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Good Decisions Can Have Bad Outcomes (and Vice Versa)

If I’m playing blackjack and I choose to hit on 18, I have made a bad decision. Even if I get a 3 and win a bunch of money on the hand, it was still a bad decision — just one that happened to have a lucky outcome.

Point being: A decision is good or bad based on what was known at the time of the decision, not based on how it turned out. In the context of a card game, this is all fairly obvious. But it trips people up when it comes to investing.

Like card games, investing involves a significant degree of randomness. As a result, it’s not rare for good decisions to have bad outcomes or for bad decisions to have good outcomes. Over the course of your investment career, you will almost surely make some good decisions that turn out poorly — or vice versa.

The problem in investing, however, is that people often evaluate a decision based purely on its outcome, causing them to sometimes “learn” a faulty lesson in the process (the equivalent of “learning” that it’s a good idea to hit on 18 in blackjack).

For instance, it’s a mistake for most people to pick individual stocks, given that doing so usually increases risk and reduces expected return relative to using an index fund. Similarly, it’s a mistake to put money into an actively managed mutual fund just because it’s “hot” right now, given that most actively managed funds underperform their benchmark and given that even actively managed funds with winning track records tend not to continue to win.

But either of those poor decisions could actually turn out very well. Of course, in the short-term that would be a good thing. (Can’t complain about good returns!) But it’s dangerous if it leads a person to conclude that the decision was wise and should be repeated.

Conversely, if you have a portfolio of expensive actively managed funds and you decide to move your money into lower cost investments, you’ve made a smart decision. Even if your old portfolio (the portfolio that you abandoned in favor of a less expensive option) happens to perform well over the immediate future, you wouldn’t want to conclude that the change was a mistake.

Overall point: Be wary of doing something just because it’s worked well for you in the past. And be similarly cautious about avoiding something just because it hasn’t worked well for you in the past.

Preparing Your Spouse to Manage the Portfolio

A reader writes in, asking:

“This week there was a great discussion on the Bogleheads about preparing your spouse for how to handle the finances once you’re no longer there. I would be interested in hearing your thoughts on simplifying a portfolio for the sake of a spouse. My current AA has 7 different funds plus a few smaller things we’ve picked up here and there that we’ve never gotten rid of.”

There are several things you can do to put your spouse in a better position to manage the portfolio after you’re gone. For example, I think all of the following actions would be helpful:

  1. Simplify the portfolio to the extent practical,
  2. Provide a specific, written plan for how to manage the portfolio,
  3. Reduce the significance of the portfolio by increasing annuity-type income, and
  4. Establish a relationship with an advisor.

It’s worth noting that such actions are helpful not only for protecting your spouse in the event of your death, but also for protecting you in case of cognitive decline later in life. No matter how smart you are, you’re not immune to Alzheimer’s or dementia. And the fact that you’re still at the top of your game is precisely why you want to be making these decisions right now rather than later, when your abilities might not be as strong.

Simplifying the Portfolio

A portfolio that is simple to one person may be a logistical nightmare for another person. For example, rebalancing even a relatively simple 3-fund allocation would be quite difficult for many investors if the portfolio is spread out across several accounts. If your spouse isn’t comfortable with a spreadsheet, that’s not the type of task you want to leave to them.

When it comes to simplifying, most people have a few pieces of low-hanging fruit:

  • Eliminate duplicate accounts by moving everything to one brokerage firm so that you don’t have, for example, traditional IRAs with three different companies.
  • Eliminate holdings of individual stocks and bonds.
  • Eliminate any holdings whose role in the portfolio is questionable in the first place (i.e., anything that you would have already sold if not for simple inertia).

Beyond that, it’s just a question of how simple you want to make the portfolio. For example, you might want to simplify to a “total market” -type portfolio instead of one with separate allocations for various sub-asset-classes (e.g., REITs or small-cap value stocks). Or, you might even want to simplify all the way down to a single all-in-one fund (e.g. Vanguard’s Target Retirement Income Fund).

