Most of us don't think in probabilities -- but we should.
Statistician Nate Silver correctly predicted the outcome of every state in the 2012 presidential election. It instantly shot him to fame in a field most people associate with the most boring class they ever took. He’s been on The Daily Show twice. He has more than a million Twitter followers.
But the most important part of Silver’s analysis is that he’s not really making predictions. Not in the way most people think of predictions, at least.
You will never hear Silver say, “He is going to win the election.” You might hear him say, “He has a 60% chance of winning,” or “The odds are in her favor.” Pundits make predictions. Nate Silver calculates probabilities.
All probabilities of less than 100% admit a chance of more than one outcome. Silver put a 60% chance of Obama winning Florida in the 2012 election, which, of course, implied a 40% chance that he wouldn’t win. Silver’s pre-election probability map gave Obama the edge. But, had Mitt Romney won the state, it wouldn’t necessarily have meant Silver was wrong. In his book The Signal and the Noise, Silver wrote:
Political partisans may misinterpret the role of uncertainty in a forecast; they will think of it as hedging your bets and building in an excuse for yourself in case you get the prediction wrong. That is not really the idea. If you forecast that a particular incumbent congressman will win his race 90 percent of the time, you’re also forecasting that he should lose it 10 percent of the time. The signature of a good forecast is that each of these probabilities turns out to be about right over the long run … We can perhaps never know the truth with 100 percent certainty, but making correct predictions is the way to tell if we’re getting closer.
What set Silver apart is that he thinks of the world in probabilities, while the punditry crowd of coin-flipping charlatans thinks in black-and-white certainties. His mind is open to a range of potential outcomes before, during, and — most important — after he’s made his forecast. Things might go this way, or they might go that way. He adjusts the odds of certain outcomes when new information arrives. It’s the most effective way to think about the future.
Why don’t more people think like Nate Silver?
Twenty years ago, Berkshire Hathaway vice chairman Charlie Munger gave a talk called The Psychology of Human Misjudgment. He listed 25 biases that lead to bad decisions. One is the “Doubt-Avoidance Tendency,” which he described:
The brain of man is programmed with a tendency to quickly remove doubt by reaching some decision.
It is easy to see how evolution would make animals, over the eons, drift toward such quick elimination of doubt. After all, the one thing that is surely counterproductive for a prey animal that is threatened by a predator is to take a long time in deciding what to do.
In other words, most of us don’t think in probabilities. It’s natural to quickly seek one answer and commit to it.
If you watch financial TV, or read investing news, you will almost never hear someone say there’s a 55% chance of a recession this year. They say there is going to be a recession this year. Rarely does an analyst say there’s a 60% chance of a bear market this year. They say there is going to be a bear market this year. There’s no room for error. There are no probabilities. People want exact answers, and pundits are happy to oblige.
Consumers of financial news are part of the problem. Not knowing what the future holds is scary. But you don’t gain much confidence hearing someone say there’s a 60% chance of one outcome and a 40% chance of another. We are more likely to listen to a forecaster who uses unwavering confidence to insist they know the future. It’s like warm milk for our fears.
But thinking in certainties is usually a reflection of how you want the world to work, rather than how it actually works. Silver writes:
Acknowledging the real-world uncertainty in [pundits’] forecasts would require them to acknowledge to the imperfections in their theories about how the world was supposed to behave — the last thing that an ideologue wants to do.
If you have a view of the world that says raising taxes will slow the economy, no amount of information will change your mind. You won’t tolerate a claim of an 80% chance a tax cut could slow the economy, because it leaves open the possibility that your entire world view about tax cuts could be wrong.
One of the top reasons investors make mistakes is that the world works in probabilities, but people want to think in certainties. It’s why bear markets surprise people, banks use too much leverage, budget forecasts are always wrong, and most pundits make themselves look like idiots.
As soon as you start thinking probabilities, all kinds of things change. You’ll prepare for risks you disregarded before. You’ll listen to people you disagreed with before. You won’t be surprised when a recession or a bear market that no one predicted occurs. All of this makes you better at handling and navigating the future — which is the point of forecasting in the first place.
