Previously I wrote about House Money and taking chips off the table.  That is, selling some of your stock holdings that have increased in value over the past year or several years.

Today’s posting addresses what you should do with the chips that you cash in.  I offer a different take than many other financial planners.

Congratulations!

First of all, if you have made money in the market lately, you should feel good about yourself.  But, a rising tide lifts all boats, right?  Even a fool can make money in this market, right?  Well, not all boats rise, and some really smart investors have still lost money.  Lee Ainslie, the renowned manager of the Maverick hedge fund, has lost money this year and is reducing his fees in order to stay alive (Wall Street Journal, October 19, 2017).  It is never easy to make money in the market, even in a bull market, because there are always arguments the other way.  Cognitive bias also plays a part – you don’t like the current President, so you are going short, or vice versa.  Biases usually lead you down the wrong path.  If you have made money investing in the market for the past year, you are due plaudits.

What Next?

If you have some House Money – profits that you want to sell – you next should ask yourself, What should I do with these profits?  Maybe you decide you will ask a financial planner what you should do.  I’m guessing that many financial planners would counsel you to be cautious and to reduce the risk in your portfolio.  Reduce your stock holdings and increase your bond holdings, for instance.  Maybe move from 70/30 stocks to 60/40 stocks.  After all, the reason you sold your profits is that you think the stock market is getting too risky, too overvalued, and you are concerned about a deep correction.  Better to protect yourself from the correction.

Different Idea

While it is sound advice, it is also boring.  My advice is:  You have just created some Fun Money for yourself, so go have fun with it!  Buy yourself a new car, whether a luxury car or just a plain one you need.  Luxury car sales are up due to the “wealth effect” of people feeling more wealthy due to their stock market gains, per this article in TheStreet.com:

https://www.thestreet.com/slideshow/14023913/1/6-super-luxury-cars-selling-like-crazy-because-of-trump-s-stock-market-surge.html

Other ideas for your fun money:

• Improve your house!
• Vacation!
• New clothes or other shopping!

I am not suggesting spending all your profits.  Just enough to make yourself happy and to give yourself a pat on the back.

Speculate

One last idea for your profits, your Fun Money, that I will put out there:  Speculate.  Instead of spending all of your fun money, you should think about creating more fun money.  Great speculation opportunities can often be found in the latter innings of a bull market.  For instance, new tech companies that have been able to grow because of economic growth may now be looking to go public.  Maybe you should invest in a new IBO.  Not a lot; just a little.  Watch it like a hawk.  Stay up to date on the company’s situation.  Read their press releases and SEC filings.  Then maybe invest in a second new company.  Soon you will have a decent portfolio that will keep you interested.  Make Investing a hobby.  It is good to have hobbies such as investing that could make you money, rather than traditional hobbies such as golf that likely won’t make you money and could cost you a lot of money.

Caveat

One word of warning prior to starting your speculation hobby:  Make sure your house is in order before you do so.  Pay off all expensive debts such as credit card debt.  Make sure your remaining investment portfolio is consistent with your desires and in line with your goals.  You may want to consult with your Financial Planner as part of this process.

People ask me quite often if the bull market we have had this year will continue or if we will soon have a correction.  I tell them I Don’t Know, but I don’t see a catalyst that would cause a correction.  Especially a correction that happened 30 years ago, in October 1987, or the dot-com bubble burst in the early 2000’s, or the Financial Crisis crash of 2008. Then again, who foresees a correction coming until it actually happens?

House Money

Many investors who have had money invested in the stock market have seen their account values rise for the past year, and for the past several years.  This gives rise to the concept of “House Money”.  Even if you haven’t heard that concept expressed as such before, most people know exactly what it means:  Profits.  Picture yourself sitting at a Blackjack table in Las Vegas, and you have had a good run.  You are looking at a pile of chips larger than the pile with which you started.  The difference between your current, larger pile of chips and your starting pile is House Money.

Take Chips Off the Table

What should you do with your winnings?  You know your run of good cards has probably been lucky or at least unlikely to continue (otherwise, casinos wouldn’t exist!).  Should you “let it ride” and continue to play with your now-larger pile of chips?  Or should you “take chips off the table”, meaning go and cash in some of your chips at the window?  It’s Vegas, after all, and you have probably also had a couple of cocktails, so perhaps your judgment is impaired.  In this situation, most card players will let it ride.  It takes a lot of discipline to take chips off the table.