If, however, a significant portion of the portfolio is in taxable brokerage accounts, there are a few additional things to keep in mind:

  • You may want to continue hanging on to holdings where significant capital gains have built up.
  • If you do not have unrealized capital gains in your holdings, it might be preferable to make these changes now (even though you’re still alive and in full possession of your mental faculties) rather than later, by which point capital gains may have built up, thereby creating a cost for your spouse to make the switch.
  • One-fund solutions might not be the best choice, given the tax-inefficient nature of the fund-of-funds structure.

Providing a Written Plan

In addition to simplifying the portfolio, you’ll want to provide a set of written instructions for how to manage it. The plan should provide clear instructions not just about the target asset allocation, but also regarding:

  1. When and how to rebalance,
  2. How much can safely be spent per year, and
  3. How to decide which account(s) to spend from each year.

Annuitizing More of the Portfolio

Income from a lifetime annuity is easy to handle — all you have to do is decide how to spend it. As such, if you have doubts about your spouse’s ability to manage an investment portfolio, you may want to take actions to ensure that most (or even all) of your spouse’s basic needs are covered by annuity, pension, and Social Security income.

Note: Like purchasing an annuity, delaying Social Security benefits has the same effect of reducing one’s reliance on investment returns, and it is often a better deal than purchasing an annuity on the private marketplace.

Establishing a Relationship with an Advisor

If you think the best plan for your spouse is to use the services of an advisor, I would suggest selecting the advisor and having your spouse meet with the advisor now, before the actual time comes to make full use of his/her services. If your spouse is already comfortable with this person, it will make things much easier when the time comes.

Lump Sum vs. Dollar Cost Averaging

A reader writes in to ask:

How would you advise someone with a lump sum to invest for a 15-20 year time horizon? It’s really hard for me to invest a lump sum in this current environment, when tomorrow I could wake up and have lost a substantial portion of my investment. Is it advisable to dollar cost average into the market over a period of time in order to slowly switch into one’s appropriate asset allocation?

I chose to adopt passive investing with an asset allocation that mirrors my age so that I would not have to worry about the markets on a daily basis. Yet here I find myself STRESSING about how and when to take the plunge and invest this lump sum.

Regarding dollar cost averaging, I’ve always found this brief interview with academic finance hotshot Kenneth French to be helpful.

French’s position — which I agree with — is that, from a technical standpoint, if you know your ideal asset allocation, it’s usually best to switch to that allocation as soon as possible rather than use any other (and therefore non-ideal) allocation for any period of time.

From an emotional/psychological standpoint though, dollar cost averaging is less frightening for many people than investing the entire lump sum all at once. And the expected return you forgo by dollar cost averaging over a few months is relatively slim.

Is Your Asset Allocation Appropriate?

I think it’s worth noting, however, that if the idea of having your entire portfolio invested according to what you think is your target allocation causes you to experience the degree of stress that you indicated, then perhaps that shouldn’t be your target allocation at all. Perhaps your target allocation should be more conservative.

Remember, the “age in bonds” rule of thumb is just a rough guideline. It often makes sense to adjust it one way or the other based on an individual investor’s needs.

Stock Market Volatility is Normal

Finally, I think it’s also worth noting that, if measured by monthly or annual returns, the market hasn’t actually been significantly more volatile over the last 10 years than over the previous 30. This isn’t to say that the market hasn’t been volatile. It has been. But that’s normal.

And while the recent market volatility has been accompanied by a whole list of frightening economic events, that’s normal too.

I think the best approach is to find an allocation that you could use today (without having to coax yourself into it) that would let you sleep well at night even with an unpredictable market and frightening economic news.

Why Buy IPO Stocks?

For the most part, people are risk averse. We prefer not to take on any additional risk unless there’s an increase in expected return.

On occasion, however, we’re not risk averse. We’re risk seeking. When we go to a casino or play the lottery, we’re taking on risk despite the fact that our bets have a negative expected return.

Why? Because in some contexts, risk is fun. It’s entertainment.

Picking Stocks for Fun

Many investors like to pick stocks for fun. For them, attempting to outsmart (and outperform) the market is an enjoyable intellectual challenge. (And for the record, I see nothing wrong with that, as long as they’re aware that the value is in the entertainment rather than in the likelihood of success.)

But what does this have to do with those of us who are buy and hold investors, who have no interest in picking stocks? In short, we may want to attempt to avoid investments that carry a high entertainment value.