Here’s Silver again:
The more eagerly we commit to scrutinizing and testing our theories, the more readily we accept that our knowledge of the world is uncertain, the more willingly we acknowledge that perfect prediction is impossible, the less we will live in fear of our failures, and the more liberty we will have to let our minds flow freely. By knowing more about what we don’t know, we may get a few more predictions right.
Morgan Housel owns shares of Berkshire Hathaway.
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Q: My 89-year-old father has $750,000 after selling his Medtronic stock and paying capital gains. He’d like to make a low-risk investment with easy accessibility, but one that would give him more than a savings account. Any suggestions? — Karen
A: Before your father gets too focused on where he should reinvest the proceeds of this sale, it’s important to ask how this fits into the bigger picture of his finances, says Shari Burns, a chartered financial analyst and managing director with United Capital in Seattle.
Given the current state of the bond market — interest rates are very low but poised to move higher this year, which would threaten the value of older bonds — there is no simple answer for making a low-risk investment that is easily accessible and that pays more than just a savings account.
“Preserving principal is one priority, and getting a better return than a savings account is another,” says Burns, noting that any time you look for additional reward, you’re taking on additional risk.
With that in mind, your father needs to think about his priorities and his timeline. Let’s consider three scenarios:
Scenario # 1: He needs all the proceeds of the stock sale to support his cost of living.
Under this scenario, he should start with how much he needs and for roughly how many years. Working backwards will help him determine the right balance of risk and reward.
In simplistic terms, his $750,000 translates to $75,000 in annual income for the next 10 years. To keep up with inflation and preserve capital consider a mix of cash and individual bonds.
Burns suggests keeping $250,000 in a savings account to draw on over the next few years. “If short-term rates go up, then the interest on the savings account will rise,” she says.
Your dad can then invest the remaining $500,000 in a laddered bond portfolio of individual Treasury securities. A simple way to build such a “ladder” is to divide that money equally among Treasuries maturing in two-year increments, starting with 2-year notes and going out to 10-year securities.
At current rates, those Treasuries are paying out 0.72%, 1.29%, 1.74%, 2.07% and 2.33% respectively. So combined, this $500,000 ladder will average 1.63% per year or $8,140 in annual income for the first few years.
“As you spend down the savings account, you will replenish your cash as bonds mature in the years that remain,” she says. “After 10 years your portfolio will be depleted.” It’s important to point out that because your father is holding these bonds to maturity, rising rates aren’t a concern.
Scenario #2: He doesn’t need the additional income but will rest easy knowing it’s safe.
Under the second scenario — which we’ll venture to say is the most likely based on the size of this single holding – he will probably want to keep about 70% to 75% of these funds in cash and a short-term bond fund, such as the Vanguard Short-Term Bond Index VANGUARD SHORT-TERM BOND INDEX INV VBISX 0.19% .
The remaining 25% to 30% should go to a low-cost stock fund, such as the Schwab S&P 500 Index fund SCHWAB S&P 500 SWPPX -0.4% or the Vanguard Total World Stock Index fund VANGUARD TOTAL WORLD STK INDEX INV VTWSX -1.19% . “The stock portion of the portfolio will provide growth over time, which will keep the total portfolio ahead of inflation,” she says. Because neither the bond market nor the stock market are exactly cheap, however, it makes sense to dollar-cost average into these portfolios over the next six months to a year.
Scenario #3: He wants to preserve wealth to eventually pass this on to his heirs or charity.
Finally, if your father is more focused on long-term wealth preservation, he may want to rethink his goal and invest for the long term, she says. “He will want the capital to rise faster than inflation to maintain the purchasing power of his wealth,” she says. Use the same approach described above, only plan to bring the equity portion up to 50% to 60% of this segment of the portfolio.
Why the bond market rises as the days get longer.
Ah, springtime. It’s the time of year when the trees and the flowers start to blossom, the birds start singing, the weather warms up, the grass turns green, and…Treasury bond returns start to rise?
