Tag Archives: investing

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.

Great Ideas, Bad Timing

The stock market is setting new highs, but fundamental economic data remains subpar. For the past several years, we have expected “next year” to finally break out to a GDP growth rate of at least 3%, representing an escape velocity to grow our way out of the credit crisis doldrums.

The zero interest rate policy sustains the slow growth scenario, but there is only so much Fed monetary policy can do. The fundamental problems are fiscal in nature, and until Washington decides business and rich people are not the cause of the problem, we’ll continue to trudge along. Policies to stimulate business and job creation would be a nice start. Can you name one pro-business policy? Requiring businesses to offer health-care helps some people with medical issues, but does it stimulate job creation? Raising the minimum wage has noble intent, but if you are running a business, you’ll sharpen your pencil again before expanding.

No one can say how long the divergence between disappointing GDP growth and a rising stock market will last. Either the economy’s pent up demand overcomes Washington’s bureaucracy and grows faster, or we’re in for a correction. Let’s ignore the possibility of change in Washington for the meantime.

The key takeaway is, plan for liquidity, lean toward equity with the balance, and hope Washington will get out of the way. Lyndon Johnson pushed his Great Society programs at the same time as he funded the Vietnam War. We had a miserable decade in the stock market. Obama is pushing social reforms at the same time we try to recover from a credit crisis. Great ideas, bad timing.

Bubbles

During the past 20 years, we suffered 2 vicious corrections, 2000 and 2009. Attribution is simple. In 1999, tech stocks took off to the moon on the back of internet hype. Then, the combination of low interest rates, a love of real estate born of the prior equity bubble, mortgage securitization, and other factors led to soaring house prices. By 2007, houses were generally highly leveraged and overpriced. The collateral damage of the housing and mortgage crisis spread throughout the economy in ways few had imagined.

Which brings us to today. Allow me ask the obvious, what is overpriced today and which dominoes might prove vulnerable in a correction? Our artificially low interest rates and corresponding bond valuations seem the most likely candidates for disruptive movements.

The factors driving interest rates are complex, and countless financial instruments are tied to interest rates. This is not to predict economic Armageddon, but the dominos are set. There are paths to unwind QE without disruption, but we have not been down this path before. We can hope the path to normal will not be too disruptive. I am acutely aware of what I don’t know, but I have an idea where it might come from. This is fat tail risk.

When liquidity is important, it is important to reserve for it. If managing volatility is important, you might pay a steep price to hedge. Much like the crisis of 2000 and 2009, this one, if it occurs, will likely pass within a few years. I suggest reserving for liquidity needs anticipated within 3 to 5 years, and staying the course with the balance. Manage risk, don’t try to avoid it (you can’t).

A Simple Perspective on Equity

People often trade stocks as if they were baseball cards. They know when a company (player) is doing well and they speculate that if performance continues, they will be able to sell the stock (card) for more money.

What if Congress passed a law that prohibited the sale of stock. You could buy it, but you couldn’t sell it (never mind the inconsistency). As in musical chairs, the music stopped. How would you feel about what you own if you were stuck with it? If you made investment decisions based on the principal that the value of an investment is a function of the cash it can give you back, this probably would not be a big deal. You made wise capital allocation decisions.

If you have speculated on the greater fool theory, assuming someone will pay more for something without intrinsic value, you might be in a bad spot.

Business owners usually run their business to generate cash and profits. Maybe they plan to sell someday, but they know that future valuation will be based on profitability and/or liquidation value, not speculation.

When buying stock, consider whether you’d want to own the whole company if you could afford it.