It’s easy to sit around and lecture people to cut back on spending, pay off debt, and get control of their finances. That’s what so many financial advisers and writers do — yet they never stop to ask themselves why so few of their readers actually follow through.

So today, I want to introduce you to Carl Richards, one of my favorite financial advisers on the planet. You might be familiar with his sketches, which have been seen on the New York Times.

He understands that math is only a small part of personal finance — and that psychology is hugely important. Below, you’ll learn…

• The startling and surprising numbers of how you can actually get equal or higher returns — with lower risk
• The classic mistake investors make after a market has changed directions
• The psychology of automatic rebalancing

I asked him to write up a detailed account on the psychology of investing. And if you read to the end, you’ll see a little surprise just for IWT readers.

Carl, take it away.

Successful investing is hard. Not complicated, just hard. It’s hard because for the most part, we are wired to make the same mistake over and over again. We buy high and sell low because that’s what everyone else is doing. But like any problem that needs to be fixed, the first step is recognizing the problem and then coming up with a plan to prevent it.

Buying High and Selling Low

We don’t have to look too far to find ample evidence of poor investor behavior on a wide scale. In 1999 when the dot-com bubble got bigger and bigger, the NASDAQ was up over 85 percent…FOR THE YEAR. That was crazy enough, but what happened in the first quarter of 2000 was insane. We went on a buying binge, all of us. Up until January 2000, the record for net inflows (money going in, minus money going out) into stock mutual funds was $29 billion. Now here we are in January 2000, right after an 86 percent run up. Look at these numbers.

In January we poured $44.5 billion into stock mutual funds.

In February, the shortest month of the year, inflows hit $55.6 billion. That’s almost $2 billion a day!

And March was nothing to sneeze at either with an investment of another $39.9 billion.

Think about it. Over three months, $140 billion dollars entered the market—AFTER it already had gained over 80 percent. At a time when we should have shown some caution, we allowed ourselves to get swept along with the crowd, and we paid for it. March 24, 2000, was the peak of the dot-com bubble, and by October 2002 the market had lost 50 percent of its value. So we poured money in, just in time to get our heads taken off!

If the behavior at the top was wild, clearly we still hadn’t learned the lesson on the way down. With the S&P 500 down over 50 percent from its highs, we couldn’t sell fast enough. October marked the fifth month in a row that investors pulled more money out of stock mutual funds than they invested. That had never happened. I repeat, never. October turned out to the market low. So at the market low, instead of buying equities at the best “sale” prices in five years, investors moved their money into bond funds, making the classic mistake of having bought high and sold low. Bond funds experienced a record inflow of $140 billion in 2002, at a time when bonds where at 46 year highs.

How many of us became a real estate investor in 2006? Are we buying gold now? See the pattern.

Breaking the Cycle

Once we recognize the problem we can fix it. The first step is to have a thought-out investment process that we can stick to when things get tough. Investing involves risk so no matter our investment process so there will be times that we are tested. There will be times we are tempted to go to cash, “just until things clear up” like some did in 2002. But the only real hope of sticking with an investment strategy is to understand it at least enough to have the confidence to stay disciplined when times get tough.

Step One: Buy a S&P 500 Index Fund

This is a great first step and I know it is nothing new. It is well documented that 80 percent or more of the actively managed mutual funds out there underperform their index.

So why pay for underperformance?

Simply own the entire S&P 500 in the form of a low-cost index fund. They are showing up more often in 401(K) plans, and you can buy them easily at Vanguard. The simple decision to invest this way will help you avoid:

• Betting on a particular industry or sector. We see this in the form of trying to pick the next hot sector, like technology, banking, or oil stocks. It’s super common for people to think they can do this, but they can’t.
• Market timing. We all know on a theoretical level that market timing is a loser’s game, but we’re often quick to latch on to anything that might look like detailed research about the direction of the markets. Just remember that forecasts are nothing more than guesses, and you need to stick to your plan.
• Owning individual stocks. While it’s certainly not impossible to identify the next Apple, history proves that it’s highly improbable. Placing large, concentrated bets on individual stocks can be a path to incredible wealth, but so can a single spin of the roulette wheel (if you get lucky).

Step 2: Building a Diversified Equity Portfolio

Diversification is the closest thing we can find to a free lunch in finance. The magic of diversification is that you can take two risky assets, and when you blend them, the result becomes less risky because they zig and zag at different times.

