I know many frugally minded people like to use something called the “30-Day Rule” to help curb their spending. Here’s how Leo from ZenHabits once explained it:

Make a new rule: you can’t buy anything (except necessities) until a 30-day waiting period has passed. Put a 30-day list on your refrigerator, and when you have the urge to buy something, put it on the list with today’s date. After a month has passed, you can buy the item. Many times the urge will have passed and you can just cross the item off the list.

The reasoning is that when we see a shiny new toy, we want it. Our emotions kick in and attempt to overtake our more sensible lines of thinking. If we delay action, it gives the emotion a chance to subside somewhat, thereby allowing us to think clearly about whether making the purchase really does fit in well with our goals.

Let’s apply it to investing.

How about this: Every time you’re tempted to adjust your portfolio in some way, don’t. [Noteworthy exception: Regularly scheduled rebalancing.] Instead, write down your idea, your reasoning behind it, and the date. 30 days later, if the reasoning still makes sense, then (perhaps) give it a go.

For example…

• Many investors are tempted to respond emotionally to big market swings.
• Other investors are frequently tempted to “tinker” with their portfolios.

Give it 30 days. If it truly made sense in the first place, it should still make sense a month later. On the other hand, if the idea doesn’t seem so wise when considered again 30 days later, it’s likely that your emotions were getting the better of you originally (even if you were unaware of it).

Quick note: The rule only works when we’re talking about portfolios with a lengthy investing time frame. (An asset allocation that makes sense for 15 years is probably also a good one for 14 years and 11 months, but an investment that is ideal for a 3 month time frame may not be fitting for a 2 month time frame.)

It’s difficult–if not impossible–to eliminate the emotional urges to take unwise actions (whether buying some unnecessary luxury or pulling out of the market after a drop), but what we can do is put systems in place to help overcome those emotions.

Ever since I first read about it, I’ve found the Monty Hall problem to be absolutely fascinating. It’s a math question that almost everybody gets wrong–even very smart people who have careers in math. Here’s the riddle:

Suppose you’re on a game show and you’re given the choice of three doors. Behind one door is a car; behind the others, goats.

The rules of the game show are as follows: After you have chosen a door,the door remains closed for the time being. The game show host, who knows what is behind the doors, now has to open one of the two remaining doors, and the door he opens must have a goat behind it. If both remaining doors have goats behind them, he chooses one randomly.

After the host opens a door with a goat, he will ask you to decide whether you want to stay with your first choice or to switch to the last remaining door. Imagine that you chose Door 1 and the host opens Door 3, which has a goat. He then asks you “Do you want to switch to Door Number 2?” Is it to your advantage to change your choice?

When they read the question, most people (myself included) answer that changing doors wouldn’t affect the chances of winning. And most people are wrong. If you switch doors, your chances of winning the car increase from 33% to 66%. It seems like a simple question, though, doesn’t it?

Fooled by common sense

In a similar vein, Nassim Nicholas Taleb, in his book Fooled by Randomness asks:

What is the greatest factor in determining how many fund managers outperform the market in a given year?

Here’s what came to mind for me as possible answers:

• Average expense ratio among mutual funds
• How well the market did that year (with the dodgy assumption that actively managed funds would outperform in down years due to their significant cash holdings)

The real answer? The total number of fund managers attempting to outperform the market is the biggest factor in determining how many fund managers do outperform the market.

Oh yeah. Duh. It’s so obvious, and yet I hadn’t thought of it.

What’s the lesson here?

It seems to me that the takeaway is that, when it comes to investing, the most obvious answer isn’t always the correct one. For example, common sense tells us that:

• A growing company should be a growing stock. (Wrong.)
• Professional management should beat no management. (Wrong.)
• A fund manager who has outperformed the market for the last 7 years in a row must be good at what he does. (Wrong.)

In the world of investing, terrible practices can be supported with common-sense-sounding arguments.

There. I said it.

You’ve probably spent your whole life learning that you have above-average intelligence and above-average work ethic. And, when considering the entire population of people around you, that may very well be true.

But if you plan to pick stocks (or do anything else to beat the market), the group that you’re being compared to is no longer same group. The fact that you’ve been above average at everything else in your life doesn’t necessarily mean much here, because the same thing is true about your competitors.

More important, though, is the fact that this isn’t just about intelligence.

It’s about resources.

Time: They have more of it. They do this full-time. You probably don’t.

And if you’re currently thinking “Sure, I do this in my spare time, but I still work on it for roughly 40 hours a week,” you’re kidding yourself. I’d be surprised to hear of very many fund managers who call it quits after putting in a 40 hour week.

Data: They have more of it. There’s nothing that you can find in your Motley Fool newsletter or Morningstar subscription that they don’t have access to as well.

News: They get it sooner. Many of your competitors are literally on the floor of the NYSE. When something starts to happen, they can react far more quickly than you can.

Don’t worry. I’ve got some good news too.

The good news is that you don’t have to beat the market to be a successful investor. (This concept doesn’t get nearly enough media coverage.)

It seems to be a pretty safe bet that the businesses in our global economy will continue to earn a net profit for the foreseeable future. Capture your share of that profit, and you can build a great deal of wealth.