What Should I Do Now?

Vegas is one thing – the objective is to have fun and to experiment with the effect of cocktails on decision-making.  After all, you are in Vegas with money you can afford to lose, right?  Investing is a different animal.  Sober decision-making is needed.  This is your nest egg, your retirement money, that you can’t afford to lose (although you should think about how much you can afford to absorb during an ordinary downturn).  If you are In The Black now, should you take some chips off the table?  My advice to you is that you should if it helps you sleep better at night.  However, the trick is to balance your ability to sleep at night with the regret you might have if the market continues to go up after you take those chips off the table.  It also depends on where you are in your lifecycle.  If you are closer to retirement, it makes more sense to take chips off the table.  If you are younger and have many more years to work, then Let It Ride (as Bachman-Turner Overdrive said).  Watch it here:

IMO

A lot of us who were in the market in 1987, 2001, and 2008 remain scarred by those experiences.  We are convinced that because it happened back then, it will happen again.  A major correction probably will happen again, but we have pulled out of every past correction and gone on to make new record highs.   We are near a record high in the major indexes as I write this.  Gloom-and-doomers in the media are always out there.  Have confidence in your own ideas and research, and make sure you have a good financial advisor to help you.  I know how to contact one.

In a future blog, I will discuss what to do with any money that you do in fact take off the table.  I offer some advice that may be counterintuitive and may be different than advice offered by my financial planning brethren.  Please stay tuned!

In the world of television, you have new shows, and you have reruns.  Prime Time (8:00 to 11:00 PM) on the big 4 networks is reserved for new shows.  (Often, the networks re-run their new shows during Prime Time, but that is beside the point.)  New shows are original content.  Increasingly, some of the best original content is coming not from the big 4 networks, but from other sources such as HBO, Netflix, and even all-cable networks such as Fx.  For the big 4 networks, Prime Time often now means Reality TV, which is a whole another topic.

Emmy Awards

The Emmys are awarded to new shows.  New, original content is the advancement of art, literature, and civilization itself.  They are the cutting edge.  Last night’s shows are the next day’s water cooler discussion at work.  They are the growth of popular culture in the United States.  Through an antenna, and unless you live way out in the boonies, the big 4 networks are still broadcast free of charge.  What a deal!

Economics

Networks take a big financial risk when they agree to fund new shows because no one knows whether the show will be a success or not.  No one knows if people will watch the show, which in turn will attract more advertisers.  New shows cost a lot to produce.  HBO’s “Game of Thrones” was a huge risk – it was a very expensive show with an unknown appeal.  Medieval clan battles?  Would that play in the 21st Century?  Turned out that it did – big time.  But, for every “Game of Thrones”, there is a flop.  Network execs hope that there are way more successes than there are flops.  That’s how networks make money, and how network execs stay employed.  Using investing language, new shows are High Beta – they can be highly volatile,  hit or miss, and we don’t know at the outset which it will be.  Successful shows are extended, while flops are axed.  The networks don’t throw good money after bad.

Reruns

Reruns, on the other hand, are the milieu of independent, non-big 4 stations and cable networks.  Reruns are syndicated and sold to individual stations or cable networks by the studios that produced the shows and own their rights.  Mostly, only shows that were successful during their original airings are subsequently syndicated and rerun.  You don’t see flops rerun.   To the stations and networks that air them, reruns offer a known quality, less risk, low Beta, comfort.  No Emmys are awarded to reruns, but the stations that air them know they will make money from showing these reruns.  Reruns are a known formula that has been proven to work over time.

Investing

What does all of this have to do with investing?  A great deal, if you think about it.  There are new strategies for investing, and there are proven strategies, such as index investing.  Index investing is the equivalent of the “Seinfeld” rerun:  It is not new, but you know it works, and while it could make you wealthy, it isn’t going to make you Forbes 400 rich.  None of the Forbes 400 wealthiest people got there by index investing.  They all got there by creating something original and then betting everything on it.

