Fast little loans
This article was first published in the fourth-quarter 2012 edition of Personal Finance magazine.
A simple diagram on the back of an envelope or serviette is often a far more effective way of getting across an idea than a long verbal explanation.
That’s why sports commentators can explain the leg-before-wicket rule in cricket to novices any number of times without success, but a knowledgeable friend with a koki pen and the back of an envelope can clear up the confusion forever. It comes down to visual simplicity and a friendly, empathic tone of voice.
And that’s why a financial planner who uses the same technique can make a difference when other methods fail. That man is Carl Richards, who has a Certified Financial Planner accreditation and lives in Park City, Utah, in the United States.
In his financial planning practice, he found that his clients repeatedly made the same mistakes.
The problem, he says, does not lie in the fact that asset prices boom and then bust; the problem lies between our ears. It originates in our tendency to follow the herd and to act on our perfectly normal feelings of fear or greed. In short, the “problem” lies in simply being human.
The distance between what we should do in our financial best interests and what we actually do is what Richards calls the “behaviour gap”. And that is the name he gave to the book he wrote to help us to stop making the mistakes that deplete our savings. He would also like to help us to stop worrying so much about money and to be more efficient.
It comes down to knowing how to sift out what is important and what is in your control, and letting go of the rest. In other words, it means shedding excess baggage, just like The Behavior Gap uses relatively few numbers, reduces graphs to a few quick lines, and – in line with American spelling – drops the “u” in “behaviour”.
It also means Richards speaks to his readers in an easy, natural way – as if we were all his friends.
Below is a good example from The Behavior Gap: a conversation he had with three clients early in 2009, after severe falls in global stock markets. It’s so informal, they could all be mates sitting at a bar chatting.
The guys: Hey, Carl, we think it’s time to sell.
Carl: Are you suggesting that we sell something simply because it is down 30 percent?
The guys: Well ... you know ... are we just going to keep sitting here while this thing goes down?
Carl: The damage has been done, guys ...
The guys: It’s scary.
Carl: It’s okay to be scared, but it’s a bad idea to act on your fear ... Actually, stocks were a lot riskier when they were more expensive. Back then you were happy to hold them. Why sell now?
Richards picks up the conversation a couple of years later, after stocks had rebounded sharply.
The guys: Should we move more of our cash into stocks?
Carl: Uh, why?
The guys: Because the market’s done so well lately.
Carl: You mean you want to buy more stocks because stocks are more expensive?
The guys: Well, they might keep going up!
Carl: We have no idea what the market will do in the future. Why don’t we stick with our plan?
“I have these conversations all the time,” Richards writes. “In early 2011, with gold up 80 percent over two-plus years, everyone wanted to know if they should be buying it.”
Figures from Allan Gray, the asset management company that brought Richards out for a visit to South Africa in July, confirm that investors lose money because they switch between funds rather than stick with their investment.
The Allan Gray Balanced Fund showed an average annual return of 17 percent for the 10 years to June 30, 2012, and yet the average investor return was 14.4 percent. That means investors lost 2.8 percent because of their behaviour.
In the same period, the Allan Gray Stable Fund’s average performance was 12.7 percent a year, and the average investor return was 10.3 percent.
Both funds beat their benchmarks by about four percent over the period, Rob Dower, Allan Gray’s chief operating officer, writes in the fund manager’s second-quarter 2012 magazine. So about “two-thirds of the out-performance of these funds has been lost over 10 years through investors not being invested when the funds did their best work. This is an alarming outcome,” Dower writes.
Richards recognises that, at the deepest level, our instinct is to avoid pain and seek pleasure. The trouble is that deferred pleasure and self-inflicted discomfort are vital if we are to thrive in the modern world. Almost all the time, we have to override our instincts to flee when part of our brain screams “Danger!”.
Ideally, we recognise when it is appropriate to rein in the primal responses and when to let them take over. If the deep-seated responses get the upper hand in an inappropriate situation, we recognise that as an “emotional” response. It usually ends badly.
Richards isn’t critical of the fact that we have emotions and do “dumb things with money”. He understands all too well – he and his wife lost their family house in the US property crash of 2008.
One of Richards’s strengths is that he accepts human frailties. But his aim, as a financial planner, is to try to get us to break those patterns that harm our financial well-being.
In doing so, Richards has a clear awareness of the principle of “start from where you are”, with all your good qualities and bad habits, without generating a whole lot more emotion in judging them and striving to change them.