Seasonal clichés are not unusual in the market, “sell in May and go away” is a classic that seems to hold in the equity market. Since 1950, according to the Stock Trader’s Almanac, the Dow averages a 7.5% gain in the November through April periods and only a 0.3% gain from May through October.
Given that relationship, it stands to reason that in aggregate bonds, there would be a relatively better investment in May through October. If you do pull some of your money out of stocks, you are not just going to hide it under the mattress.
Why these relationships hold is another matter. Lower trading volumes in the summer, vacation effects, and other theories have been posted over the years.
Lisa Kramer, a researcher at the University of Toronto, has a different theory. Her team finds that Seasonal Affective Disorder (SAD) can be extended beyond the effect on individual investors to produce a tangible effect on the overall market. The shorter, gloomier days of winter appear to be having a measurable effect on the bond market.
Kramer’s group found that monthly returns on Treasuries change by 80 basis points on average from October to April. Bond returns hit their peaks in the fall and troughs in the spring. After studying multiple potential factors, including the auction cycles for bonds and fluctuations in supply, Kramer’s group concluded that the appearance of the sun, if you will, reduces the overall effect of SAD and “brightens up” the bond market.
The full paper is scheduled to appear in an upcoming issue of Critical Finance Review.
What is the connection between SAD and bonds? Kramer suggests that it is risk aversion brought on by SAD. Her previous work on stocks suggested that seasonal cycles also affect stock markets through SAD-based risk aversion. Finding the opposite effects between the Northern and Southern hemispheres bolsters her argument, as one would expect given the opposite cycles of summer and winter. The full paper is not yet available for review, but the current summaries suggest a complementary pattern that explains bond returns using seasonal factors.
Should anything be done about this? Should all winter financial efforts in the U.S. take place in Phoenix or Miami from now on? That may spark some spirited discussions and pleading with financial executives, but we suggest that the solutions are simpler.
Traders are not always known for their life balance. Those who suffer from SAD should be encouraged to get out more often and take vacations in sunny locales to balance out their lives. That certainly seems like reasonable advice even without any stock market indicators. Meanwhile, traders suffering with more severe cases of SAD might benefit from various therapies. If you are in this position, there is more suffering going on than just with your market performance. Get the help you need.
Should you switch your ratios of investments to match the hemispheres? Probably not. Just like “sell in May and go away,” this finding is a generality. Monitor your investments with the usual broad view in mind.
We are looking forward to the next movie remake of Little Orphan Annie in which she visits Wall Street and sings, “Bond returns will go up tomorrow…you’ve got to buy bonds tomorrow, come what may!”
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Father's Day has a financial adviser thinking about important lessons to be passing along.
A friend recently asked me to recommend a book for his son on buying and selling stocks.
As I pondered his request, I started thinking about the various books I’ve read or skimmed over my 24-plus years of working in financial services. Initially, I was overwhelmed with titles. Then I started thinking about my own teenaged son and the difficulty I was having getting him to think differently about his money—that he won’t always be able to depend on his parents to help him out. Anyway, I thought if I couldn’t compel a 14-year-old to change his ways, what could I say to my friend’s son, who’s in his 20s?
Finally, I asked myself what would I say—not bark, I promise—to my own son if he were in his 20s and came to me for investing advice? This is what I came up with:
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For now, I would advise you to think long and hard about why you want to invest. In other words, take time to map out your life goals for the next three to five years and the financial resources you will need to achieve them.
Simply saying you want to invest “to make money” will not work when you are invested in a fluctuating market. Short-term volatility can be a bear (pun intended). You have to be willing to ask how much money you can withstand losing when the market goes down, as well as how much profit is enough. As the old Wall Street saying goes, bulls make money in up markets, bears in down markets, and pigs get slaughtered. You also have to be willing to ask yourself how long you plan to stay invested, no matter how much the market fluctuates or falls.
Why am I focusing on declining markets and roller-coaster, up-and-down markets? It’s because people tend to fixate on rising stocks and profits, but pay very little attention to the markets’ inevitable declines. Everyone loves bull markets, which are great for the average investor. But when the market heads south quickly or takes a long, slow journey to the cellar, someone who was looking to make a quick profit can suffer a lot of stress.