Individual Stocks vs. Funds

Another way to look at it is that investing in individual stocks is like new shows while investing in funds is like reruns.  I mean like, not equivalent to.  When you invest in an individual stock, you may have huge upside, but your outcome is very uncertain, and you have a lot of downside.  As you invest in more individual stocks, you add to your diversity, and you lower your individual company risk.  With fund investing, your upside is more limited, but so is your downside, and your outcome is more predictable because you are diversified.  You are even more diversified if you invest in multiple funds across multiple asset classes.  By investing in multiple funds, you are acting like the head of your favorite independent TV station:  Using proven content to produce a profit.

IMO

Most people who work for a living in jobs not associated with the investment industry are probably better off going with the rerun formula.  The fear of losing your hard-earned money is greater than the appeal of striking it rich.  Put the bulk of your savings into funds, diversify your holdings among different asset classes, and then take a small portion that you are willing to lose as your “fun money”, and invest that in individual stocks.  The rerun strategy will allow you to sleep at night.

This blog is admittedly a stretch, but please stay with me.  What do Venezuela, Syria, North Korea, and Cuba have in common?  They are all dying nations ruled by authoritarians and whose citizens are severely and violently repressed even to the point of starvation.  I’m sure I am omitting some other fine examples of central planning – Equatorial Guinea, for instance.  What else do they have in common?  They are all still alive as nations.  Maybe just barely, but still alive.  How many of you would have taken the bet 4 years ago that any of these states would no longer be around by now?  Maybe you would have, but it would not have been a good bet.  That’s my point.  It is very hard to tell when a state will die, or otherwise, cease to exist.

Likewise, it is difficult to predict or to make money wagering when and if corporations will cease to exist.  How would you make such a wager if you want to?  Sell short.  It is very difficult – not impossible, but very difficult – to make money by selling short.  Some investors have made fortunes by selling short – William Ackman (Pershing Square) and David Einhorn (Greenlight Capital) are two noted short sellers.  Ackman made a big splash a couple of years ago by selling short Herbalife.  Ackman’s research was well-founded.  There was a lot of evidence that Herbalife’s product was being wasted:  purchased by would-be Herbalife vendors with dreams of stay-at-home businesses.  There was little evidence that Herbalife product was being bought by end-users in the general public.  Herbalife’s multi-level-marketing program looked from the outside like a Ponzi scheme.  Ackman wagered a lot of money – hundreds of millions of dollars – that Herbalife stock would decline, and spent tens of millions of dollars on an ad campaign to try to force Herbalife stock down.  How did that all work out for him?  Not well.  Herbalife did decline for a short time, but then it rallied.  According to Fortune Magazine, Ackman lost about $500 million shorting Herbalife.

Short Selling

The attitude of a short seller has to be very skeptical and cynical.  They look at a product or a business and they see what is wrong with it and why it won’t work.  Short sellers are problem finders, not problem solvers.  Have you ever met anyone like this?  Someone who objects to any idea you have, or any statement you make?  Maybe your own children come to mind?  That is the mindset you have to have to be a short seller.  A pessimist to the core.  Do you like working with a pessimist?  Are you one yourself?

Optimist

This economy and this country weren’t built by pessimists.  Steve Jobs is hailed as a visionary for his ability to see the future when he built the iPhone.  Skeptics didn’t see things as Jobs did, and skeptics continue to write that we should be selling Apple now, that the new iPhone versions won’t live up to projections.  Perhaps not, but they are singing an old tune.  I am not advocating buying AAPL stock, but I am saying that there are always reasons to be skeptical, and it may be appealing to sell short when you are skeptical about a company, but it is very difficult to make money on the short end.

IMO

I still don’t like the prospects of the countries I mentioned – Venezuela in particular.  I believe Venezuela could result in a refugee situation similar to that of Syria.  But I wouldn’t want to bet that the Maduro government in Venezuela will soon go down.  There is a lot of money at stake trying to keep Maduro in power – native Venezuela money, as well as Cuba money and personnel.  Similarly, whereas I see danger ahead for some companies, I wouldn’t bet on their demise.  You can short a stock and then be in the red for a long time waiting for it to go down.  I am an optimist, and though I may hedge my bets, I still have money on the table on the long side.

Do you use Yelp!?  For the uninformed, Yelp is a reviewing website.  Go to Yelp on your computer or on your phone.  Type in anything in any city or town, and up pops a review or several reviews about it.  A lot of people use it for restaurants where they haven’t yet been.  Type in the name of the restaurant and there will be several reviews.  Alternatively, if you are new to a town and don’t know where to eat, just type in “Best Restaurants” in the town where you are, and up will pop several reviews of various restaurants.  Very handy for travelers.  The reviews can be very specific:  “The cedar plank salmon is to die for!”  Presto!  The cedar plank salmon becomes the best seller for that restaurant.

