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Ddd WEALTH LOGIC, LLC A Random Walk Down Behavioral Finance Allan S. Roth, MBA, CPA, CFP ® July 15, 2005 © 2004, 2005 Wealth Logic LLC, all rights reserved.

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Presentation on theme: "Ddd WEALTH LOGIC, LLC A Random Walk Down Behavioral Finance Allan S. Roth, MBA, CPA, CFP ® July 15, 2005 © 2004, 2005 Wealth Logic LLC, all rights reserved."— Presentation transcript:

1 ddd WEALTH LOGIC, LLC A Random Walk Down Behavioral Finance Allan S. Roth, MBA, CPA, CFP ® July 15, 2005 © 2004, 2005 Wealth Logic LLC, all rights reserved

2 ddd2 Disclosure Wealth Logic, LLC is a Registered Investment Advisor providing fee-based investment advice and financial planning services. Wealth Logic, LLC is registered with the State of Colorado. All content on this site is for informational purposes only. This content is not investment advice to your specific situation nor is any of this to be considered legal, accounting, or tax advice. Opinions expressed on this site are solely those of Wealth Logic, LLC. Internet site live links to other internet addresses are external to Wealth Logic, LLC and contain information created, published, and maintained by those outside organizations. Material presented is believed to be from reliable sources and we make no representations to its accuracy or completeness. The purpose of this site is limited to the dissemination of information and is not intended to be a solicitation or offer to sell investment advisory or financial planning services in states where Wealth Logic, LLC is not currently authorized to do so. Warning! This is not for the faint of heart! While economically superior to traditional investing under any levels of desired risk, it will not provide emotional excitement. This style of investing is not suitable for anyone demanding entertainment from their investing.

3 ddd3 Presentation Goals 1.For us all to learn something…especially me. 2.Have some fun 3.Balance between creating some controversy and getting kicked out of the Investment Club. CONTROVERSY ROTH BOOTED FROM CLUB Warning: You do not want to hear Roth talk for 2 hours!

4 INTRODUCTION RANDOM WALK VS. BEHAVIORAL FINANCE

5 ddd5 The standard theory The rational agent of economic theory: has consistent opinions and beliefs – uses all available information – unbiased by emotion, ‘herd’ effects has coherent preferences – tangible motives (wealth, security) – unaffected by ‘framing’ of problems – unaffected by regret Source: Daniel Kahneman (Nobel Prize Economics)

6 ddd6 Real agents are overconfident, and mostly optimistic are unreasonably loss-averse are risk-seeking when facing the possibility of a certain loss tend to frame decision problems much too narrowly are prone to hindsight, and are not always efficient in learning from experience Source: Daniel Kahneman (Nobel Prize Economics)

7 What Kind of slogan is DARE TO BE DULL? Emotionless investing designed to double your real return. It requires a paradigm shift that’s not for the faint of heart. It is for any level of desired risk, but only to get additional expected return.

8 ddd8 …AND NOW LET’S GET GOING

9 ddd9 3 Key Points 1.I’m Good 2.Get Real 3.Think Dull Wealth Logic on Investing

10 ddd10 When it comes to market timing and picking winning stocks, I’m really good… …at forecasting the past! I can forecast the PAST with nearly 100% accuracy! It’s the future I’m so lousy at – and so is everyone else! Point 1: I’m Good

11 ddd11 In 1973, Burton Malkiel compared portfolios carefully selected by professionals using sophisticated techniques (technical and fundamental analysis) and research to blind-folded monkeys throwing darts at the financial pages. Since then, many academic studies have “proven” the chimps are every bit as good as the experts. Unfortunately, these academic studies are FLAWED! Comparing experts to apes is DISPARAGING and DEGRADING… SELECTING THE RIGHT STOCKS

12 ddd12 …BUT MALKIEL HAS NEVER APOLOGIZED TO THE CHIMPS! REALITY Most academic studies assume a theoretical world with no emotions, taxes, or transaction costs. In the real world: Chimps aren’t subject to the same emotional need to keep throwing the darts creating more costs and taxes. Chimps will work for bananas – the experts charge billions of dollars for increasing risk and decreasing return.

