Are you an emotional investor?- Part #2 (Left or right brain: Which side are you on?)

In our last blog entry we introduced the concept of behavioral finance which is a relatively new field that has been gaining importance over the last twenty years. Behavioral finance is the area of economics that studies how the financial decisions we make are influenced by factors beyond a purely logical analysis of the situations we face. Specifically it studies how our biases and emotions affect the manner and quality of our decision making.

Left and right brain

Much of the research conducted on how the brain operates suggests that the left and right sides of our brain perform different and specific functions and determine much of our personality traits and problem-solving styles. In general, the left hemisphere of our brain is primarily responsible for fact gathering, logical thinking and analysis. The right side on the other hand is more visual and creative and determines how we act on our feelings and emotions.

Most experts agree that while both sides of the brain are involved in almost every human activity, most people seem to have a dominant or preferred side that we tend to rely on almost automatically. In other words, while some people are adept at using both styles of thinking and making decisions, most have a preference for one style over the other.

The implications for our finances

What does all that have to do with how we make important financial decisions like saving for retirement, managing our investments and paying for our kids’ education? More than you may think. The evidence suggests that there is often a significant gap, especially when we are under stress, between how we should behave to get the results we want vs. how we actually behave. Rather than applying both sides of our brain when confronting an important challenge we often abandon our rational thinking and let our emotions take over. Unfortunately, the consequences of this behavior gap can be hundreds of thousands of dollars of lost wealth over our lifetimes and more importantly, the regret of not achieving some of our most important goals. Yet other studies indicate that logic and reason alone are not enough. It is the combination of intuition, emotions and reason that yield the best decisions.
Behavioral finance is interesting, but is still primarily an academic field dominated by scientific research filled with technical terms that are beyond the scope of these articles as well as my own expertise. My purpose in writing this series of articles is to demonstrate how we can apply the theory of behavioral finance to the real-world situations we encounter.
Identifying and understanding those aspects of behavioral finance relevant to our own financial lives can help us make more sensible decisions and achieve better results for ourselves and our families.

In the next blog entry, we’ll talk about how investors sabotage themselves.

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Are you an emotional investor?- Part One

Emotions trump smarts

Making good financial decisions can be difficult, even for very smart people. One reason is that most people make decisions based in large part on their own biases and the emotions they are experiencing at the time rather than analyzing the facts. In other words, their choices are based more on what they are feeling rather than what they know. However most
decisions, especially financial ones based on emotions, often turn out to be the wrong ones.

The difference between theory and practice

Conventional financial theory assumes that people make financial decisions based upon rational rather than emotional factors. In many cases, however, this assumption doesn’t reflect the reality of the real world where things can get messy and people often behave unpredictably and irrationally. We see it in how people in otherwise similar personal and
financial circumstances behave radically differently when it comes to spending, saving, and investing their money.

Since the 1990s the emerging field of behavioral finance has been applying the areas of psychology and neuroscience, as well as finance and economics to more fully understand how people approach financial decision-making. This includes how biases and emotions can distort reasoning and influence the way people make decisions. The implications are important
because if we can better understand the role these factors play, we can learn to recognize and harness them, improving the quality of our decisions.

Humans are emotional beings, so don’t underestimate the difficulty of controlling your emotions. It’s not easy to ignore the euphoria when the markets are soaring and everyone else (you think) is making a killing, or the panic when the market is plummeting and your retirement fund and your son or daughter’s college fund is evaporating by the day.

The key to successful investing

What sets successful investors apart from everyone else is not the ability to predict the direction of the markets because history has shown that no one can do this consistently. Nor is it financial genius, because the road to financial success is littered with brilliant people who have been spectacular failures at investing. It is rather the ability to recognize and understand what their emotions are telling them and then although it may not feel good at the time, to either control them or use them to make a more informed and rational decision. The bottom line is that great investors don’t confuse facts with feelings and they understand that success is mostly about behaving rationally, not emotionally.

In the next several articles we will address some of the important principles of behavioral finance and discuss how you can apply them to help you become a better investor.

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Understanding the European Debt Crisis – Part Five

The potential impact of the crisis.

In addition to the risk of the fiscal problems spreading from smaller countries to bigger ones, like Italy and Spain, investors worldwide are worried about the potential impact of the
crisis and the risk of these problems crippling the big European banks.