Yelp is not just for restaurants.  Traveling to Italy and need a haircut?  Yelp can tell you the best salon in Siena.  Reviews are stars plus comments.  5 star is the best.  Star reviews are added up and averaged.  Pick a reviewer and read their specific comments, if you want.  Yelp is a creature of the internet age and the desire for immediate satisfaction:  I want to read a review of this service or establishment and I want to read it now!  Yelp accomplishes this.

Maybe you have written a review on Yelp.  The Yelp home website highly encourages new users to write reviews.  Some Yelp reviewers develop followings, just as some Amazon reviewers develop followings, for being particularly insightful or well-written.

Yelp for Investing

Yelp doesn’t have reviews of individual stocks or portfolios.  What is the equivalent of Yelp for investors?  There are many in the greater financial media.  For individual stocks, you have analyst reports by brokerage houses or by firms like Value Line.  Internet age options include sites such as Seeking Alpha or any number of blogger forums such as Tumblr, where ordinary folks pen their thoughts on individual stocks.  As for portfolio allocation – % stocks vs. % bonds vs. % other assets in your portfolio – there are a number of sources that you can Google and find.  Out there on the Web, there is no shortage of people’s opinions about anything you want to invest in.  Or, tune in to CNBC.

Reliance

Do you fully rely on Yelp?  Should you?  Or should you use Yelp as one piece of information that may or may not be helpful for you in making your own decision?  I think you know the correct answer to that question, and how I feel about it.  Yelp reviews are worth what you pay for them.  That’s probably not true – they are worth something but don’t bet the farm on what some Yelp reviewer thinks.

Similarly, for investing, stock analyst reports, blog posts, CNBC stories, and word of mouth can be helpful.  These sources aren’t necessarily free – you get analyst reports from your broker, to whom you pay commissions, and Value Line and Morningstar are pay services (at various levels).  Some people like to make decisions by reading or listening to different arguments or points of view and then synthesizing their own opinions and make their own decisions based on their take on other people’s takes.  The question is, how much should you rely on other people’s opinions about various investments?

Difference

One difference between Yelp and the various sources of opinions about investments is that the investment world is fluid with respect to prices.  Investments really all boil down to price.  The stock market is open 5 days per week and prices of stocks can move quickly.  What may be a good investment at $40/share may not be such a good investment at $60.  That’s one reason that stock analyst reports usually have a top end price target, and the analyst may re-look at the stock if and when the stock hits that target.  In contrast, Yelpers do discuss prices – Yelpers, on the whole, are pretty thrifty, in my experience – but the service that the vendors provide is relatively static.  The $30 cedar plank salmon will probably still be the same $30 entree a month from now and even a year from now.

IMO

I am a Yelp skeptic.  I don’t know who these people are who write these reviews.  I like to make my own decisions.  If it is a restaurant, I will try it once.  If I like it, I will go there again.  If not, I won’t.  If it is a bigger decision, I want references to speak with me personally.  My wife and I used Yelp to find a contractor for some major work on our house.  The Yelp reviews were helpful, but we chose the contractor based on previous jobs he had done and references from those people.  Similarly, with investing, I make my own decisions and I use my own indicators.  Even if you use other peoples’ opinions about whether an investment is good or bad (at a certain price), you should still dig deeper and do your own analysis about the investment and its future prospects.  That doesn’t necessarily mean you should dig up the company’s 10K and analyze its financial statements, but you should at some level make up your own mind about the future of this potential investment.  If you dive in and invest in it, then see how it plays out over time vs. what you thought might happen when you bought it.  If things play out as you thought you would, then keep it.  If not, sell.  Make your own decisions, and take responsibility for your own future financial well-being.

Yesterday, October 19, 2017, was the 3oth anniversary of the Black Monday stock market crash.  On that day the Dow Jones Industrial Average fell 508 points to close at 1,738.74, losing 22.61% of its value in one day.  It was and remains the largest one-day decline ever.  This was after losing 108.35 points, or 4.6%, the preceding trading day (Friday, October 16), and other large sell-offs in the week preceding that.  It truly was a crash.