It means you don’t have to be what you are not.
It also means focusing on what you can control and letting go of the rest. The quieter and clearer we are, the easier it is to work out what is important, to plan properly in line with those values and priorities, and to stop worrying about the rest.
“I am always trying to figure out how to worry less,” Richards said in an interview with Personal Finance in July.
In 2008, the Richards family – Carl; his wife, Cori; and their four children – were living in a house they had bought in Las Vegas, which he describes as ground zero for the housing crisis.
The Richards owed more than the house was worth. “It was incredibly painful,” he said.
Not only that, the stock market’s fall meant that less money was coming in to pay for a depreciating asset on which the repayments were climbing.
“My income was cut in half, because I earned my income from the amount of money I managed,” Richards told Personal Finance.
Slowly, the family worked their way out of the crisis, and part of the recovery plan was moving to Park City, where most of Richards’s clients were.
“I made a bunch of mistakes, the very same ones that I now go around warning people to avoid,” Richards wrote in the New York Times, which carried his story on its front page. The experience “made me better at what I do, but it wasn’t much fun”.
His New Year’s resolution for 2010 was to stop worrying about money and to “be in the present”, he told Personal Finance. “The way to do it is to be present here and now and to be aware of emotion.”
He got help with this from his cycling coach. Richards enjoys sport: cross-country skiing and long-distance cycling, which includes 200-mile (320-km) races. His coach told him not to worry about the miles; all he should worry about is pushing down the pedal now.
“One time, I was doing a 200-mile race and my knee started hurting, and I thought that if it’s hurting now, how am I going to manage the next 194 miles?” Richards told Personal Finance.
“But then the coach’s words came back: ‘Just worry about pressing down the pedal now.’”
Richards’s coach is influenced by Eckhart Tolle, who espouses mindfulness: being fully aware of what you are doing when you are doing it.
Being present in the moment doesn’t mean you live for the moment. You plan for the future, but your financial planning and paperwork is best dealt with in specific times set aside for that purpose.
“My wife and I have a regular monthly planning meeting. That’s when we talk about money. People should try to set aside a specific time.
“What happens with couples is that the topic of money usually comes up when someone returns home with a whole lot of parcels or a bill arrives. Then it becomes an argument, not a discussion,” he told Personal Finance.
The person who practises mindfulness doesn’t encourage and entertain thoughts that are not conducive to the current activity.
“Your son is just about to go on stage in a play and you have just seen that one of your shares has fallen in price. It’s difficult not to let that take away from your experience of your son’s performance,” Richards told Personal Finance.
Regret about past mistakes and worry about the future distract us from the present, he says.
Making good decisions in the present requires emotional clarity. “Try to pay attention to your emotions around money … Acknowledging those feelings and being aware of their potential impact on your decisions can be important, often in ways that aren’t clear right away.”
By keeping financial matters in their correct place, you can simplify your life. Simplicity helps you to use your time, energy and money more efficiently.
The trouble is, Richards says, we may say we want simplicity, but we gravitate towards complexity. “People worried about money tend to take comfort from a 60-page doorstop packed with charts, graphs, bullet points and calculations.”
One reason for this contradiction, he writes, is that we tell ourselves the solution to an important problem must be complex.
The other is that the simple solution requires behaviour change – and that is seen as painful and difficult. One example is a person who obsesses about her blood pressure medication and the returns on her savings for retirement. Both her doctor and her financial planner agree that the best remedy is not different medication or a different investment but that she gives up smoking and invests the money she saves on cigarettes. That’s the simple and efficient – but not the easy – solution.
Richards suggests some ways in which you can prioritise calmness and efficiency:
* Distinguish between “urgent” and “important”. The really important activities – updating your will, for example – have a habit of sliding down the “to do” list, whereas trivial things have us jumping to attention.
Richards says it helps if we rate our tasks on two dimensions:
– How urgent they are; and
– How important they are. (By this he means how fundamental they are to achieving our goals.)
Tasks that have both these qualities should be at the top of your list, followed by the important but less urgent tasks. Urgent but unimportant tasks, in which we are all too frequently involved, can move towards the back of the line.
* Ignore chatter. There is a lot of information out there. Following every twitch of the stock exchange, every forecast and every release of economic data will not be good for your mental health. And you don’t need to do it for your financial health, either.