13 ddd13 Money Magazine – Oct. 03 Top Picks from 24 Top Pros – Invest in the Best Asked some “first-rate investing minds to share their best ideas.” “We call this gathering of wise minds the Ultimate Investment Club.” The 24 top pros identified 34 domestically traded stocks as their top picks. Each pick was backed by brilliant and compelling logic. EXAMPLE

14 ddd14 The Ultimate Investment Club destroyed 14% vs. the Market! First Rate Investing Minds -2.4% +11.5%US Stock Market Twelve months ended August 31, 2004. Source: Calculated from Yahoo Finance - included dividend reinvestment. This included six stock picks listed on US exchanges but not included in the Wilshire 5000 Total Stock Index. The 28 US domiciled stocks had a -7.6% return which lagged the index by 19%. THE STORY MONEY MAGAZINE NEVER PUBLISHED BUT THE COLORADO SPRINGS BUSINESS JOURNAL DID

15 ddd15 TWO LESSONS LEARNED 1.Track record, brilliant minds, the most sophisticated technical and fundamental analysis, and every other thing that money can buy, was of negative value. 2.34 stocks is not enough diversification to eliminate tracking error. Malkiel is wrong here!

16 ddd16 The Value of Expert Advice The Wall Street Journal 4/11/05

17 ddd17 The Value of Expert Advice June 10, 2005latimes.com : Business E-mail story Print Most E-mailedlatimes.comBusiness E-mail story Print Most E-mailed THE NATION Long-Term Interest Rates Buck Conventional Wisdom By Tom Petruno, Times Staff Writer The surest bet on Wall Street a year ago was that long-term interest rates would rise, boosting the cost of home mortgages and in general making credit tougher to get. That forecast seemed to make perfect sense because the Federal Reserve was raising its bellwether short-term rate for the first time since 2000. Long-term rates usually move in tandem. REALITY: The WSJ Semi-annual survey of 50 Top economists predictions of long-term interest rates have been DIRECTIONALLY correct 29% of the time.

18 ddd18 The Score: Sophisticated MBAsChimps 1.Money’s top Advisors X Picking Stocks 2.Wall Street Analysts X “Sell” vs “Buy or Hold” 3.WSJ Top 50 Economists X Score 0 3

19 ddd19 4.5%1.4% 2.0% 1.1% Real Return Less Fees Less Taxes Actual Real Return Source: Ibbotson Associates, Charles D. Ellis - Winning the Loser's Game (1965-1994). The actual Tax cost during the Period was 2.1% and this calculation was based on the new lower tax rates. The individual investor will give away most of their real return! Estimated Future Portfolio Returns based on Lower Tax Rates Point 2: GET REAL...as in real returns

20 ddd20 4.5%1.4% 2.0% 1.1% Real Return Less Fees Less Taxes Actual Real Return Investors barely beat inflation but think they are trouncing the market Point 2: GET REAL! Inflation Adjusted & Reality Based 7.5% Perceived Real Return REALITY DISCONNECT

21 ddd21 Behavioral Finance $1 Billion 1 to the person who finds the most patterns 1 Not really

22 ddd22 Behavioral Finance

23 ddd23 Dogs of the Dow WHAT HAPPENED?

24 ddd24 The Highest Correlation Ever Found: Butter Production in Bangladesh! + = S&P 500 Performance

25 ddd25 Behavioral Finance In college basketball, what percent of the time do you think the team behind at halftime wins the game?

26 ddd26 Behavioral Finance The NASDAQ plunge from the 1999 technology bubble was predictable: T or F.