The most obvious examples of such investments are penny stocks and IPOs. Because so many people use them like lottery tickets, their long-term historical returns (as a group) are rather low, despite their high risk.

Further, some experts–William Bernstein in The Investor’s Manifesto, for instance–argue that a part of the reason for value stocks having slightly higher historical long-term returns than growth stocks is that growth stocks (especially small-cap ones) carry a higher entertainment value than value stocks.

In other words, it’s fun to try to pick the next Microsoft or the next Google, so many people try to do exactly that. And in the process, they drive prices of small-cap growth stocks upward and returns downward.

The natural response, of course, is to actively seek to make your stock portfolio as boring and unglamorous as possible. The less popularity or entertainment value an investment has, the better.

Insufficient Sample Size

“I created my system back in 2001 and have been using it since. It works. It’s not luck.”

This claim came from an investor explaining his method for picking market-beating mutual funds.

9 years is a long time in a person’s life. Can you think of something you’ve been doing for the last 9 years? Whatever it is, it’s probably an integral part of your identity by now.

In this person’s mind, his market-beating ability is a part of his identity. Tell him there’s a good chance that he’s just gotten lucky, and he’ll think you’re full of crap.

But it’s true. 9 years isn’t a large enough sample size to tell us with confidence whether this investor’s results were due to skill or luck.

Anecdotal Evidence

I particularly like this quote from John Cochrane, professor of Finance at the University of Chicago:

“Modern medicine doesn’t ask old people for the secrets of their health. It does double-blind clinical trials. And to that we owe a lot of our health. Modern empirical finance doesn’t ask Warren Buffett to share his pearls of investment wisdom.”

We have a natural tendency to assign too much significance to anecdotal evidence, especially when that evidence is our own life experience. Yet anecdotal evidence is worth almost nothing. Even if it’s yours.

The fact that somebody has successfully beaten the market by picking stocks, picking funds, or jumping in and out of the market at the right times doesn’t mean a thing…

  • unless we can combine that with other information about other investors who are doing something similar and (reliably) getting similar results, or
  • unless we can see that the degree to which (and reliability with which) the investor is outperforming the market is sufficient to show that it’s not due to randomness.

One investor (or one fund) over one decade just doesn’t cut it.

Math vs. Psychology

Personal finance is one of those fields in which our human brains seem tailor-made to fail.

Often, the best approach is to recognize our psychological shortcomings and make concessions to deal with them. For example, if Investment Approach A is mathematically superior to Investment Approach B, but we don’t have the psychological traits necessary to carry out A successfully, it might be better to go with B.

A few examples:

Asset Location

Mathematically, it makes more sense to put all of your fixed income investments in your tax sheltered accounts before putting any equity investments in them.

Yet it’s much easier to simply use the same asset allocation for each account. (For example, if you intend to have a 60/40 stock/bond allocation in your entire portfolio, use a 60/40 allocation in your 401k, in your IRA, and in your taxable accounts.)

Also, using the same allocation in each account eliminates a situation in which one account is extremely volatile (and therefore worry-inducing) because it has all of your stock investments in it. One single mistake–like bailing out of the market after a downturn–would eliminate any gains derived from tax-sheltering your bonds instead of stocks.

Debt Snowball

Mathematically, there’s no question that the best approach is to pay off debt in order of interest rate, regardless of balance. So, typically, that means consumer debt, followed by mortgage debt, followed by subsidized college loan debt.

Yet Dave Ramsey’s “Debt Snowball” method of paying off debt encourages people to pay off debts in order of size (smallest first), and it’s possibly the most successful debt repayment method ever devised. It takes advantage of the fact that frequent victories early in the process tend to motivate people to keep at it.

Invest First, Or Pay Off Debt?

Mathematically, you should invest prior to paying off debt anytime you expect to earn a rate of return that’s greater than the interest rate of the debt you’d be paying off.

Yet, as Matt reminded us yesterday, many people derive a real psychological benefit to being completely debt free. To value that mental benefit at zero seems to be a mistake.

How do you resolve it?

Do you find yourself running into these same math vs. psychology conflicts (or others that I didn’t mention)? If so, how do you attempt to resolve them?

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