Unlike the U.S. government which relies on the capital markets for credit, European banks supply much of the credit to the governments in the region. In other words, the banks own many of the bonds issued by both their home and neighboring countries. Therefore defaults by European governments such as Spain and Italy would damage the balance sheets of the banks that own their bonds and place the financial system in peril. Even without actual defaults occurring, a constant decline in the value of the bonds of these European governments would make it harder for the banks to borrow to finance their own operations. This would limit their ability to lend to businesses, further reducing economic growth and employment in the region, increasing the prospects of another recession in Italy and Spain. Although the causes were different, this is what happened in 2008 and 2009 when banks and other institutions around the world stopped lending to one another, causing the credit markets to seize up. European banks are already being forced to borrow more of their funds directly from the European Central Bank, indicating that they are having trouble getting the money they need from the capital markets including the United States.

We live in a truly global economy where the events in one area of the world affect the rest of us. Therefore the crisis in Europe has important implications for investors in the United States and other countries outside of Europe. We rely on Europe to be one of the world’s engines of growth and if that engine sputters, it could impact the financial recovery for the U.S. and the world. One effect would be lower demand out of Europe for U.S. products and services. Also, if the value of the euro declines relative to the U.S. dollar, U.S. goods will become more expensive for Europeans, further reducing demand for our products and services.

In addition to purely economic and financial factors that could impact the U.S. and other economies, there is the danger that investor and consumer confidence could be undermined, dragging down the financial markets and with it, the consumers’ willingness to spend money.

Conclusion

Although the solvency crisis in the Eurozone and the United States are unfolding independently of each other, there is a common denominator. In financial terms, both Europe and the U.S. have run up a large debt-to-GDP ratio. In simple and straightforward terms, both have resulted from living beyond their means, spending more money than their revenues can support and using the ‘government credit card” to borrow the balance. Continuing to spend while interest costs are mounting instead of paying off the balance creates a snowball effect so the debt just keeps growing making it difficult to ever get under control.

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Understanding the European Debt Crisis – Part Four

Corrective Actions

 In May 2010 the Eurozone countries and the International Monetary Fund agreed to a €110 billion low interest loan for Greece, conditional on the implementation of harsh austerity measures. The Greek bail-out was followed by a €85 billion rescue package for Ireland in November and a €78 billion bail-out for Portugal in May 2011.

Also in May 2010, in exchange for promises by its troubled members including Greece, Ireland Portugal, and Spain to implement significant austerity and other fiscally responsible measures, the EU approved a comprehensive rescue package worth €750 Billion (then almost a trillion dollars). It is aimed at addressing the events in Greece but also generally ensuring financial stability across Europe by creating the European Financial Stability Facility (EFSF). The funds would be available to rescue Eurozone economies that get into
financial trouble. The plan would consist of €440 billion of loans from Eurozone governments, €60 billion from an EU emergency fund and €250 billion from the IMF.

It’s important to understand however, that the EFSF is simply a “borrowing facility” and doesn’t have any real money in its accounts. In other words, it would first have to borrow money through a bond issuance in the financial markets and then in turn, loan it out to the European countries that are having trouble borrowing.

Although the financial markets generally received the news positively, several questions remain among investors. First, will these troubled countries actually make the difficult fiscal changes they have promised? Second, how willing will future bond buyers be about loaning money to an intermediary such as the EFSF whose purpose is to loan money to countries with poor credit? Ironically, some of the guarantors of the fund are the same countries who themselves are having difficulty from investors. Fortunately, other European countries like Germany, Austria and France, which are in much better financial shape, are guaranteeing the fund as well. Third, many question the logic of addressing fiscal problems
created by excess debt by issuing more debt.

In my next blog, I’ll talk about the potential impact of the crisis and why investors worldwide are worried about the risks of these problems crippling the big European banks.

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Understanding the European Debt Crisis – Part Three

The Problem

For individuals and families, their debt-to-income ratio says a lot about the state of their financial health. Generally, the lower the ratio the better because lower debt means less
money spent on interest payments and more money available for savings and investments. These can be used to fund important things like education or a new business, and to provide financial security to cover unexpected expenses or the loss of a job.

With countries, the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt that a country is carrying as a percentage of its Gross Domestic Product (GDP). A low ratio indicates that a country is producing a large number of goods and services and presumably profits while maintaining a reasonable debt level. Just like families, countries with low debt-to-GDP ratios spend less money servicing interest payments so they have more money to use for productive investments including infrastructure and education and to weather the inevitable difficult economic times faced by every nation.

Another negative consequence of high government debt is that government borrowing drives up the cost of borrowing for the private sector. This makes it more expensive, and therefore less attractive, for businesses to finance investments in plants and equipment, harming their ability to create the jobs and wealth needed to get out of a recession.

