Investing with Humility

Our society places a high value on confidence and most people identify it as a key element for success in life. But does it necessarily hold true for successful investing?

In daily life when we talk about confidence we are referring to the degree of certainty that we hold in the validity of our knowledge, predictions about the future, or decisions. In other words, self-confidence reflects our opinion about our own abilities. However, not everyone is realistic about their limitations and their abilities.

People that lack confidence are at one end of the spectrum. They underestimate their understanding of the facts and their ability to make sound decisions. This often leads to over-analyzing situations and inertia or even paralysis in making decisions.

Overconfident people on the other hand overestimate their predictive and problem solving abilities. Experts have long known that people in general, and men; in particular, tend to overestimate their abilities in a wide variety of areas from driving a car, solving problems and investing their money. When they decide on a course of action, it is done with a high degree of certainty that it is the right one. In reality however they may have failed to seek clarification and expert counsel, consider all the available facts, and identify the potential consequences of their decisions. These oversights often result in poor choices that can come at a heavy price. Overconfidence and its ramifications has been an important area of study for behavioral economists, especially in the area of investing. This tendency to overstate what they know about a particular investment, the financial markets or the overall economy can wreak havoc on their finances in several ways:

1. Taking on unnecessary and excessive risk by concentrating their investments in a few industries or companies that they expect will outperform. By definition, concentrated portfolios are less diversified and expose investors to greater risk of loss.

2. Excessive trading in an effort to time the financial markets. This has proven to be a strategy for failure even when executed by the most sophisticated investors in the world. The research in this area is broad, deep, and clear. Market timing results in investors earning only half of what they otherwise could have earned by simply sticking with a well constructed long-term portfolio. When the effects of trading costs and taxes are introduced the results are even more disappointing.

3. Reliance on intuition or “gut-feelings”. There is no substitute for facts, logic, and common sense when it comes to successful investing. It requires a commitment of time and effort and the application of sound investing principles.

4. Not adequately preparing for the future. Believing they have a sound plan to reach their financial goals and actually having one are two different things. While most Americans list a comfortable retirement as their highest priority and largest liability, fewer than half have a plan in place to reach that goal.

There is no question that confidence is an admirable quality and the basic foundation for optimism, motivation, and success. It is overconfidence, which is the belief that we know more than we actually do and acting on that belief that can undermine our financial future.

Protecting your investments from inflation

In an effort to mitigate the effects of the recent global financial crisis, the United States and governments worldwide have pursued economic policies including low interest rates and significant government spending that have increased the possibility of higher inflation.

Like stock prices and interest rates, future inflation is unknowable and thus unpredictable. Therefore positioning your portfolio to weather various inflation environments protecting is a smart move. Although there are effective strategies to counter its corrosive effects, no single investment serves as a reliable or perfect hedge in every inflation environment because other powerful forces such as interest rates are simultaneously at work. Some assets perform well during periods of mild inflation while others offer better protection when prices are rising faster. Because of this uncertainty, the goal for long-term investors should be a diversified portfolio that can weather different scenarios at an acceptable level of risk. Here are some suggestions to help you achieve that goal.

Commodities including gold are often cited as effective inflation hedges under certain economic environments. The rationale being that the values of these types of assets often rise with inflation. However, the increased risk and complexity that these investments entail offset their potential inflation protection benefits, making them a poor choice for all but the most sophisticated investors. That leaves us with stocks and treasury inflation protected securities (TIPS).

Stocks play a prominent role in most portfolios and are the primary drivers of investment returns. In addition, during periods of anticipated and mild inflation, stocks tend to perform reasonably well. This is due in large part to the risk that investors are willing to accept to earn these higher expected (not guaranteed) returns. Also, at least in theory, many companies can eventually pass their higher costs onto customers, preserving their profitability. Sudden and high inflation however can inflict serious damage on stocks. During the transition from low anticipated inflation to high unexpected inflation, stocks have performed poorly.

