risk (the kind that cannot be diversified away) in exchange for expected reward.

For example, it’s presumed that value stocks are riskier than growth stocks. In “Do Value Stocks Outperform Growth Stocks?” CBS MoneyWatch columnist Larry Swedroe explains: “Value companies are typically more leveraged (have higher debt-to-equity ratios); have higher operating leverage (making them more susceptible to recessions); have higher volatility of dividends; and have more ‘irreversible’ capital (more difficulty cutting expenses during recessions).”

A Tale of Behavioral Instincts

There may also be behavioral foibles at play. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their impulsive, often damaging gut reactions to breaking news. Once we complete our exploration of market return factors, we’ll explore the fascinating field of behavioral finance in more detail, as this “human factor” contributes significantly to your ultimate success or failure as an evidence-based investor.

Your Take-Home

Factors that figure into market returns may be a result of taking on added risk, avoiding the self-inflicted wounds of behavioral temptations, or (probably) a mix of both. Regardless, existing and unfolding inquiry on market return factors continues to hone our strategies for most effectively capturing expected returns according to your personal goals. The same inquiry continues to identify other promising factors that may help us augment our already strong, evidence-based approach to investing. We will turn to these next.

We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.