In all my years of working with clients, I can only think of two people who wanted to retire in the traditional sense.
Retiring the Idea of Retirement

The concept of retirement, as we understand it today, is completely outdated.

Wait a minute, did I say completely outdated? I mean completely, ridiculously, totally, absurdly outdated. It wasn’t a good idea when Otto Von Bismarck, the chancellor of Germany, cooked it up, and it’s certainly not a good idea now.

In 1881, Bismarck designed a plan for retirement, hoping to defuse a threat from Marxists, who were gaining popularity throughout Europe. The plan was carried out in 1891 with the age initially set at 70; it was lowered to 65 in 1916. At the time, most potential pensioners would be dead by 65. Smart politics then, perhaps, but bad policy now. If you reach 65 today, according to the Social Security Administration, you can expect to live around 20 more years. But we can’t exactly blame Bismarck for not being forward thinking enough — it was 135 years ago!

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Do you remember playing pretend when you were little? Maybe you were a superhero, a dinosaur or a princess. It’s normal when you’re little, and it’s usually harmless. Most children know the difference between pretending to be a superhero and jumping off the roof thinking they can fly.

But adults often forget.

For instance, we may stop pretending to be superheroes, but a lot of us seem convinced that we can pretend to be investors. That’s dangerous.

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On your deathbed, it’s too late to make wish lists.

That’s the thought that went through my head high over the ocean, willing the plane to go faster as I rushed thousands of miles back to New Zealand to meet up with my gravely injured wife in the hospital near Christchurch.

Let me back up…

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Imagine you’re sitting in an auditorium full of all kinds of people. Everyone is there to learn about what to do with his or her money. All of a sudden, the door to the room opens, and in walks the much-anticipated speaker. Who do you think it is?

If you said Warren Buffett or the retired Fidelity ace Peter Lynch, you’re wrong. The famous speaker is Numbers.

That’s right, Numbers.

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Recently, a financial advisor shared a story about a prospective client. The client had a problem. He didn’t like how heavily his portfolio was invested in the stock market. The risk just felt as if it was too much.

When the new adviser asked why it was invested that way, the client replied, “It’s the way my current adviser said the money needed to be invested.”
After spending considerable time to make a thorough diagnosis, the adviser suggested his client invest much more conservatively. It turns out that this particular individual had way more money than he would ever need. It could have been in cash, earning close to nothing, and he’d still meet his goals.

When he suggested the change, the client said, “You can do that?” It was the first time someone took the time to link his actual goals (low-risk investments and maintaining a steady income stream from them) to how his money was invested.

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You catch the news on the way into the office.  Yesterday the market reached a 10% low relative to its last peak.  Immediately in your mind you begin to filter your clients and prospects.  Some will care and others won’t.  You’re grateful most of your clients either don’t pay attention to that stuff or don’t seem to react.

Yet in your mind you can picture three or four faces.  These are clients that seem to consume the news and, when the market reaches certain thresholds, they become unnerved.

They are unnerved for a simple reason.  In their mind a pattern has formed.  Their hidden belief is that because the market has gone down 10%, then it will go down another X% (fill in the blank with 5%, 10%, 15% or what have you).

In other words, they don’t mind so much that the market has gone down, but they mind a lot about where they think it’s going to go.

We can’t really blame them.  Humans are programmed to form patterns – this is why we see constellations in the stars.  As Wall Street Journal personal finance columnist Jason Zweig says in his fantastic book Your Money and Your Brain, “After two repetitions of a stimulus – like, say, a stock price that goes up one penny twice in a row – the human brain automatically, unconsciously, and uncontrollably expects a third repetition”.

This behaviour is everywhere, but it especially hurts us with money.  Consider how many fortunes have been blown in the casinos of the world because the gambler thought they were on a ‘hot streak’.  Rolling consecutive sevens in craps or hitting 21 on consecutive hands in blackjack makes us think, for some reason, that the next seven or 21 is more likely than it really is.

Carl Richard illustrates the phenomenon this way:

How do we counteract this behavioural bias?  By being relentless with the truth.  And the truth is this: a recent down turn in the market never has, and never will, be any predictor at all of future negative returns.  The graph below shows the how the market performed 12 months, 24 months and 36 months after market falls of varying magnitudes from a previous market high point.

Across the board the median case is that markets were positive after any size drop.  Looking at the upper and lower quartiles shows a distribution of results is possible (of course) but it’s mostly positive.  We use the S&P 500 to take this illustration all the way back to World War II.