Finally, I hope this short note does not come across as too preachy. I congratulate you on your interest in investing, and I will end by saying you are way ahead of the game because you’re thinking about investing now instead of later. Good luck.
Frank Paré is a certified financial planner in private practice in Oakland, California. He and his firm, PF Wealth Management Group, specialize in serving professional women in transition. Frank is currently on the board of the Financial Planning Association and was a recipient of the FPA’s 2011 Heart of Financial Planning award.
Are markets efficient? Yes and no, says Robert Shiller.+ READ ARTICLE
The stock market goes through big swings, commonly known as bubbles. Nobel economist Robert Shiller says these swings are the normal cycle of the market, but they don’t necessarily mean the market is inefficient. If a $10 bill is lying on the sidewalk, you’re going to pick it up, but when is the last time you actually saw a $10 on the sidewalk? Which leads to the classic joke about the economist who’s walking down the street.
The legendary basketball payer wants to recruit more individuals to invest in them
Shaquille O’Neal wants to recruit more individuals to invest in IPOs at a time when more and more of the deals are turning out to be air balls.
The legendary basketball payer is investing in Loyal3, a brokerage firm that wants to give more individual investors access to initial public offerings, according to The Wall Street Journal. Shaq is also joining the San Francisco company’s advisory board and said he will help promote the company’s mission.
Loyal3 was started three years ago, and is run by Barry Schneider, a former golf company executive. Loyal3’s executive vice president Bill Blais is a long time Wall Streeter, and a former Goldman Sachs and Morgan Stanley investment banker. Loyal3 doesn’t run do its own deals. It partners with other investment banks to get a small chunk of an IPO, typically 5%, that it then markets to individual investors. Wall Street has typically doled out IPO shares to its best customers, usually large investment funds and rich investors. Instead, Loyal3 sells the shares it receives on a first-come, first-serve basis to investors with as little as $100 to invest, and for no commission. Loyal3 says companies like to have the brokerage in on their deals because individual investors tend to be more loyal investors than large institutions.
Despite the highly sought after nature of IPOs, they tend to be risky investments, and Shaq is running into the IPO game at a time when the quality of many of the most recent deals is clearly looking deflated.
Of the 37 companies that went public in the first quarter of the year, just 10% had operations that were turning a profit, down from 43% in 2013. And the performance of the deals has waned. Shares of the average IPO have risen just 15% this year. That’s better than the market, but far less than 40% return of two years ago, though that is based on full year.
Many noteworthy IPOs have tumbled recently. Shares of Etsy have fallen nearly 50% from where they closed on their first day of trading. Etsy also set aside a chunk of its IPO shares for individual investors, selling 5% of its shares online through Morgan Stanley. Etsy also sought to limit the number of large investors in the deal. Loyal3 was not involved in the offering. Some have blamed the unusual structure of the IPO for why the shares haven’t done so well. Other IPOs this year, like that of cloud company Box, have also been duds.
Loyal3 has been involved in 13 IPOs, including some high profile deals like camera company GoPro [fortune-stock symbol=”GPRO”], shares of which are up nearly 150% from its 2014 IPO. Pet Insurance company Trupanion, another deal Loyal3 has been in on, have not done as well, down 20% from it’s IPO price. It’s not clear how well Loyal3’s deals have done overall. Loyal3 does not include its complete list of IPO deals on its website. The company did not respond in time to comment for this piece.
Read more on IPOs: The IPO used to be a moment of glory. Now it’s a sign of desperation
The FUBU founder shares what he's learned about investing since then.
On ABC’s “Shark Tank,” Daymond John scrutinizes the business plans of wannabe entrepreneurs, but how does he manage his own finances?
A self-made businessman, John is actually pretty realistic – working his way up many ladders and learning from failures. A native of Queens, New York, John founded FUBU at age 23 in 1992, riding the wave of hip-hop fashion trends.
Now 46, he has been with “Shark Tank” since its debut in 2009. He serves as a consultant, gives motivational speeches, writes books and is a spokesman for other businesses, such as Gillette.