27 ddd27 Hindsight Bias – Who wouldn’t want to go back 15 years and revisit a decision to invest in a product that hadn’t changed in 50 years versus the leader in a technology that would ultimately change the way we all communicate? Hindsight is almost 20/20

28 ddd28 Recent Hindsight Bias If on July 6, you had a crystal ball and knew on the morning of July 7 that there would be a major terrorist attack, you would: A)Get out of the market. B)Buy more stock. Even hindsight isn’t 20/20!

29 ddd29 Terrorist Attack S&P 500 After the Terrorist Attack

30 ddd30 Behavioral Finance The last time I went to Las Vegas, I think I: Won overall Broke even Lost overall Never gambled in Las Vegas Over the past few years, I believe I have: Outperformed the market as a whole Performed about as well as the market as a whole Under-performed the market as a whole

31 ddd31 Behavioral Finance Never underestimate our ability to believe what we want to believe. Remember the Beardstown Ladies? They were an investment club claiming that by using common sense, they earned an incredible 23.4% annual return for the 10 years ending 1992. It was an amazing and compelling story, but after writing five best selling books, someone actually went back and looked at their data. Instead of the celebrated 23.4%, their return was actually about 9%, barely more than half the market return! Anybody heard from the Beardstown Ladies lately?

32 ddd32 Behavioral Finance The average AAII member reports they beat the market by 3% annually. –Fact or the “Las Vegas Effect”?

33 ddd33 Behavioral Finance

34 Below is a brief summary of Behavioral Finance Economists view the goal of investing as maximizing economic wealth. Yet behavioral finance shows investors are being led by their feelings and achieving sub-optimal economic gains. Heuristic biases are mental shortcuts that cause us to make systematic mistakes. Even after we make these mistakes, we are usually not aware of them and continue to systematically make them. Examples of these biases include: Overconfidence and Optimism - In ourselves or expert advisors. Data Mining – Finding patterns out of randomness to predict the future. Anchoring - mentally locking in a price even though it is now irrelevant. Hindsight Bias – Predicting the past as if one knew what would happen. Fear and Greed – Running from a down market and toward a bull market. Mental Accounting – Believing we are doing better than we are. Status Quo - Aversion to change.

35 ddd35 Point 3: Dare to Be Dull ® A New Investing Paradigm Investing is Complex. Your investments need constant monitoring & a big team of professionals. Sophisticated products are superior. Hard work pays off. You think you are only paying 1% fees but are paying far more in hidden costs and unnecessary taxes. Investing is radically simple. Investing is long-term & requires little monitoring. Simple, ultra low-cost & tax-efficient vehicles are far superior. With a properly designed portfolio, doing nothing will be your hardest task. Cutting fees, hidden costs, & taxes will produce wealth for you. OLD PARADIGM Exciting & Feels Good NEW PARADIGM Dull, but Doubles Real Return

36 What does Warren Buffet have to say? “Over the past 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns. All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous…. Investors should remember that excitement and expenses are their enemies.” 2004 Berkshire Hathaway Annual Report

37 ddd37 1. Behavioral Finance (Psychology) 2. Efficient Investments (Mathematics ) MPT 2a. Asset Allocation 2b. Diversification Dare to be Dull sm Framework Copyright © 2004, Wealth Logic, LLC. All rights reserved. = Mathematically Superior Wealth Accumulation 3. Pick the low hanging fruit

38 ddd38 1. BEHAVIORAL FINANCE (Psychology) The entire plan is developed with an understanding of the behavioral aspects of investing for both the client and the investing public. It is important to understand that we are all programmed to do the wrong things regarding investing. 2. EFFICIENT INVESTMENTS (Mathematics) A portfolio is designed to achieve a high expected return for a given level of risk using two tools: 2a. Asset Allocation: Determining the client's willingness and need to take risk and then selecting non-perfectly correlated asset classes that maximize the risk return equation. 2b. Diversification: Within each asset class, maximum diversification reduces overall risk without impacting expected return. 3. PICK THE LOW HANGING FRUIT Most portfolios have ample opportunity to make easy changes to get greater returns without taking additional risk. Some portfolios actually have opportunities to seize guaranteed higher returns with lower levels of risk.

