Learn from the folly of others.
We can learn a lot from the mistakes of other investors because most mistakes are caused by human nature. We all experience the same psychological biases and emotions. Therefore, we are all susceptible to making the same mistakes. Some of these mistakes can have a large impact on our wealth.
Consider Irv and Louise Trockman, two retirees in Dallas. With the help of an overzealous broker, they managed to turn their $1.3 million nest egg into just $700,000. Imagine a loss of 46% of your retirement money. People in their 20s or 30s could recover some of the money before retirement, but Irv and Louise are already in retirement! Their standard of living will be dramatically affected. Irv and Louise made common mistakes. First, they got caught up in the overexuberance of the times and selected a poor asset allocation. Specifically, they were far too overweighted in stocks. Second, they picked risky tech stocks. They complicated the matter by borrowing money, called leverage, and investing that borrowed money. In short, they were tricked into thinking that their investments were much safer than they really were. They were tricked by their own minds.
The Trockmans were taking a lot of risk. Their broker should have warned them about the problem. Unfortunately for the Trockmans, their broker was more of a cheerleader than an advisor. Many investors believe their losses are due to poor advice from their brokers—which sometimes leads to arbitration. Over 6,000 cases of arbitration between investors and brokerage firms occurred in 2001. The need for arbitration can often be avoided when people fully understand the risks of investing and how to properly manage those risks. This book explains how people are often tricked by their own minds into believing their level of risk is low.
The advice we get from the professionals is not always that good. This is often due to the structure of the financial industry. The Trockmans' broker may not have discouraged their investment style because it made the broker money in commissions and fees. Indeed, we have been hearing strange investment advice for a decade. Through investment seminars and infomercials (and even some movies!), we have been conditioned to think that we can get rich by using other people's money. We are told that we should buy real estate with no money down. It is suggested that we should use the broker's money for our investments. What we haven't been told is that using other people's money is very risky! When you borrow money to invest, you are increasing your risk. Borrowing the maximum that is allowed from your broker will double your risk. Why aren't investors told this? Because the incentives of the financial industry do not always favor the individual investor. This book will help you to understand the investment industry and your own investment needs and behaviors. Hopefully, you will be able to avoid an investment blunder (or another one) like the one that befell Irv and Louise. Now, more than ever, your wealth is affected by your decisions.
Do-It-Yourself Investing - Win Investing
There is a worldwide trend toward investment autonomy. That is, people are being asked to manage their own money. Consider the trends over the past couple of decades in the pension arena. Employee retirement plans have gone from predominately managed by professionals in the defined benefit plans to predominately managed by the employee in the defined contribution plan—known as the 401(k) plan. In the late 1990s and early 2000s, serious debates occurred over the possibility of allowing Americans to manage their own social security investment money. Social security reform may yet include some type of self-directed account. Another example is the incredible amount of wealth transferred in the mid to late 1990s from full-advice brokerage firms to no-advice online brokerage firms. Investors have to make their own decisions.
In 1990, employees frequently had few choices in their 401(k) retirement plan. Options commonly were only a money market fund, a bond fund, a stock fund, and the company's own stock. Now participants are faced with allocating retirement assets over an average 11 different choices. Some plans have hundreds of mutual funds to pick from, or even the ability to buy individual stocks. Recent social security reform in Sweden will allow workers to direct 2.5% of their salary to individual accounts where they will have 450 funds to choose from. It is not yet clear how the social security reform in the United States will be accomplished, if at all. But self-directed investment of a portion of social security money is a possibility.
However, the question remains whether people make good choices and benefit from being able to choose their own portfolios. Indeed, people may not make good choices for many reasons. The next chapter discusses how psychological biases and emotions influence choices, usually in a bad way. Another problem is that people often don't really know how the choices they make now affect the realization of their future. Consider your current predicament. You may have preferences for the amount of wealth you want at retirement. You may have a total dollar amount (like $500,000 or $1 million) you want to acquire. Or you may define your preference as a monthly income in retirement. However, right now you are faced with forming a portfolio that will help you achieve those desires for the future. It probably isn't clear how your asset allocation into different investments, such as large and small cap stocks, international stocks, and bonds, will lead to your future success. In other words, the investment choices you face now are not well linked with your preferences for the future. If you don't have clearly defined retirement objectives, then your current choices are even further disconnected from your preferences.
Darren Winters
A lack of clearly defined investment preferences causes problems when you must pick your portfolio. For example, consider the options that confront the typical employee when selecting a 401(k) asset allocation. Different investment options entail different levels of risk. Your future wealth depends on the amount of risk you take and some luck. The luck is the result of not knowing how our economy and the stock market will perform over the next few decades. An investor who takes a lot of risk and invests much of the portfolio in stocks will be rewarded if the stock market does well and will suffer if the stock market suffers. Employees can invest their retirement money in low-risk, medium-risk, and high-risk options.
If your employer confronted you with the investment options, which options would you prefer? Rank the three options into your first, second, and third choice. Note that the options are ordered from the least amount of risk to the highest amount of risk. As you would expect, the more risk you take, the higher the potential rewards. However, there is also a greater chance for a bad outcome if the stock market does not perform well.
Thanks Darren Winters
No comments:
Post a Comment