Reuters spoke with John about how his acumen for business translates to managing his own money:
Q: How much of your net worth is locked away for the future, and how much is at your disposal now?
A: I’ve probably put in 50 percent for long-term, and the rest I play with. I have squirreled away enough to not have to worry about it. Hopefully, I’ll never have to touch it, and it will be passed onto my kids or a great organization.
What I play with now, it can fluctuate. I can end up using a good percentage of it on a great acquisition, or I can hold it.
Q: How involved are you in the management of that money?
A: There are several levels of it. I’m involved when I’m doing my day-trading. When we’re talking about asset allocation, I have very different approaches. I’m with Goldman (Sachs) and various other firms. I kind of let three out of five of them do their own thing. For two out of five, I monitor (my account) over the course of every month or so.
Q: Most of what you do on ‘Shark Tank’ can be considered alternate investments, but do you do anything beyond that to diversify your portfolio?
A: My larger investments have been apparel brands. As for real estate, I’m part of a fund, but I’ve never been that great at real estate.
Q: When you do a promotion like for Gillette’s Shave Club, do you have an investment in that, or is it just for promotion?
A: It’s a brand association. It’s just an investment of my time and my face and my integrity. I don’t take it lightly.
Q: You lend your name to a lot of causes as well. How do you decide what charities get your time and money?
A: It’s not really a planned thing. I try to give on various platforms, and not do too much check-book philanthropy. For some, I will try to make more people aware of the plight, and help get more people to give. To some I will dedicate time, such as my desire to get out word about dyslexia.
Q: Do you have planned giving worked into your estate plan?
A: I don’t have that formal plan – some will go to family and certain small organizations. One is animal related, one is dyslexia, one is hip-hop against violence.
Q: Who first taught you about finance and money management?
A: I got the knowledge by blowing about $20 to $30 million the first time I made it. I’m not one of the few who hit lotto or peaked at 25 as an athlete. I have had several other bites at the apple.
Q: You have listed Robert Kiyosaki’s “Rich Dad, Poor Dad” as one of your favorite books. What have you learned from it?
A: The fundamental lesson to it is it’s not how much you make, it’s how much you save. You should go after small opportunities that have the potential to grow into large opportunities. That educated me on the tool of money.
Bidding wars are back. Here's how to win.
Homes are selling faster, and getting more multiple offers and bids above the asking price than just before the financial crises, new research shows. Yet with the typical home still selling for less than it did in 2006, it is difficult to call this a bubble.
Some 28% of homes this year and last year sold within two weeks of being put on the market, up from just 19% pre-recession, according to a survey from Coldwell Banker Real Estate. Meanwhile, 47% of recent home sales saw multiple offers, vs. 42% pre-recession; and 27% got offers above the asking price, vs. 25% preceding the recession.
This data, however, may be somewhat misleading. For starters, the median home nationally sold for $219,400 in April, up 9% from the year earlier and a robust 42% from the market bottom in 2011-2012. But that remains shy of the $230,400 median price reached in July 2006, and after the sharp bounce back price gains now seem to be leveling off, says Budge Huskey, CEO of Coldwell Banker Real Estate.
And most of the heated activity is taking place in desirable neighborhoods, where obstacles to new construction put a premium on existing homes. The bidding wars generally are occurring on move-in-ready homes that are priced to sell. “The vast majority of markets around the country reflect more balanced inventories and rates of appreciation which have decelerated from the pace of the last two years,” Huskey says.
Still, in many ways this is a seller’s market, fueled in part by rising interest rates. Mortgage rates remain low at just above 4% for a 30-year fixed rate. But the trend has been up since January, and many expect rates to continue climbing. That brings in buyers from the sidelines that want to act before the cost of money goes higher.
Even if sellers fail to entice an offer above the asking price, they may take advantage of the conditions and be exceptionally choosey about a buyer. Just 46% of sellers take the first offer they get, down from 59% during the recession, the survey shows. A record 36% of sellers since 2013 say they chose a buyer based on emotion in addition to their ability to pay—up from 19% pre-recession.