Europe has been dealing with a serious debt and confidence crisis in the Eurozone as a consequence of the solvency problems in Greece and to a lesser extent, Ireland, Portugal, Spain and Italy. These countries are carrying excessive levels of debt and at the same time their economies are weakening, impairing their ability to continue repaying bondholders.

In late 2009, fears of a sovereign debt crisis regarding some European states were beginning to surface and then intensified in 2010. This included Eurozone members Greece, Ireland and Portugal and also some EU countries outside the area. This created alarm in the financial markets that the problem might be spreading to other countries in Europe. Without some kind of intervention from the European Union or even the IMF, it could have a devastating economic effect on nations across the globe.

The first country to elicit worldwide concern was Greece which has become the symbol of fiscal irresponsibility as a result of wasteful spending on large projects, payments to public sector employees and entitlement programs. To make matters worse they were ineffective in raising taxes and even collecting the ones owed legally to the government. Tax evasion has been estimated to cost the Greek government several billion dollars each year. Although Greece is a very small part of the overall European economy, it has been front
and center in the European crisis and the one that has sparked the greatest concern.

If these severe problems in Greece were to spread to larger countries including Italy and Spain, it could have a negative domino effect across the continent and beyond. As a sign that the odds of such a scenario materializing are increasing, interest rates demanded by investors in the region have been rising, indicating they perceive more risk in lending these countries money and are demanding higher returns to compensate them for that risk. Unfortunately higher interest rates mean higher government borrowing costs, making default
more likely. In an effort to reassure investors and decrease the likelihood of default by these two countries, and drive down interest rates, the European Central Bank began buying Italian and Spanish bonds in a move aimed at bailing out the two giants from defaulting. However, legitimate concerns remain as to whether borrowing more money, even at favorable rates, will help solve or worsen the problems facing these economies.

The next blog will address the corrective actions being taken by the Eurozone countries and the International Monetary Fund to help stabilize the financial markets across
Europe.

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Understanding the European Debt Crisis – Part Two

The European Union (EU) is an economic and political union of 27 sovereign (i.e. independent) member countries located primarily in Europe. The EU was created after World War II with the goal of fostering peace, economic cooperation and prosperity for its member countries. The EU has a combined population of over 500 million people and comprises about 25% of the world economy. The Council of the European Union is the EU’s main decision-making body, and each EU member country takes a turn to hold the Council Presidency for a six-month period. Every Council meeting is attended by one minister from each EU country.

The Eurozone consists of seventeen European Union member countries including France, Germany, Greece, Ireland, Italy, Portugal, and Spain, that have adopted the euro (€) as their common currency. The United Kingdom is an EU member but is not part of the Eurozone. The European Union with a population and GDP that exceeds that of the United States is an important political and economic factor in the world.

In order to impose fiscal discipline, member countries of the Eurozone must agree to comply with the Stability and Growth Pact (SGP), adopted in 1997, which specifies the maximum amount of debt that members can carry. Specifically the Pact stipulates that each member have an annual budget deficit no higher than 3% of GDP (this includes the sum of all public budgets, including municipalities, regions, etc), and a public national debt must not exceed 60% of GDP.  However, as the investor community later found out, several Eurozone members violated those debt covenants by borrowing larger amounts with less ability to repay the loans. Still, the Council of Ministers whose responsibility is to enforce the Pact, failed to impose sanctions on these members.

However, as the investor community later found out, many members had been consistently running deficits substantially in excess of 3%, and the Eurozone as a whole has a debt percentage exceeding 60% of GDP.

The Monetary Policy of a country or region is a set of tools designed to expand or contract the money supply circulating in the economy. The goal of a sound monetary policy is
to maintain price stability, low inflation, keep unemployment low and foster steady economic growth. In most economies, the institution responsible for formulating and implementing monetary policy is called the central bank. The Federal Reserve Bank serves as the central bank of the United States. The monetary policy of the countries in the eurozone is managed by the Eurosystem which consists of the European Central Bank and the central banks of the individual eurozone members. Generally speaking, the European Central Bank formulates the monetary policy and the central banks of the members apply that policy within their countries.

Because there are a number of the EU member states that are not part of the eurozone, the European System of Central Banks (ESCB) is the system of central banks consisting of the ECB and the central banks of all member states, both inside and outside the Eurozone.

Now that we have discussed the structure of the European Union and the Eurozone, as well as the role of key financial institutions within those organizations, the next blog will explain the nature and implications of the debt issues confronting those European states.