TIPS are an effective tool to preserve a portfolio’s purchasing power especially during periods of high inflation. These bonds rise and fall commensurate with changes in the Consumer Price Index (CPI). Although they can be negatively affected when interest rates are on the rise, because of their high sensitivity to changes in the CPI, TIPS are the most versatile inflation hedge across various inflation environments.

Regardless of your outlook for future inflation, preserving your portfolio’s purchasing power should be a top priority. Unfortunately there is no simple, comprehensive solution to this challenge because the US and world economies are not simple. There are complex economic, market, and behavioral forces constantly at work that affect asset prices and therefore the performance of individual investor portfolios. Different investments behave differently under various inflation scenarios and we can’t predict which of those we are likely to face in the future.

While you can’t control the future, you can prepare for it by constructing a sensible portfolio that balances the amount of risk you can tolerate with reasonable protection against the corrosive effects of inflation. The most effective way to accomplish this is with a diversified portfolio that includes a mix of inflation-hedging investments that will serve you well regardless of the economic climate.

Building a sensible retirement portfolio

For most Americans building their retirement nest egg is one of their most important priorities and most difficult challenges. A big factor to achieving that goal is constructing a well-designed portfolio. We can’t predict the future so no one knows what the ideal investment plan will turn out to be. However, we can construct a sensible one that is broadly diversified, low-cost, tax-efficient, and consistent with your goals and investing temperament. Such a portfolio will significantly improve your chances of reaching your retirement goals. Here are the key steps to developing an intelligent retirement investment plan.

Clearly identify the goals for your portfolio. What do you want it to accomplish in the period leading up to retirement, during retirement, and after you are gone? In addition to a secure retirement, are you planning to leave assets to family members or a charity? If so, how much do you plan to leave?

Understand your risk tolerance. This is your willingness to accept short-term losses in exchange for expected, but uncertain, longer-term gains. If you can’t sleep at night fearing that a severe drop in the market could cost you a significant portion of your assets, a portfolio that holds a high percentage of risky investments such as stocks may not be right for you. Your risk tolerance affects your portfolio design so take the time to get this right.

Determine your time horizon. For most investors this will consist of two or possibly three phases. They are the period before retirement, your retirement years, and many years after you’re gone if you plan to leave assets for others. For someone in their fifties those three phases could total over five decades. To increase the chances that your assets will continue to grow and keep ahead of inflation, you will likely need to include some higher risk assets such as stocks in the mix.

Establish your asset allocation. The most important investment decision you will make is the portfolio’s asset allocation, which is determining the portion of your investable assets you want in the three major asset classes of stocks, bonds, and cash. This decision will determine the majority of your portfolio’s performance and risk. Different asset classes have different risk and return characteristics and can respond differently to economic and market forces. Therefore, you can balance a portfolio’s risk and return by spreading your investments among different types of assets. This doesn’t guarantee a profit or ensure against a loss, but it can help you manage the level and type of risks you face. A sensible asset allocation depends upon your investment objectives, time horizon, risk tolerance, and other personal and financial circumstances.

Diversify through sub-asset allocation and security selection. To further diversify your portfolio you’ll need to select the sub-asset classes and specific funds that offer you the exposure within the specific stock and bond categories you want.

Determine your asset location. Different types of accounts, assets, and gains are taxed differently. Therefore, choosing which assets to hold in which accounts can help improve after-tax returns. Generally, investors should hold tax-efficient investments such as broad market index funds in taxable accounts, and tax-inefficient investments such as taxable bond funds in tax-advantaged accounts. However, factors including short-term cash needs and estate planning decisions can dictate exceptions to this strategy.

Rebalance periodically. Asset classes perform differently during the year, so in order to maintain your target asset allocation, and manage your portfolio’s risk; you should rebalance the portfolio periodically.

Minimize costs. Investment expenses reduce performance. Choose funds that do not charge sales commissions or impose high annual fees.  Do this and you will keep more of the returns you earn.

The bottom line: although you can’t predict the future, having a sensible, well thought out investment plan can give you peace of mind and a better chance for a comfortable retirement.