UCLA

I remember it all well.  I was in my first month of my MBA program at the Anderson School of Management at UCLA.   All in the program were shocked – students and professors alike.  One finance professor canceled class because he was so shocked (he rallied and resumed his classes the next day).  It was all anyone could talk about.  One of our classmates who also had a Masters in Geology said the Mount Saint Helens eruption happened just as he started his Master’s program, and now this.  What next?

The main ramification for us in the MBA program was that the investment banks curtailed their hiring.  Curtailed, but not eliminated.  This came to pass over time, but not immediately.  A number of our classmates who originally were looking to break into investment banking suddenly became more interested in consulting and other fields.  MBA students can be very resourceful and adaptable.  The 1987 Crash remained a topic of conversation throughout our 2 years at UCLA.

What do you remember about Black Monday?  Were you even born?

Since Then

As I write this, the Dow Jones Industrial Average is trading at 23,128, just off a new record high.  That is a 9.0% compounded return since the 1,738.74 Black Monday close.  If the same thing occurs for the next 30 years, the Dow will close at 306,855 on October 19, 2047, when I will be 86 years old.  I hope it happens, although it will be difficult because we are starting from a higher base.  Black Monday turned out to be a great buying opportunity.  Buy the dips?  That was a big dip.

It was a completely different world then.  The big brokerage houses, the Merrill Lynches and the Paine Webbers, still dominated stock trading.   It was full commission trading.  Charles Schwab and other discount brokers were up and running but were still a small part of trading.  The Internet barely existed – can you imagine that?  It has been nothing short of a revolution in stock ownership and trading since then.  The tech revolution since then has struck financial services perhaps as much or more than any other industry.

1987 vs. 2008

The 9.0% compounded return since 1987 includes the financial crisis of 2008.  The Dow peaked in October 2007 at 14,000 and bottomed in March 2009 at about 6,600, which was a peak to trough drawdown of almost 53%.  The 1987 Crash happened over the course of about a week, and mostly in 1 day.  The 2008 crash happened over about 18 months.  The 1987 Crash was substantially caused by a liquidity crisis caused by algorithmic program trading, which was a relatively new phenomenon.  Parties to the program trades lost a ton of money, but the economy as a whole was only marginally affected, and so the economy quickly recovered.  The 2008 Financial Crisis was caused by poor underwriting in sub-prime mortgages, and its effects were more widespread, enveloping first the entire housing and home lending industry, then the entire banking industry, and finally the entire economy.  The Federal Reserve Bank reacted to the 1987 Crash by increasing liquidity, and markets stabilized due to the Fed’s actions as well as other adjustments within the markets themselves, with little long-term ramifications to the Fed.  The Fed reacted to the 2008 Financial Crisis ultimately by buying bonds and increasing its own balance sheet by $4 Trillion.  That’s with a T.  Think about that for a minute.  Those $Trillions remain substantially on the Fed’s balance sheet, although the Fed has announced it will wind down its bond holdings over time.  Thus, we are still seeing the ramifications of the 2008 financial crisis today, 9 to 10 years later.  Did the Fed help, or did it make the crisis worse and the recovery, therefore, more drawn out?  We will never know.  But, the Dow is now over 23,000.  Maybe it would be over 40,000 had the Fed not intervened as much it did, or maybe it would be 13,000, but we will never know.  However, the “in and out” strategy that the Fed used in 1987 led to a quick recovery from that crisis, whereas the more extensive Fed involvement since 2008 remains a drag on the economy now.

I remain stuck on Dr. Richard Thaler and his findings that won him the Nobel Prize in Economics.  Dr. Thaler’s findings put him at odds with previous economics theoreticians, most notably Professor Harry Markowitz.  Markowitz is not a Nobel laureate – at least not yet – but his Efficient Frontier theory is a cornerstone of modern finance and modern portfolio theory.

The Efficient Frontier

Pioneers lived on the frontier, but it wasn’t very efficient.  Staying alive every day was a struggle.  Personally, I wouldn’t have made it very long on the frontier in the Wild West.  I am a creature of comfort, and not willing to risk life and limb for land opportunities in the West.