39 ddd39 MATH…and other boring stuff that can have you earn double the real return of most investors. RISK OF ASSET CLASSES RISK OF INVESTMENTS WITHIN ASSET CLASSES CORRELATIONS – BE AS BAD AS YOU CAN BE!

40 ddd40 What asset class has the most risk? 1.CASH 2.BONDS 3.STOCKS

41 ddd41

42 ddd42 HOW DO YOU MEASURE THE RISK OF A STOCK? Fama – French Three Factor Model Beta (& CAPM) Market Cap Value vs. Growth

43 ddd43 CORRELATIONS Imagine you live in a simple world where a year is either sunny or rainy and there is a 50% probability of either. You review two stocks. How would you construct your portfolio? Golden Tan, INC (GTI) Expected return – (+10%) Return on sunny years – (+30%) Return on rainy years – (-10%) Rainy Day Umbrellas (RDU) Expected return – (+10%) Return on sunny years – (-10%) Return on rainy years – (+30%)

44 ddd44 The Perfect Portfolio in my “Simple World” A portfolio of 50% GTI and 50% RDU would earn 10% every year. If you did not rebalance, your expected return would drop. –A simple average 10% return does not equate to a geometric 10% average. Compare a portfolio that goes up 20% one year and 0% the next to one that goes up 10% each year. –The power of rebalancing is not to be ignored.

45 ddd45 In the real world, the best we can hope for is low correlations (R 2 ) REITS and Metals are also great diversifiers

46 Nonetheless, low correlations combined with tax and cost efficient rebalancing give you a mathematical boost! It also makes you a contrarian investor in a way far superior to the DOGS.

47 ddd47 Wealth Logic Investment Club It would be so boring that even I wouldn’t join!!!

48 ddd48 So How Do the Leaders of Each discipline invest? Random Walk Investing is radically simple. Investing is long-term & requires little monitoring. Simple, ultra low-cost & tax- efficient vehicles are far superior. With a properly designed portfolio, doing nothing will be your hardest task. Cutting fees, hidden costs, & taxes will produce wealth for you. Behavioral Finance Investing is radically simple. Investing is long-term & requires little monitoring. Simple, ultra low-cost & tax- efficient vehicles are far superior. With a properly designed portfolio, doing nothing will be your hardest task. Cutting fees, hidden costs, & taxes will produce wealth for you.

49 ddd49 Think like an institution and Dare to Be Dull® So what does this all mean! 1.Understand your emotions on investing. 2.Stop making others rich and capture as much of the market return capitalism has to give. Then let the magic of compounding take over. 3.Keep investing as simple as possible and costs dirt low. You will get what you don’t pay for! 4.Quit paying unnecessary taxes. 5.Diversify and understand your willingness and need to take risks. 6.Pick the low hanging fruit – FREE MONEY! 7.Dare to give up the illusion and build wealth!

50 ddd50 1.I’m Good: Like all sophisticated MBAs, I’m nearly as good as the chimps at picking stocks and market timing. Don’t pay to increase risk and decrease return. 2.Get Real: Think in inflation adjusted returns and be realistic on your performance. How much of an expected 4.5% real market return do you want to give away? 3.Think Dull: If you are getting excitement and entertainment from your investing, you are probably making other people rich. Summary

51 ddd51 To those sophisticated gurus and money managers leading people to pick winning stocks and time the market: THANK YOU! Your seductive appeal to our basic emotions is what keeps the stock market efficient and allows us to double the real returns of those that trust in you. I need you!

52 CONCLUSION 1.If you want excitement in your life, try parachuting! 2.But if you want to build wealth for yourself, DARE TO BE DULL ® To learn more, visit: http://DareToBeDull.com http://DareToBeDull.com Subscribe to Wealth Logic articles.


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