Salient for current markets, the median returns after the markets have fallen 10% is a positive 8.19% for the next 12 months, which is right around what the market returns on average anyway.

As advisers, it may be useful to show this chart to clients so they can read the facts, but perhaps it’s even more useful to memorise the facts for ourselves.  How powerful is it if, over the phone, you can say, “I know you’re concerned, Joe, but since the end of World War II, the market has lost 10% from a previous high a total of 14 times.  In those cases, the median return 12 months later was 8.19%.  Based on that, I don’t think we should read too much into recent performance.”

Of course, there is another approach.  An adviser we work with recently told us they say to clients who ask, “I know the market just lost 10%.  Isn’t it great?”

“What?” says the client, slightly exasperated.

“Listen, if the market didn’t ever go down then we would never earn the premium for owning shares, and without the premium for owning shares we’d never reach our financial goals.  We need volatility!  Don’t worry, we haven’t taken on any more volatility than you can handle”.

“Oh, ok” says the client, and changes the subject.

Insurance and portfolio management have a lot more in common than most people think.

Imagine for a moment that you own an insurance company and your entire portfolio is made up of ten very big policies, all paying you healthy premiums.  Imagine also that you know a lot about your insured policy holders, and you feel confident about each policy.

But, being a responsible person, you hire an actuary to take a look at your risks.  After careful examination, the actuary comes to you in a panic.

“You’ve got a big problem” he says.  “A few of those claims going wrong could really hurt you.”

Then he adds some grist to his words.  “You only have a small number of large policies.  Most of the insured risks are from the same area and it is possible one big event could affect multiple claimants at once.  In other words, the risks between policies are correlated.”

“Correlated?” you say.

“Yes,” he responds, “It means that a risk affecting one can affect others.  The problem for you is that one rare event could bring this company down.”

It’s clear you’re unimpressed.  The actuary continues, undeterred.

“Your portfolio of policies is completely under diversified, breaking the first rule of risk management.  Let me put it this way – you could make a killing, get average results or get killed.  But the chances of getting killed are way too high!”

You don’t like the sound of getting killed.  “What’s the solution?” you ask.

The actuary responds, “Obviously, you need more policies; smaller policies, from more locations with different and less correlated risks.”

This story isn’t just hypothetical.  In 2011 AMI Insurance held 35% of the market share in fire and general insurance in Christchurch.  Clearly, the risks on those policies were correlated, in so far as one event affected nearly all policy holders at the same time.  AMI had the audacity to allude to the fact that they were victims of their own success…but equally they were victims of their own hubrisregarding risk control.

What’s the connection to a portfolio of investments?

Well there is quite a strong connection if your share portfolio includes only a dozen or so New Zealand shares and a few from Australia.  A portfolio concentrated in such a way is susceptible to two big risks:

• A sudden reversal in the fortunes and price of any one business you own.
• Something happening in New Zealand that seriously affects the profitability of all businesses in this country (they’re called recessions).

Like an insurance company that wants to control risk, you don’t want a few huge holdings.  You want thousands of small holdings (shares) in your portfolio, across dozens of countries and hundreds of different industries.

This is exactly what a diversified asset class portfolio offers.

You know that some of those businesses will fail or deliver very poor returns, but it doesn’t matter, because any one company is only a miniscule part of your portfolio.

Similarly, an insurance company with a diversified group of policies understands that someone will make a claim, and they have spread the risk of that eventuality so that the impact will be minimal.

This approach, while making perfect sense from a risk perspective, has one important drawback.  Whilst it removes the chance that your portfolio will get ‘wiped out’ by some inevitable poor returns, it simultaneously removes the chance that you will make a killing.

It essentially destroys the potential of a get rich quick event, but if that’s your game, why have a dozen or so shares?  Just pick your favourite one and pray…

Of course you wouldn’t insure your home with a company that had such a foolish strategy.   Why would you insure your future that way?

Traveling as you frequently do, you find yourself sitting next to another guy in a suit on a plane for an hour or so.  Chit chat soon turns to, “So, what do you do?”

As someone who works in the investment industry, this can actually be a dreaded question because you know where this conversation almost always leads. “I’m a financial adviser.  I work with investors to help them achieve their long term goals.”

And then, the inevitable follow up, “So what’s your track record?”

It’s hard to explain to someone that this is actually the wrong question to ask.  The fact is, a financial adviser doesn’t have a track record, they have many track records.  This is because they are actually managing many different portfolios  – one (or more) for every client, and each client is different.  Some are in retirement, some are saving.  Some are at their peak earnings, others are approaching it.  Some have just received an inheritance, some have a mortgage.