But, that’s not the frontier we are talking about here.  Dr. Markowitz’s frontier has to do with optimal risk and return.  He posits that investors will always choose an investment that provides them with the highest return with the lowest risk.  For instance, let’s say there are 3 different investments:

a) a 10% return with a 1 standard deviation (measure of risk),
b) a 9% return with a 1.5 standard deviation, and
c) a 8% return with a 0.7 standard deviation.

The rational investor would likely choose the first and possibly the third (absent additional information), but would not choose the middle investment, the one with 9% and 1.5.  Why?  Because the first investment offers a better return with less risk, and because the third investment offers a lower return but also with lower risk.  Dr. Markowitz says the first and third investments are on the Efficient Frontier, but the second investment is not.  The second investment’s price will have to go down, and its corresponding return needs to go up, in order for it to move into the efficient frontier.

Portfolios of assets that lie on the efficient frontier are a continuum, and so they can be represented in graphic form, as follows:

People vs. Econs

Dr. Markowitz’s underlying assumption is that of the “rational investor”, who is someone who is machine-like and able to make rational, quatitatively-based financial decisions about their own portfolios instantaneously.  These decisions include not only individual stock investments, but also asset class allocation decisions, such as 70% stocks/30% bonds vs. 50%/50%, and the like.  Doesn’t that sound like a big ask of people?  Dr. Thaler says this type of rational, machine-like thinking is not consistent with ordinary people.  Dr. Thaler calls people who can make Markowitz-approved decisions “econs”, which sounds like machine-like people.  Everyone else are “people”, and people are fallible, and not able to always make rational decisions about their finances, portfolio allocation, or many other self-interested decisions.  People are human, according to Dr. Thaler, and therefore apt to make poor, or non-rational, decisions.  That’s why people will still invest in stocks and portfolios that are the dots on the graph above that are not on the efficient frontier parabola.

Who’s right?

If Dr. Thaler is right about humans and their inherent fallibility – after all, he just won the Nobel Prize – does that make Dr. Markowitz wrong about his efficient frontier theory?  No, Dr. Markowitz is not wrong.  One should not choose an investment or portfolio with a lower return and higher risk.  He is, however, purely theoretical in his approach, and does not address the behavioral economics aspect of human decision making.

Real Econs

Econs, in Dr. Thaler’s view, are fully rational humans.  The Mr. Spocks of the investment world.  They make unemotional decisions based wholly on facts.  You know who or what else can make such decisions?  Computers.  Hence, the rise of Robo-Advisers, such as Betterment and Wealthfront.  If followed to a T, the investment decisions put out by these robo-advisors can minimize the effect of human fallibility.  Dr. Thaler should approve, although I have not read of his opinion about them.

IMO

I am not advocating that investors should move to robo-advisors.  That would not be good for my business.  I am only pointing out that there are differing theories out there on investment and portfolio management and that it is good for us all to be cognizant of these theories and to forgive one’s self for making incorrect or not-fully-informed decisions because we are human beings.  Thank you, Dr. Thaler, and enjoy the Nobel Prize accolades!

In my Tuesday, October 10 blog post titled “Your Own Risk Tolerance”, I referenced “Nudge”, a book I recently read by Cass Sunstein and Richard Thaler.  I had written that post a couple of weeks earlier.

Nobel Prize

Lo and behold, on the day prior, October 9, Richard Thaler was announced as the winner of the Nobel Prize in Economics.  How great for Dr. Thaler, and how prescient of me!  Dr. Thaler is a professor at the University of Chicago.  His work has been very important to the fields of investing and financial planning.

Opt-In/Opt-Out

Dr. Thaler’s most famous and most significant contribution to financial planning is his recommendation that companies adopt an “opt-out” policy for its employees when they sign up for their 401k.  “Opt-out” means the default position is that employees are in the 401k plan unless they choose to opt-out.  Prior to Dr. Thaler’s recommendation, the default position was the opposite – employees needed to “opt-in” to the 401k.  Companies that switch to “opt-out” find that their 401k participation rate rises dramatically, up to perhaps 90%.  This is very important because qualified plans such as 401k need to meet “non-highly compensated employee” participation quotas.  Whereas, under “opt-in”, companies may have had to cajole or further incentivize employees to enroll in the 401k, under “opt-out”, it is less of the problem to meet the quotas.  It also means that more employees are saving for their retirements, which is a very good thing.