“Believe it or not, the ability to build and protect wealth is often inversely related to knowing what’s going on in the market,” Richards says.
First, it increases our anxiety, which can lead to bad decisions. Second, the more information we receive, the harder it is to distinguish between what is important and what is just noise.
If this is a problem for you, Richards suggests weaning yourself off the media, or at least reducing over-exposure, and getting in touch with your goals.
The way to realise your financial goals is the same as it has always been: slow and steady accumulation of capital, pay off debt, spend less than you earn, and steer clear of large losses. There is no magic bullet, Richards emphasises. But it’s easier to follow the principles if you are in touch and aware.
USING YOUR HEAD, NOT YOUR HEART
To help keep your emotions from damaging your finances, financial planner Carl Richards suggests you adopt the following strategies:
* Deal with fear and greed. One of these two emotions will be more dominant in you than the other. When you are aware of which it is, you and your financial adviser can build a portfolio around managing fear or greed.
But Richards says you can’t have it both ways. Trying to do so generally results in your jumping in and out of the market as it moves up and down. “The idea is to aim for a balance that truly reflects your emotional strengths and weaknesses,” he writes in The Behavior Gap.
* Beware of over-confidence. The smartest investors are those who acknowledge they are not smart enough to forecast events or pick the best stock, Richards says. He suggests that before you make a change that will affect your investments, you discuss these three questions with someone you trust:
– If I make this change and I am right, what impact will it have on my life?
– What impact will it have if I am wrong?
– Have I been wrong before?
* Don’t look for the world’s best investment. How many people wish they had bought Capitec shares when they traded at R20 rather than above R200, as they do now? But the search for the next Capitec – or the next hot fund manager – hides some fundamental financial mis-steps:
– It may result in your having a pot-pourri of holdings, all of which have costs and take a toll on your time to administer. And for your effort, you may still not be properly diversified.
– Investors are often told not to invest with fund managers based on their past performance. Richards repeats this advice, and goes further to say there is one factor that can reliably predict performance: fees. The higher the fees, the worse the performance.
Cape Town-based financial planner Daniel Wessels says Morningstar, a data provider in the United States, found that total expense ratios (TERs) were a strong predictor of future performance in US unit trust funds. In every asset class over every time period, the cheapest 20 percent produced higher total returns than the most expensive 20 percent.
The TER includes the annual management fee and performance fees, as well as adminsitrative charges such as custody and trustee fees.
Wessels, of financial planning firm Martin Eksteen Jordaan Wessels, analysed South African data from 2007 to 2009 to see if the findings could be replicated. The TERs of popular unit trust fund sectors showed that the cheapest funds, on average, out-performed the most expensive ones, Wessels found.
Richards says you can’t predict a hot stock based on its past performance, either. He quotes Nathan Pinger, of data-analysing company YCharts, as saying: “Trying to pick a stock’s future growth path based on past growth is like trying to guess if a coin will come up heads or tails when you know that the last toss was heads. The previous toss tells you nothing.”
Richards says it makes emotional sense to take a flier on a stock (or a fund manager) in the hope that it will be a hit. We root for the underdog, we buy lottery tickets, and we believe one financial decision will change our lives forever. “For 99.99 percent of us, chasing after the Googles and Apples of the world will lead to disappointment. Meanwhile, the odds of achieving financial success are much higher if we simply work, save and build an investment portfolio based on reality.”
* Lengthen your definition of the past. You are likely to fall into the boom-and-bust trap if you base your decisions on what you have experienced over the past couple of months or years.
Richards says we don’t have to look far into the past to remember asset booms and how they played out. “But we sometimes push such memories aside – especially when things are going well. Truth is, we like the new trend. When home prices were rising, we were really happy about it. Why worry about the past when the present is so pleasant?”
* Stick to sound principles. Sometimes folly is rewarded, and prudence can be punished in the short term, because investing isn’t always fair. Nonetheless, Richards says, you have to judge advice based on whether or not it sticks to sound principles. One of these is diversification.
If you have 90 percent of your portfolio in one stock, that’s a bad financial decision. (It’s usually an emotional decision and comes because the shares were bequeathed to you or because they are your only connection to a former employer, for example.) If the shares double in value in a year, it’s still a bad financial decision, Richards says.
“There is no best investment out there,” he writes. “But sometimes the best decision is obvious.”
* You can read Carl Richards’s blog and sign up for a free email newsletter at www.behaviorgap.com