A financial adviser is a planner first and foremost; they are a portfolio manager only in the sense that they use investments as the means of achieving the goals of a plan.  The investments are a tool, but they are never an end in and of themselves.

The first thing an adviser will do is have an honest conversation with you on exactly what you are trying to accomplish, and how much time you have to get there.  Together, you and the adviser will develop a strategy that is very likely to achieve that objective.  Then, and only then, will an adviser consider a portfolio that is:

1. Likely over the requisite time period to achieve the objective, and

2. Is a fit with the investor’s willingness to go through the vagaries of market gains and losses.

As the sketch below describes, the process starts with goals, which lead to a plan, which then lead to finding investments that fit the plan.    

Why this order?  Because in the scheme of things, investments are probably not all that important, and certainly, track records are dubious guides as well.  An excellent adviser isn’t focused on picking great investments, they are focused on creating great investors.  Great investors invest primarily with their long term goals squarely in mind.  The only track record they are interested in is whether or not they are on course to achieve their goals, and if they’re not, what they should do about it.

As you can see, for a real adviser their approach is goal-focused and planning-driven, rather than based on some attempt to outguess the economy or the markets.  All successful investing involves constantly acting toward the realisation of goals, and all unsuccessful investing is based on reacting to whatever the market happens to be doing at the time, or overanalysing recent track records.

How do you explain that on an airplane?  We’d better work on that one.

According to a new study by State Street called “The Folklore of Finance: How Beliefs and Behaviors Sabotage Success in the Investment Management Industry” (which can be accessed here), investment professionals use easy to articulate – but often incorrect – guidance for making and justifying investment decisions.

We’d like to comment on a few of these folklores, and first up is the folklore of time.

The folklore of time describes beliefs related to what occurred in the past and what may occur in the future.  For example, the paper says that investment professionals rely heavily on analysts’ expert forecasts (which are essentially a prediction of the future).  Evidence shows, however, that when measured properly, accuracy rates of these forecasts over 24 month time frames are as low as 5% – 10%.

How much confidence would you put in forecasts with 10% accuracy over two year periods? Probably less than the investment management industry apparently does.

The folklore of time doesn’t merely affect attitudes about the future.  The State Street study finds that investment professionals also show a baffling tendency to rely on past performance when making investment decisions.  This is despite the truism that past performance is no indication of future results.

The State Street study corroborates this truism with a study of 715 US stick market funds which posted top quartile performance in March 2010.  After four years, only two (yes, that was two!) of 715 had maintained that top performance throughout the subsequent four year period.  Persistence in performance is a myth.  Authors also point to another study that shows that managers fired because of poor past performance often subsequently outperform the managers hired to replace them.

The fact is that relying on extrapolations of the past or predictions for the future, even those provided by experts, is a very dangerous way to invest.  Yet given the uncertainty we all face with investing, our brains are hardwired to do just that.  The alternative, of course, is not to focus on predicting or extrapolating financial markets.  Instead, focus on holding a low cost, widely diversified and carefully monitored portfolio, which can achieve your long term goals and is less likely to experience inevitable downturns that you can’t stomach.

And, having done that, do something completely novel (at least in the investment industry).  Enjoy the present!

Editor’s note: Jason Zweig recently wrote his 250th “Intelligent Investor” column for The Wall Street Journal and shortly thereafter won a Gerald Loeb Award, considered the most prestigious in business journalism, in the Personal Finance category.

I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.

The advice that sounds the best in the short run is always the most dangerous in the long run. Everyone wants the secret, the key, the roadmap to the primrose path that leads to El Dorado: the magical low-risk, high-return investment that can double your money in no time. Everyone wants to chase the returns of whatever has been hottest and to shun whatever has gone cold. Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed ‘em.

In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.

It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It’s also no wonder that the media has ignored those findings. Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.

My job, as I see it, is to learn from other people’s mistakes and from my own. Above all, it means trying to save people from themselves. As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

One of the main reasons we are all our worst enemies as investors is that the financial universe is set up to deceive us.

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.

My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.

There’s no smugness or self-satisfaction in this sort of role. The competitive and psychological pressure to give bad advice is so intense, the demand to produce noise is so unremitting, that I often feel like a performer onstage before a hostile audience that is forever hissing and throwing rotten fruit at him. It’s hard for your head to swell when you spend so much of your time ducking.

