We all want to be wise with our money, but doing so is a lot harder than most people realize. Studies show that most people save too little, withdraw too much, and make matters worse by buying and selling investments at inopportune times.
The past nine years have masked a lot of financial mistakes. We’re in the second longest economic expansion in history and have had average stock market gains north of 15% per year. We don’t know what tomorrow will bring, but it’s probably smart to assume that the next five years won’t be as easy. That makes now a perfect time to think big picture, get organized, and correct any deficiencies.
There are lots of financial errors one can make, certainly as it pertains to personal finance. But there are certain mistakes that have the power to upend a lifetime of otherwise good financial stewardship. We call these the pivotal mistakes that cripple family wealth, and we want to help you avoid them.
The Pivotal Mistakes
1) Chasing Performance
Studies show that individual investors substantially underperform basic indexes because they are consistently bad market timers. A 2016 study by DALBAR showed that for the 20-year period ending 2015, the average individual investor (non-professional) in a stock mutual fund underperformed a simple index by almost 3.0% per year, due entirely to poor buy and sell decisions.
Financial flows into and out of mutual funds, closed-end funds, and exchange-traded funds confirm the DALBAR study. As you can see in Chart 1 below, investors put money in and take money out of the stock market based on past market performance. The blue line is S&P 500’s quarterly performance, while the black and red bars are investor money flows into (black bars) and out of (red bars) the stock market.
Market performance (1) consistently precedes stock investor money flows (2). That is, investors consistently chase past performance to their detriment.
Chart 1: Past Stock Market Performance Leads Investor Flows
Investors chase performance lots of ways: buying and selling securities, adding or switching managers, “diversifying,” altering strategies, and changing asset allocations. The common denominator is changing emotions. Emotions change, then explanations do, and the groundwork is laid to rationalize chasing performance.
2) Falling for the Pitch
Wealthy individuals are often inundated with meeting requests and phone calls from random brokers, neighborhood advisers, and big-name firms, all with sales pitches meant to excite and impress. There is big business for firms and advisers that offer a lot of varied products and strategies. One of their products is always working, so there is always something to sell. These “opportunities” are pitched on recent past performance, but they often don’t turn out so well.
Chart 2 below shows the impact of the hiring and firing decisions of institutional investors. The blue bars on the left show the past relative outperformance of hired managers over just fired managers. The red bars on the right show that the performance of these newly hired managers subsequently trails the very managers the institutions fired–and performance gets worse over time.
Chart 2: Impacts of Manage Hire/Fire Decisions
This information is relevant to an individual investor because it reveals an important truth. Brokers and advisers tend to pitch ideas that have displayed short-term outperformance, and thus look good on paper. And they tend to build portfolios with recent past winners. But these are the very investments that are likely to underperform in the years ahead.
3) Expecting Success with a Limited Time Commitment
You’re busy. Whether you’re working or retired, you have other things to do besides researching individual stocks or finding new investment managers. Industry professionals spend their entire working day doing that, and a lot of them–really smart people to boot–don’t get a return on that investment.
Ask yourself, with time as a finite resource, how much of it do you plan to spend reading public SEC filings, reviewing investment offering documents, scrutinizing economic data, and reading financial planning articles and investment books? If you aren’t ready to take on this task like a job, you shouldn’t try to be your own financial adviser, let alone select securities or investment managers yourself.
4) Making Important Financial Decisions without Sound Counsel
Despite what you might read in a personal finance book, there are no foolproof methods that an individual can consistently rely upon to answer important financial questions. Context is always required.
Take the standard advice regarding an at-retirement 4.0% withdrawal rate. This rule states that individuals can comfortably withdraw 4.0% of their assets in their first year of retirement and then take an inflation-adjusted amount in future years. Investors that retired in 1928, 1929, 1965, 1967, 1968, and 1999 and followed this advice without modification would have run out of money. Insight must go beyond the shorthand rules found in most financial writing.
I’m a regular industry mentor and competition grader for the annual CFA Research Challenge. It’s a stock analysis competition between teams of some of the brightest business students in the world. The participants, with undergraduate and graduate level study in finance, spend hundreds of hours researching and analyzing just one single company. And yet, the professional mentors and graders like myself poke holes in the vast majority of their analysis, not because the participants aren’t smart, but because they lack the accumulated wisdom necessary to see all the ways their conclusions are wrong.
Many individuals, putting in far less time and effort than these students, make real-world, life-altering financial decisions without the necessary financial guidance.
5) Becoming Your Own Financial Adviser
Psychologists note that our memories of events and decisions are consistently distorted by our brains in ways that enhance our self-image. We’re hardwired to take credit for positive outcomes and to blame external factors for negative outcomes.
If you’re your own financial advisor–managing your estate plan, financial plan, asset allocation choice, and manager/investment selection yourself–an honest assessment of your decisions and overall performance is extremely difficult. Plus, you can’t fire yourself.
But there’s another way to make this mistake. And that’s by having multiple adviser or manager relationships with no clearly defined leadership role. If there is no principal adviser, then you’ve become your own financial adviser.
A cohesive, holistic plan for your estate is likely sacrificed, because hired managers/advisers will operate independently of one another. And multiple relationships mean multiple opinions. Having multiple advisers/managers does diversify away the risk that one adviser might underperform, but multiple relationships doesn’t guarantee better long-term results or sufficient estate diversification. And in other cases, having multiple relationships just ends up resulting in a portfolio that looks increasingly like the market. Therefore, it’s best to have one person–a trusted adviser–that is empowered, accountable, and in charge of the entire investment plan.
6) Not Including Your Spouse
In many households, one of the spouses is deeply involved in the finances while the other is not. Unless the financially-active spouse plans ahead, this can result in disaster.
What happens if the financially-active spouse dies first? Will the surviving spouse have the financial skills necessary to manage what remains of the estate? And if there isn’t a principal financial adviser already involved that both spouses know, will the surviving spouse turn to the right person for help?
It’s best for both spouses to be involved in family financial matters. Financial, estate, and investment plans should to be in place, but so too should relationships. That way if one spouse dies, the surviving spouse already has an adviser both spouses knew and trusted.
Otherwise, the surviving spouse, in their search for sound counsel, may fall prey to bad actors that quickly undo a lifetime of good planning.
7) Not Equipping the Next Generation
You’ve probably heard the statistics. According to the Williams Group wealth consultancy, 70% of a wealthy family’s estate is lost by the 2nd generation (kids), and 90% by the 3rd generation (grandkids). Future generations get the family money, but the necessary financial discipline, good personal finance, and sound advisory relationships aren’t always passed down.
If an individual wants multi-generational impact, he or she must equip the next generation. To start, wealthy parents should encourage their children to work with a financial adviser, especially if they are providing the children financial gifts during life for estate purposes. Financial education starts with personal finance, because it establishes the right financial habits and develops the important life-skills they’ll need to manage any inheritance they may receive.
Multi-generational planning can be improved further if the children work with the family adviser. The advice will be consistent across generations, parent-approved (they selected the adviser), and holistic because the family adviser understands the larger estate plan, and how that impacts the children.
Another way to prepare children is to involve them in the family’s finances. That can be as simple as discussing the estate plan with the entire family each year or as involved as starting a donor-advised fund or a private family foundation.
Make 2018 the Year of Good Financial Stewardship
Our goal with this letter is to cut through the noise dogging financials markets, and to draw attention to the wealth-destroying mistakes many are making today. It’s so easy to get caught up in all the hype of bull markets, but diligence and sound judgment always prevail. By avoiding these pivotal mistakes, we can make great strides in becoming good financial stewards.
May you have a Happy New Year and an abundant 2018.