How to Think About Investing
The title of this article might sound strange, but all too often investors focus on investments more than themselves. In this respect, financial planning may favor the introvert, the philosopher, or even the selfish. The reality is that investments will largely behave how they behave; the individual investor does not have much say over the performance of a multi-billion dollar international company. If an investor can grasp this truth, that he is essentially powerless to his investment’s success or failure, then the individual’s experience is that of a passenger, not a driver. Furthermore, the passenger’s experience is defined by the time of the investment’s journey in which he hopped on board and hopped off, and judged solely by himself against his expectations of the ride.
There are two methods with which a person can think, not just in investing, but in life. This is not a psychologically approved claim from your favorite financial advisor, but nevertheless, hard to prove false. First, are casual thoughts. An individual may think he likes reading science fiction today, but cannot discard the chance he will prefer autobiographies ten years from now. This is the space in which change is the only constant. Second, are beliefs. A belief, be it religion, politics, and the like, is a deep-rooted stance that requires a revolution in thought to change. Some people approach investing with casual thoughts versus others with a set of beliefs.
Here is the historical context to casually think or construct beliefs about, granted past performance is never a guarantee of future results:
- Equities have higher volatility in the short-term, but over the long-term generally outpace other financial instruments.
- Higher returns are associated with higher volatility or risk.
- Volatility can present opportunity.
Volatility, usually bringing about discomfort, does breed opportunity. The markets have shown that major uncertainties initially introduce extreme volatility, but once the uncertainty has lifted, stocks have risen and volatility has declined. Also, consider the advances of some companies in tumultuous times– Apple introduced the iPod on October 23, 2001, less than two months after 9/11, then they released the iPad in 2010 after the Great Recession. Airbnb got started in 2008 as the stock market collapsed. There are plenty of relevant anecdotes.
The casual thinker falls prey to periodic bouts of interest in the above, like any other hobby. He invests with newfound enthusiasm based on recent ideals or advice, only to be ignored for months or years until another revelation occurs, bringing about a new investment philosophy. He is too flexible, too quick to think he’s smart, yet too quick to think he’s dumb.
The believer pledges allegiance to an investment approach that can’t possibly be adjusted. He’s not flexible enough, often leading to a feeling of complete dominance of finance in good times or total abandonment from the markets in bad times.
Casual thoughts and unshakeable beliefs can both lead to inefficiencies. Market timing is one of the most common reasons why individual investors routinely underperform the stock market. Inflation, which the Fed has set at a target rate of 2%1, is another sneaky wealth eroding factor along the way. This weighs heavily against any risk-free strategy that may result in a zero or even negative real return. Lastly, there is the mistake of shopping while hungry. This is a surefire way to break a diet or lose track of the grocery list. Similarly, investing when emotional leads to irrational behavior. Fear leads to selling at a loss and missing market rebounds, whereas overconfidence can lead to too much risk.
The optimal investor adopts a financial plan he can believe in with the confidence to think casually about it thereafter. In other words, a strategy that is deep-rooted, but without attached emotions. This is done through the following steps:
- Investing with a long-term horizon, as markets often overreact in the short-term to noise.
- Diversifying as necessary with uncorrelated asset classes that are in sync with overall risk tolerance. Within that diversification, the investor can decide on allocations between equity to fixed income, and then deeper to sectors such as value, growth, small-cap, international, etc.
- Creating guaranteed income for a longer, livelier retirement through annuities, social security, defined benefit pensions, CD’s, and other guaranteed instruments.
- Dollar Cost Averaging (DCA), or systematic investing, with regular contributions. This removes the temptation of market timing and keeps the investor present in all markets.
- Hiring a coach, preferably a Certified Financial Planner™, to hold the oneself accountable.
Understanding the aforementioned principles and following these five steps can help an investor create a sound investment strategy that fosters rational behavior. That’s how to think about investing.
Bryan M. Kuderna, CFP®, MSFS, RICP®, LUTCF is the host of The Kuderna Podcast and founder of Kuderna Financial Team, a NJ-based financial services firm. He is also the author of ANOROC and Millennial Millionaire.