Save More Tomorrow

Another Dr. Thaler recommendation is Save More Tomorrow.  With this, the employee starts in the 401k at a relatively low level of contribution.  Perhaps the employee is young and has a commensurately low salary, or they really need the money today, or they expect they will have a long career with this company.  Next year, the employee gets a raise.  Dr. Thaler recommends you allocate your raise portion to your 401k, thereby increasing your contribution amount without cutting back on your take-home pay.  Continue to live on your same net income, but save more for retirement.  Employees should do this on their own even if their employer doesn’t offer a 401k or other retirement plan.  It’s a good personal sacrifice and good financial planning.

Fewer is Better

Do you like going to a restaurant that has a huge menu?  If so, is it easy or difficult to decide what you want to order?  Maybe you have been to that restaurant before and you know what you want, or you know what is good there – you can choose what you want to eat without help.  Or, are you like me, and you ask the waiter what’s good today?  He may reply, “The salmon is especially good.”  Often, I hardly look at the menu and rely only on the waiter’s (and the chef’s) good judgment.

If choice is good, then more choice is better, right?  Well, not necessarily.  Dr. Thaler noted that people often have a difficult time choosing and that adding to the number of possible choices only serves to add to one’s confusion.  A restaurant that offers a smaller menu is effectively limiting the customer’s choices on purpose.

What do restaurants, salmon, and menus have to do with investing?  Dr. Thaler’s work suggests that employers who offer 401k plans should limit the choices that employees have in allocating their contributions.  Instead of offering 10 different large-cap growth funds and ask the employee to choose, only offer 2, but make sure both of the choices offered are strong funds with relatively low fees.  By limiting choice, Dr. Thaler believes more employees will become engaged in their investments and will ultimately pay more attention to their own future needs.   Same with financial advisors outside of 401k’s.  Offer a choice, but only a choice of the best investments in your, the expert’s, opinion.

IMO

Dr. Thaler calls choice-limiting “Libertarian Paternalism”.  I agree with the Paternalism part, but maybe not Libertarian.  Like any theory, one can agree or disagree with all or part of it.  With respect to investors and how they allocate their portfolios, Dr. Thaler’s findings are very helpful.  It is a good thing if more people save and invest and learn how to allocate their portfolio, and it is a good thing that they increase their engagement with the investment world.

Next blog, I will discuss another Richard Thaler finding and how it relates to modern financial theory.  There may be conflicting theories among Nobel laureate economists.

Two books that I recently read are “The Undoing Project” by Michael Lewis, and “Nudge” by Richard Thaler and Cass Sunstein.  Both books are about the broad field of Behavioral Economics, or what economic choices people make and how they make them.  “The Undoing Project” is a semi-biography of the founders of the field of Behavioral Economics, two Israeli economists/Ph.D.’s named Amos Tversky and Daniel Kahneman.  Tversky and Kahneman both taught extensively in the United States, and Thaler and Sunstein studied under them and are their disciples.  I am not a proponent of Sunstein’s politics, but the book was very interesting.

Both books stated that individuals are not very self-aware and that they make poor economic (and other life-related) choices as a result.  Individuals are not objective when it comes to themselves, and they often need a third-party objective eye to help them make better personal decisions.  A lot of research and some pretty humorous experiments resulted in these conclusions.  Think about it – Do you honestly think you make the best decisions about yourself?  Or does it help if you talk it over with friends, relatives, spouses, experts, people you trust, and the like?  Don’t you really make better decisions if you have outside, more objective help?  I think I do.  Probably you do, as well.

Financial Planners

One of the standard steps that occur when a financial planner engages with a client is to have the client fill out a risk tolerance profile.  Perhaps the planner fills out the profile while speaking with the client, but the result is similar:  The client tells the planner what they feel their risk tolerance is.  A lot of extensive brainpower and research has gone into compiling these risk profile questionnaires.

How Reliable?

How reliable are these risk profile self-assessments?  Tversky and Kahneman, as well as Thaler and Sunstein, would say Not Very.  People don’t make good decisions about their own lot in life, they all would say.  For years, sentiment among financial planners has been that people think they are risk tolerant when markets are strong, and not as risk tolerant when markets are weak.  Texas Tech University researchers Michael Guillemette and Michael Fink have researched this phenomenon, and they have presented the following chart, which graphs surveyed risk tolerance vs. the S&P 500:

The information is now a few years dated, but the point is still valid:  Risk tolerance ebbs and flows with the S&P 500, not perfectly, but pretty well correlated.  People feel they are more risk tolerant when the market is good, and not so when the market is bad.  Ergo, in a macro sense, you can’t trust yourself to determine your own risk tolerance.