On the other hand, you can’t be a columnist for The Wall Street Journal without a thick skin. I have been called an ignoramus, an idiot and dozens of epithets unprintable in a family newspaper;
accused of front-running or trading ahead of my own columns;
assailed as being in the pockets of short-sellers betting against regular investors; described as being a close friend of a person I’ve never met in my entire life;
decried as being biased in favor of high-frequency traders and as being biased against them;
and told, almost every week, that I lack even the most basic understanding of how the financial markets work.
The perennial refrain from critics is: You just don’t get it. Internet stocks / housing / energy prices / financial stocks / gold / silver / bonds / high-yield stocks / you-name-it can’t go down. This time is different, and here’s why.

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.

When, in the fourth quarter of 2008 and 2009, I repeatedly urged investors to hold fast to their stocks, I was called a shill for Wall Street and helplessly naïve.

When I took a skeptical look at Congressman Ron Paul’s gold-heavy portfolio in December 2011, angry readers called me “weak minded,” “ignorant,” “pathetic” and a member of “the big bank lobby.” (Gold was around $1,613 per ounce then; it was last sighted this week sinking below $1,230.)

When, only a few weeks ago, I warned that any hints of a tighter policy from the Federal Reserve could crush recently trendy assets like real-estate investment trusts, high-dividend stocks and “low volatility” stocks, readers protested that I didn’t even know the difference between a rise in interest rates and “tapering,” or a decline in the rate at which the Fed buys back bonds. I know the difference – but, with many of these assets down by up to 10% since then, it isn’t clear that all investors knew the difference.

Every columnist knows that if you ever write something that didn’t make anybody angry, you blew it. People don’t like having their preconceived notions jolted, and doubt and ambiguity are alien to the way most investors think.

That’s why I’m realistic. I don’t ever expect to convert all my readers to my viewpoint. I would be a fool to think I could. But I’d be a worse fool if I ever stopped trying.

So you can understand exactly where I am coming from, I will tell you a story.

My senior year of college, my father was dying of lung cancer. Most weekends, I would take the train up from New York City to Fort Edward (then the nearest train station to where I grew up in rural upstate New York).

On one of my last visits, even as my father was in severe pain, he asked me the same question he always did: What are you reading?

I fluffed my feathers a bit and said: Kierkegaard. “What is he telling you?” asked my dad. I had just been reading a volume of Kierkegaard’s journals on the train, immersed in the poetic ruminations of the great Danish philosopher. So I immediately spouted, verbatim and with the appropriate pauses for world-weary effect, the words I still remember to this day: “No individual can assist or save the age. He can only express that it is lost.”

Without a moment’s hesitation, my dad retorted: “He’s right. But that’s exactly why you must try to assist and save the age.”

In that one moment, my dad put a callow youth gently in his place, out-existentialized the great existentialist and gave me words to conduct a career by.

Only years later did I understand fully what he meant: We can’t assist or save the age, but the attempt to do so is the only way we have of even coming close to realizing some dignity and meaning for our lives. The longer the odds, the greater the obligation to try to beat them. That’s why I keep at it, even though I have profound doubts that most people will ever learn how to be better investors. I never expect everyone to listen; all I ever hope for is to get someone to listen.

I felt this firsthand in a former job in 1999 and 2000, when I wrote column after column warning people not to fling money at technology stocks and, in return, got hundreds of hate emails a week (often hundreds per day). It was grim, contrarian work, constantly refusing to tell people what they desperately wanted to hear – it was like trying to stop a hurricane by pushing against it with your hands.

The vindication came for me not when the Nasdaq bubble burst, but years later, when a hand-addressed envelope came in the mail. One of my columns was enclosed, folded again and again and frayed almost to tatters.

Across it, a reader from Minnesota had written by hand: “Dear Mr. Zweig: For a long time I have wanted to say thank you for writing this. The second I read this it made so much sense to me that I tore it out and folded it up and carried it around in my wallet. Whenever my friends started bragging about their trading profits I would excuse myself, go to the bathroom, pull this article out and read it again and it kept me out of trouble. I am returning it to you now because I don’t think I need it anymore, but I wanted you to know that I have carried it with me every day for years.”

No one writes letters anymore, of course. But I still get emails every week from readers telling me that something I wrote kept them out of trouble or helped them make sense of the market’s latest mad outburst.

I’ve had many honors in my career – being chosen as the editor of the revised edition of Graham’s The Intelligent Investor; spending two years helping the Nobel laureate Daniel Kahneman write his book Thinking, Fast and Slow; and, this month, winning the Loeb Award. But the greatest honor I have had is the abiding privilege of trying my best to serve our readers well. It isn’t always easy, and I don’t always succeed, but that effort is its highest reward an investing journalist can ever have.