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Understanding the European Debt Crisis – Part One

In recent weeks the contentious debate in Washington over the debt ceiling increase, the nation’s budget and deficits, and the Standard & Poor’s downgrade of our nation’s credit rating, has convinced most Americans that the United States has been borrowing heavily to pay its bills. To make matters worse, other economic indicators are pointing to slowing economic growth, raising the concern among some investors that we may be headed for another recession. Yet despite these grim developments, the world financial markets still view the U.S. as a strong credit that will be able to pay its bills and continue to lend us the money we need at very low interest rates.

Unfortunately since the 2008 global financial crisis, a similar scenario has been playing out in several countries in Europe. They have been spending money that they don’t have by borrowing heavily. At the same time economic growth in many of the European countries has slowed significantly. Unlike the U.S. however, the bond ratings agencies have initiated a series of downgrades on the government debt of these troubled countries, which has reduced the value of the bonds that investor’s hold and simultaneously driven up interest rates making it prohibitively expensive for these countries to borrow additional funds in order to pay their current expenses.

This situation has resulted in the need for a series of fiscal bailouts to prevent these countries from defaulting on their debts. The bailouts have been orchestrated by Germany and France and carried out primarily by the European Central Bank (ECB) and in some cases the International Monetary Fund (IMF). The countries that have been bailed out so far include Greece, Ireland, Spain and Portugal.

Now that we have established what the European debt crisis is, my next few blog entries will explain how the fiscal problems in these countries evolved into the current full blown economic crisis that is affecting markets across the globe and the corrective actions being taken to help stabilize the situation.

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Avoid Overreacting to the Headlines

In the last few weeks, the flood of economic news has gone from bad to worse, and almost every American has been affected. Stubbornly high unemployment, large deficits at all levels of government, a European debt crisis, lower expectations for economic growth, and a lack of confidence in our nation’s financial and political system, has resulted in significant declines in the world’s financial markets and in our own investment portfolios. Regardless of your financial circumstances this has been a painful few weeks.

It’s important however, to understand that although these sudden and frightening drops in the stock market are unpredictable in both their timing and magnitude, they are to be expected and accepted as a normal part of investing in volatile assets such as stocks. Plunges as well as surges are unpredictable because while in the long run, economics and
corporate earnings propel stock prices, in the short run the market is driven by emotions such as fear and euphoria, which in turn are affected by news events from around the world. These include surprising earnings announcements, political conflicts and resolutions, changes in inflation expectations, and fluctuating oil prices. These events seem to come out of nowhere when least expected, and along with investor psychology, drive the markets up and down erratically and often dramatically.

The question on everyone’s mind is – what should I do about it? After all, our natural instinct is to “do something now” to reduce the fear and anxiety that we are experiencing. However, during volatile periods, most decisions, including financial ones, based on emotions, in retrospect, usually turn out to be the ones you later regret.

So what is a reasonable strategy to use during these times of market turmoil and a continuous stream of grim news?  First, understand that it is impossible to predict the future with any accuracy, including the direction of the stock market over the next few weeks, months, or even years. Having said that, for those investors with a diversified, long-term investment plan, consistent with their goals and their emotional and financial ability to tolerate these extreme fluctuations, the most sensible approach is to resist the urge to react emotionally.

The news and the direction of financial markets can change quickly, so an emotional decision you make based on today’s news could cause you regret tomorrow. The bottom line is that changing a long-term (measured in decades) plan by reacting to short term (measured in months or even years) conditions has generally proven not to be a successful investment strategy.

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Rising Health Care Costs and the Importance of Healthy Eating

Health care costs are on the rise. For those of us who have to pay for their health insurance, we see no end in site for the foreseeable future. The situation seems out of control, however,  if you think you are powerless to do anything to stop it, think again! You can start by asking yourself a simple question, “How is my diet?” You may wonder what your diet has to do with health care costs. The answer: a lot more than you think.

A lot of people are choosing higher deductible plans in order to pay lower monthly premiums. If you are willing to pay higher co-payments for doctor’s visits, seeing your physician less often will save you money.  You can improve your overall health by eating a balanced diet consisting of fresh fruits and vegetables, whole grains, lean meats and low-fat dairy products. It’s a great alternative to grab-and-go foods that are over-processed,  high in fat, sugar and empty calories. Chances are you will feel better, look better, sleep better and ultimately be healthier. With all of those benefits working for you, your regular check-ups might be the only doctors appointments you’ll have to make.

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Buildng and Managing a Retirement Portfolio – Part 3

For most Americans, their working years are their saving years. Their goal is simple, save aggressively and invest prudently to accumulate the retirement nest egg they’ll need to live on. Once they retire, the goal becomes converting that nest egg into a predictable “retirement paycheck” that will support their lifestyle for as long as they live. Accomplishing this requires [read more]

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