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Michael's Blog: Money Matters

Our blog talks about current events that impact your financial reality and future prospects. We explain the implications.

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Reducing the Thrills and Upping the Odds: The Psychology of Financial Decision-Making

What a ride.

 

The DOW jumped past 18,000 recently, and then, somewhat predictably, has been bouncing around that area ever since. But things have been moving skyward for a while now, and many investors are feeling a bit giddy with the recent bull market. It’s an excitement that makes today the perfect the time to talk about the importance of behavioral finance and its impact on investor psychology.

If you’ve never heard of behavioral finance, it’s a theory based on the belief that cognitive psychology has the power to alter our decision-making ability when it comes to our finances. As a whole, people are rational when it comes to maximizing wealth and striving to create a more comfortable and secure lifestyle, yet it’s surprisingly common for people to make highly irrational decisions when it comes to investing. 

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A great example is the recent $500 million Powerball drawing—the fifth largest lottery prize in U.S. history. People around the country lined up in droves to buy lottery tickets in hopes of winning the jackpot. But what are the odds? 1 in 175 million. If that money came in a single, tax-free pot, such an investment may actually be pretty wise. But as taxable “income” that is most often spilt into pieces, the statistical odds of receiving a return on your investment are even more diminished. And when you realize that your odds of being struck by lighting this year is 1 in 700,000, you can see how irrational it is for people to be tossing their money in that direction. Yet millions of people make the choice to “dream big” and add their money to the pot—even when they know how little chance they have of taking home the cash.

 

It’s easy to look at the lottery as an anomaly. It’s just a game after all. But “dreaming big” may be costing people much more than they realize—especially when it comes to the stock market.

 

Last spring, James and Maya, a couple I’ve worked with for years, wanted to talk about shifting their portfolio. They felt we weren’t taking on enough risk; that our current approach was much too conservative for them to see the gains they hoped for. They were both hoping to retire by the end of 2016, and they felt more risk was well worth the potential of a greater return on their investment. James had read an article saying that equities were poised to grow for the next two years, and they wanted to take advantage of that market trend.

 

I wondered if I’d been wrong to steer them toward a level of conservative investing that seemed to fit their ages. Despite how close they were to retiring, everyone has a unique tolerance for risk. Perhaps I’d underestimated their risk tolerance. Maybe, at least for James and Maya, it made more sense to be more aggressive. I suggested they complete a detailed emotional risk tolerance assessment to see where they really stood.

 

The results were fascinating. The changes they had suggested when they first came in—shifting to 70% equities—would have given their portfolio an extremely aggressive risk tolerance score of 85. Before giving them the assessment, I was able to talk them down to a more tolerable (yet still highly aggressive) score of 69. But although both James and Maya were vocal about their desire to take on more risk, their responses to the questionnaire painted a very different picture. In fact, their combined score for emotional risk tolerance was just 29. While they clearly wanted the potential for gains, in reality, they were both emotionally averse to risk. If the market shifted downward over the next 24 months (and the odds of that happening surely beat the lighting statistic!) they would have been highly uncomfortable with the level of loss they would see.

 

James and Maya aren’t unique. Richard H. Thaler, a pioneer in behavioral finance, has been studying investor psychology for years. His latest book, Nudge: Improving Decisions About Health, Wealth, and Happiness, is based on his decades of research in behavioral science and economics, and it presents his theories about how we make choices—and how we can make better ones. Another pioneer in the field andwinner of the Nobel Prize in Economics is Daniel Kahneman. His New York Times bestseller Thinking, Fast and Slow explains the two systems that drive the way we think— “fast, intuitive, and emotional” vs. “slower, more deliberative, and more logical”—and the effect of cognitive biases on everything from playing the stock market to planning our next vacation. In both books, the lessons are clear: reducing the role of emotions can help us make better decisions.

 

Of course, a certain amount of “dreaming big” isn’t a bad thing. As your advisor, it’s my job to be sure the odds really are in your favor. I’m constantly evaluating the latest market shifts and identifying any necessary changes to your current asset allocation, and I strive to keep your approach in line with your personal goals and tolerance for risk. If you feel something’s changed, come on in and take your own emotional risk tolerance assessment. No matter what the results, we’ll build a portfolio that offers much better odds than 175 million to 1—and one that’s tax-favored to boot.

 

Are your own emotions wreaking havoc with your financial decisions? Let’s set a time to talk about how we can work together to reduce the thrills and up the odds for your financial success.

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Risk takers take note: The S&P 500 was 2014’s best high-stakes bet!

Risk takers take note: The S&P 500 was 2014’s best high-stakes bet!

The financial headlines are exciting these days. The S&P 500 added a whopping 11.4% in 2014. Nasdaq was up by 11%. And the DOW jumped 7.5%.

 

With these great numbers blaring at you from the bright lights of the news media, you might be asking: “Why aren’t my numbers looking so impressive? What am I doing wrong?”

 

The fact is, unless you’re willing to bet your portfolio on high-risk, short-term returns, if your portfolio delivered a relatively modest sounding after-inflation return of 3-4% in 2014, it’s likely you’re doing everything right. Here’s why:

A balanced portfolio of 60% stocks and 40% bonds delivers a much more reliable return on investment than 100% stocks. There may not be any fireworks when you see that single-digit number, but remember that the goal is to achieve a solid long-term return—after tax, after inflation, and after fees—all at a reasonable risk based on your long-term financial goals. A well-balanced, diversified portfolio includes four major asset classes, with varying percentages depending on your personal financial goals, time horizon, and other key factors. These four components are:

  1. Domestic large-cap equities

  2. Domestic mid-cap, and small-cap equities

  3. International equities (including global stocks in developed and emerging markets)

  4. Fixed-income securities (including bonds)

While it’s true that domestic caps performed undeniably well last year, history tells us that maintaining a careful mix of these four key components (with the riskier equities category decreasing in weight as the time horizon decreases) can decrease risk substantially and deliver a more predictable return over the long term. When comparing a strict S&P 500 to a sample diversified portfolio over a nearly 10-year period from October 2003 to May 2013, the diversified portfolio earned an extra 2.9% annually—at substantially less risk than the equities portfolio.