For the most part, all you have to do is invest regularly, select an appropriate asset allocation, diversify within asset classes, minimize costs….and then not screw up by bailing out on your plan.

Added bonus: It’s actually less work to match the market than it is to underperform it. 🙂

I recently finished reading Nassim Nicholas Taleb’s Fooled by Randomness. (Highly recommend it, in case you’re curious.)

At one point in the book, Taleb mentions that, when looking at the outcome of a transaction, our brains are set up to react primarily to whether we’ve incurred a gain or loss–not, that is, to the size of the gain/loss we’ve incurred.

Quick note: I’m certainly not a medical professional, nor is Taleb. So please keep in mind that this information is now at least 2 degrees of separation away from its source.

If the claim is true, it would certainly have some fascinating implications for investing. For example…

We prefer frequent gains to big ones.

And more to the point, we’d most enjoy infrequent losses.

Imagine that you’re given the choice between:

• a portfolio that earns a steady 6% return per year, or
• a portfolio that goes up in 2/3 years, down in 1/3, and earns an effective annual 12% return.

Our brains are hardwired to prefer the first portfolio, despite the fact that our wallets would prefer the second.

Essentially, this gets right at the heart of what I was trying to say a while back: A lack of volatility provides us with a mental/emotional benefit that is real and valuable (though not measurable). And that, in my opinion, is the primary (and perhaps only) reason for including non-equity investments in a portfolio that still has decades to go before liquidation.

Your thoughts?

What do you think? Is that true? Or is there some other reason to allocate a meaningful percentage of a decades-until-liquidation portfolio toward fixed income investments?

A criticism I hear from time to time about the passive investing/long-term buy-and-hold strategy I advocate is that it’s no fun. That’s true. It’s as boring as could be.

There’s no excitement. There’s precisely zero chance that you’ll strike it rich.

There’s none of the fun of checking your portfolio everyday to see how your latest picks are doing. (Quick note: If you are following a buy & hold, passive investing strategy and you’re checking your portfolio everyday, please, stop now. Checking your account daily will do nothing but harm.)

In fact, aside from an annual checkup and rebalancing there’s no ongoing involvement at all–everything happens automatically. (And even the annual rebalancing isn’t necessary if you’re using target retirement funds.)

Want to invest for fun? Go ahead.

If you really want to invest for entertainment’s sake, then by all means, go for it. I completely understand that picking stocks can be fun.

You probably have better odds of coming out ahead than you would if you were to take your money to a casino. After all, even a portfolio of randomly-selected stocks is likely to earn a positive return over an extended period. (Of course, over a short time frame, it’s anybody’s guess what will happen.)

Just be sure, however, not to confuse investing for entertainment and investing for retirement.

Where the real fun happens

In my opinion, however, investing itself is not supposed to be fun. It’s not supposed to be exciting. What’s fun and exciting are the goals that you can achieve using a prudent investment strategy.

I don’t know about you, but for me, the fun I get from having the resources to follow my dreams and do the things I want to do in life far outweighs the fun I’d get from picking stocks.

I recently watched a Ted talk by Dan Gilbert that I can best describe as an entertaining combination of Nudge, Predictably Irrational, and Against the Gods.

One of the things Dan talks about is that, as humans, we’re not very good at judging value. We have a tendency to judge the value of something simply by comparing it to something else in the near vicinity.

One of the examples Dan used to illustrate his point was the following:

People don’t know whether their mutual fund manager is taking 0.1% or 0.15% of their investment, but they clip coupons to save $1 off their toothpaste.

So true! The average shopper has some idea of what a tube of toothpaste costs. If the price were to drop by $2, we’d notice and perhaps buy a couple extra. If the price were to go up by $2, we might buy another brand instead.

In contrast, the average investor has (I suspect) absolutely no idea what he’s paying for his mutual funds. I imagine this is caused by two factors:

1. Fund expense ratios are hidden away in rarely-read prospectuses, and
2. Mutual fund expense ratios just aren’t something that most people spend time thinking or talking about. (But would it really be so strange to bring it up? I mean, people mention it to their friends when they “save” $15 on a pair of jeans, right?)

Price Inelasticity

Economists refer to a good/service as having inelastic demand if consumers continue to buy it at roughly the same rate even when the price increases. The most common example of an inelastic good is insulin. Even if the price of insulin goes up, the people who need it will keep buying it.

It appears that mutual funds prices are fairly inelastic. Sadly, this isn’t because mutual fund managers provide some all-important service.  Mutual fund demand is inelastic simply because people don’t know what they’re paying.

How many people are paying an extra 1% each year without even realizing it, completely unaware that it will cost them hundreds of thousands of dollars over their investing lifetime?

Fortunately, the rise in index fund popularity over the last couple decades might suggest that mutual fund prices are slowly becoming more elastic as investors catch on to the impact of costs on long-term investment results.

Takeaways

First: regardless of which funds you decide to invest in, make sure you at least know what you’re paying for them.

Second: switching to low-cost index funds will save you enough money to buy a lot of toothpaste over a lifetime of investing.