Keep that in mind if you are buying. A downsizing baby boomer may not get the price they had counted on before the recession. But they may want to be sure the house where they raised their kids goes to a family they like. “It’s increasingly common for buyers in competitive situations to provide extensive information on why they would prove the perfect owners and neighbors,” Huskey says.
Rebalancing is the most helpful when it is most difficult.
Portfolio design and rebalancing is both a science and an art. Understanding the science (see our previous article) is akin to understanding the physics of why a spinning ball hooks and bends. The art is the execution of the science, such as when you are actually playing soccer or golf.
It is the execution and follow-through that produces the desired outcome.
Knowing that rebalancing boosts returns is useless unless you as the investor have the time, discipline and nerve to follow through and actually strike the ball.
Rebalancing is the most helpful when it is most difficult. The exercise involves selling the investments that have appreciated and buying the assets that have recently gone down. People are biased to believe that recent occurrences will continue. When it comes to the markets, this instinct must be overcome.
This is one area where an investment advisor can add value. Even an advisor who does nothing other than help you set an asset allocation and then rebalance once a year might boost your returns by 1.6 percentage points over a buy and hold strategy. This rebalancing also lowers the volatility of your portfolio. Together, these bonuses help increase the likelihood that you will reach your retirement goals.
Yes, you could do this yourself, but many investors don’t. A few investors buy and hold investments while an even greater number chase returns, moving in the exact wrong direction. Even an advisor who only keeps you from chasing past performance might significantly boost your returns.
If you choose to rebalance yourself, you can accomplish this most easily by automating your rebalancing. Automatic rebalancing is most common in 401(k) accounts. If your account offers the feature, take advantage of it. If you must choose specific months or days to rebalance, we suggest May 1 and Oct. 1.
The important thing is to make sure your portfolio is regularly rebalanced. If the only available rebalancing method is manual, the danger is that you will emotionally pick the point to rebalance which will be the exact wrong time. Instead, you should pick times of the year blindly and then stick with it.
That said, receiving the rebalancing bonus requires that investors have an asset allocation plan in the first place. Most do not.
Your asset allocation definition matters. Rebalancing works best with non-correlated asset categories, like emerging market stocks and U.S. stocks. If you define your asset classes incorrectly, rebalancing between them may not help.
You should not define your asset class as one industry of the economy. One industry could lose value indefinitely as another industry rises to take its place. Rebalancing into a failing industry only brings your returns down with it.
Meanwhile, you dodge this problem with broader asset class definitions. Technology, basic materials, and manufacturing are good, broad definitions while VHS rentals, diamonds and buggy whips are too narrowly defined and may fail you.
It is even better to have two levels of asset class definitions: asset classes, like U.S. stocks and resource stocks, which are non-correlated categories – and then sub-categories, like technology, basic materials and manufacturing, which although they have some correlation are not highly correlated.
Lastly, some sectors such as gold or small cap growth are not on the efficient frontier, which identifies portfolios that achieve the highest return and the lowest volatility. Including them in your asset allocation is simply the wrong move. Rebalancing to a poorly designed asset allocation often means moving money from categories that are on or near the efficient frontier into inefficient investments, hurting returns.
There is a great deal to be said about the method of rebalancing. Keeping transaction costs and capital gains taxes low when rebalancing also helps boost the return.
Funds with high expense ratios put a drag on returns. Even an index fund drops off the efficient frontier when the expense ratio becomes excessive. Rebalancing into bad funds also hurts your returns.
While the science and art of setting an asset allocation and regularly rebalancing back to it is not an easy discipline, it can boost returns by as much as 1.6 point over a buy and hold strategy, and even more over buying and chasing returns.
There is an art to rebalancing, but it is better to rebalance poorly than not at all.
David John Marotta, CFP, AIF, is president of Marotta Wealth Management Inc. of Charlottesville, Va., providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com. Both the author and clients he represents often invest in investments mentioned in these articles. Megan Russell is the firm’s system analyst. She is responsible for researching problems and challenges, and finding efficient solutions for them.
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