 

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(Source: Diversification: Why Not Put Everything in Whatever Will Go Up the Most?, Forbes, July 2013)

 

Hedge funds are a good example of the more risky approach, and there’s a good reason these funds aren’t delivering their touted too-good-to-be-true numbers these days too. Known for their inconsistent (but sometimes high-flying) returns, hedge funds averaged a return of just under 3% in 2014. Just like betting on that long shot at the racetrack, hedging the market is a tricky game—and the more volatile the market is, the trickier the game becomes.

 

It’s difficult to look away from the thrilling numbers of the major benchmarks— the S&P 500, Nasdaq, and the Dow—in 2014, but it’s important to remember that these highly publicized indexes don’t account for the not-so-little details of taxes, fees, commissions, and inflation, so the actual return to a portfolio isn’t quite what it seems (and really, is anything ever quite what it seems?!). And while the S&P 500 is one of the most watched indicators of performance for large cap equities, it includes only 500 stocks from more than 15,000+ to choose from. These 500 stocks are certainly representative of the overall market, but historically, the S&P has outperformed international developed and emerging-market stocks only three times since 2000, and it outperformed domestic midcap and small-cap stocks only once since 2000. While a $2 Million portfolio invested only in the S&P 500 in 2014 would have gained $228,000, that same portfolio would have lost more than $1.1 million during the great bear market of October 2007 to March 2009. That’s a level of volatility that even the most seasoned risk taker may find difficult to stomach.

 

Few anticipated such stellar returns on the S&P 500 last year. Perhaps even fewer anticipated the S&P 500’s 38% decline in 2008. If you really are a risk taker—and you’re willing to bet you financial future on the potential of cashing in on the long shot—you may get a good thrill from throwing your savings at the benchmarks. If you’re really, really lucky, you may see a fireworks-worthy return on your investment.

 

As for the rest of us? We’ll keep moving forward and striving for that nice, comfortable 3-4% each year after inflation, fees and expenses. Our nerves will benefit greatly, and my guess is that our retirement cash flow will be that much more comfortable when the time comes as well.

 

Is it time to explore changes to your own portfolio?I’m here when you’re ready (just please don’t ask me to place all your bets on the long shots—I don’t have the fortitude).

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The Double-Edged Sword of the Strong Dollar

If you’ve been paying attention to the financial news, it seems all anyone wants to talk about is how the strong US dollar is bolstering business and boosting the economy. That makes for a great sound bite and gives people plenty of reasons to feel positive about their personal finances, but there’s a lot more to the story.

 

How strong is too strong?

“Strong” is a word we love to hear when it comes to the stock market. But when it comes to the almighty dollar, things get a bit more tricky. There are times when “strong” can be “too strong.” Here’s why:

•       A stronger dollar gives US consumers and businesses greater buying power in foreign markets. But while we’re all paying less for imports, foreign companies and consumers are paying more for US exports. This means they buy fewer US goods and services—which hampers US economic growth and decreases employment.

•       On the flip side, when the dollar is weak, US consumers and businesses pay more for foreign imports, and foreign entities pay less for US exports. Because foreign companies can afford to buy more US goods and services, US production and employment get a boost.

 

So how strong is too strong? When the foreign exchange rate reduces US sales. Just ask Procter & Gamble’s CFO. Last week he told CNBC the company expects net earnings to be down 12% in 2015 as a result of the strong dollar. Why? When the dollar climbs high enough to deter foreign purchasing, US exports can be quickly outpriced by foreign bidders. This means that when a manufacturer in Vietnam (a fast-growing player in the global electronics supply chain) is purchasing electronic components, Hewlett-Packard Co.—one of the largest manufacturers in the US—may be outbid by a supplier in China, simply based on the strength (or lack thereof) of the Yuan. It also makes the US a less attractive (read affordable) travel destination for visitors from Europe and Asia, which has a huge impact on our economy.

 

Balance equals harmony

Ultimately, balance is best. A strong dollar is an important signal that the world recognizes the relative strength of the US economy, so we have that going for us. Cheaper imports and fantastic travel bargains are wonderful, but you have to ask yourself: if a strong currency is so desirable, why are the EU and Japan spending literally trillions to weaken their currencies?

 

The dollar is going to be what it’s going to be, and only time will tell how this balance plays out. The best thing to do in the mean time is to make the most of the current situation. From a portfolio perspective, I’ll certainly be keeping my eye on commodity stocks and emerging markets that are at some risk due to the strong US dollar, and I’ll continue to watch for new opportunities for growth—both in the US and abroad. In keeping with my long-term approach, I’ll continue to seek, above all, balance.

 

To take advantage of the strong dollar in a very personal way, if you’ve been itching to take a trip to Europe, this would be a great time to go. Anne and I are setting a good example: we’re heading abroad for a dual celebration of Anne’s 50th birthday and our 20th wedding anniversary. Hopefully we’ll run into you in a little pub in Ireland where we’ll all be getting much more Guinness for our Euros!


Questions about how the strong dollar impacts your own financial outlook? Email me and we can schedule a time to dive into more detail. I’m here to help.

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TAM Financial Advisors
1441 Pleasant Lake Road
Annapolis, MD 21409
Phone: 410-349-4484
Fax: 410-349-4480
Website: www.tamfinancial.net
Email: info@tamfinancial.net

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