IMO

Mike Tyson famously said, “Everyone has a plan until they get punched in the mouth.”  A financial punch in the mouth is a major market correction, a la 2008, which is displayed in this chart.  Once you get a big punch in the mouth such as 2008, you become shy, and a smaller punch in the mouth hurts maybe more.  The best way to “roll with the punches” is to have a well-diversified portfolio.  When I say “well-diversified”, I mean among different asset classes – equities, government bonds, corporate bonds, hard assets, and cash.  Also, trust me when I say you shouldn’t trust yourself to determine how tolerant you are of risk.  In fact, you will find out for yourself during the next correction, when you get your account statement and your worth has deteriorated.  If you are well-diversified, the punch in the mouth should not hurt as much.  A final shameless plug:  Work with a trusted financial advisor and allow them to understand that your own risk tolerance assessment is a point to be considered, but not the final statement about the composition of your portfolio.

In March 2014, Michael Lewis published “Flash Boys”, a book that warned about the dangers of High-Frequency Trading (“HFT”).  Lewis posited that the stock market is rigged in favor of the High-Frequency traders, to the detriment of the individual investor.  HFTers knew how to skim fractions of pennies off of trades and put millions on the line in doing so.  Although the trading margins were extremely thin, the HFTers could count on those margins, so they were extremely profitable.

By virtue of his star power (he previously authored “The Blind Side”, “Moneyball”, and several other best-sellers), Lewis got a lot of attention for his warning in “Flash Boys”, including a spot on 60 Minutes.  According to Lewis, the individual investor was being ripped off because these HFTers’ actions would not allow the individual investors to buy stocks for the price they wanted to.  Lewis thought this would lead to disengagement by individual investors and could spell doom for the markets as a whole.

“Flash Boys” helped spark calls for government and/or SEC action to put the clams on HFTers,  if not to shut them down altogether.  The book highlighted an alternative exchange, the IEX, that was designed to negate the effects of HFTers and make the markets fairer to individual investors.

Since Then

On March 31, 2014, as “Flash Boys” was published, the SPY (the S&P 500 ETF) closed at 187.  The SPY closed last Friday (September 22, 2017) at 249.44, an increase of almost exactly 1/3, or 33%.  A number of HFT firms have either gone out of business or consolidated with other firms.  One of the larger HFT firms, Virtu Financial, went public in April 2015.  It closed at 22.18 its first day of trading.  It is currently trading at 16.45, a decline of 26%.  There are no more books, articles, or editorials warning of the dangers of HFT.  Likewise, there has been no new action by the SEC to restrain HFT.  In short, the stock market has risen while the HFT business has declined, and HFT is no longer on the list of problems to deal with.

Was Lewis Wrong?

Does the decline of HFT and the rise of the stock markets mean that Lewis was wrong, and that “Flash Boys” was wrong in its diagnosis of the markets?  No, Lewis wasn’t wrong, but he wasn’t correct, either.  Perhaps the stock markets have risen despite them being inherently rigged.  Perhaps HFTers’ margins were so small that individual investors didn’t much care if they lost out on fractions of pennies and went ahead and bought stocks anyway.  HFTers need volatility to make money, and volatility in the markets is at a short-term low, certainly much lower than in 2014.  So, market conditions now are not good for HFTers.  If volatility increases, HFTers will be back in force to ply their trade.

Self-Correcting

The other point that I want to make is that the HFT issue has been dealt with without further SEC intervention.  Market forces caused the phenomenon to ebb.  Trading technology improved and got faster, and new companies entered the market in an attempt to get in on the big profits the Virtus of the world were making.  This, in turn, cuts into the early entrants’ profits, which caused consolidation.  Market volatility has waned.  The SEC didn’t need to intervene.  Market solutions work best – in this case, market solutions worked far more quickly than the SEC could even get started.  My thought is that self-correcting market-based solution will work best in most any issue that arises in the economy wherein there are calls for government action or control.  Yes, I am thinking most about health insurance.