To demonstrate this let’s look at two portfolios. Portfolio A is invested 100 percent in United States stocks, as measured by the S&P 500-stock index, and Portfolio B is invested 100 percent in international stocks, as measured by the MSCI EAFE index. We’ll use 34 years (1976-2010) for our sample period since it’s the longest period available for which we have data from MSCI EAFE.

During those 34 years the S&P 500 had an annualized return of 11.17 percent, and international stocks had an annualized return of 10.72 percent. (All of the portfolios mentioned in the following examples were rebalanced quarterly. Also, while you can’t invest in an index per se, you can buy index funds and similar vehicles for next to nothing.)

Now let’s look at the risk associated with each of these hypothetical investments.

Although there are many ways to view risk, for our purposes we’ll focus on the number of negative quarters and volatility as measured by standard deviation (the lower this number is, the better). From 1976-2010, the S&P 500 had 42 negative quarters and a standard deviation of 15.39 percent. International stocks had 45 negative quarters with a standard deviation of 17.26 percent.

As you can see, each of these portfolios appears risky individually. But the magic of diversification is that when we blend them, the whole is better than the sum of its parts.

So let’s create Portfolio C using use a fairly standard 60 percent allocation to the S&P 500 and 40 percent allocation to international stocks. Now this portfolio gets a return of 11.21 percent. While that’s not much better than the S&P 500 alone, in terms of risk, this 60/40 portfolio only had 37 negative quarters with a standard deviation of 14.45 percent.

That may not sound like much, but it is indeed a free lunch. This portfolio returns at a higher rate with less risk using the simple concept of diversification.

Step 3: Reduce Risk By Adding Bonds

When I talk about diversification, I often get told that it’s been irrelevant over the last 10 years, particularly during the global credit crisis in 2008-2009.

Sure, you can see the benefits of diversification clearly when you’re focused on different types of stocks. But in times of large systematic risks to the stock market (like what we’ve seen during the last five years), the value of diversification among equity asset classes can often go away.

So while it’s still a valuable exercise to carefully plan your equity portfolio to take advantage of a free lunch where you can, the real power of diversification comes in the form of risk reduction when you start to mix stocks and bonds.

Let’s compare the 60/40 stock portfolio we built above (Portfolio C) to a portfolio where we add 40 percent in bond exposure.

Remember that Portfolio C generated a return of 11.21 percent with 37 negative quarters and a standard deviation of 14.54 percent. When we blend in a 40 percent allocation to bonds (in the form of the Barclays Capital Aggregate Bond Index), creating Portfolio D, we get a return of 10.4 percent. That’s not much lower than the all-stock portfolio, and we reduce the number of negative quarters to 35.

But the real impact is in the risk reduction we see in the form of much lower volatility as measured by standard deviation at 9.48 percent. In other words, the ups and downs of Portfolio D will be much less sharp than Portfolios A, B, and C.

While I’m not suggesting that this portfolio is right for every individual or serves as a predictive model, the historical data at least show how being diversified can give you a way to protect yourself from many of the random events that have ruined fortunes.

Plus, diversification allows you to position yourself to take advantage of the returns that equities tend to deliver, balanced with the safety that high-quality bonds provide

Step 4: Automate Rebalancing

So now you’ve got your new portfolio, what comes next? It’s time to automate some smart behavior. And one task that too often gets skipped or ignored is rebalancing. The main purpose of rebalancing is to periodically reset your portfolio back to the original split between stocks, bonds, and other investments. All you’re trying to do is keep your portfolio investing risk roughly the same as what you started with.

Most people seem to follow two rebalancing philosophies: do it according to the calendar, say once a year, or do it when you reach a certain trigger point, when one portion of your portfolio grows or shrinks outside of a predetermined range. Either philosophy can be automated to happen without your interference.

Here’s an example of how rebalancing might work.

Let’s say you sat down in 2006 and decided that based on your goals, the right portfolio for you was the hypothetical Portfolio D we just reviewed, 60 percent in stocks and 40 percent in bonds (high quality, short-term bonds). As part of that process, let’s also assume that you committed to rebalancing your portfolio back to that original 60/40 allocation whenever your portfolio balance strayed too far from it.

At 60/40, your portfolio allocation represented the amount of risk that you felt you needed in order to achieve the return necessary to reach your long-term goals. Fifty percent in stocks would be too little to meet your goals, but 70 percent in stocks represented more risk than you felt you could take.

Fast forward a few years to the meltdown of 2008-9. If you went into 2008 with 60 percent of your money in stocks and 40 percent in bonds, then as the market dropped, the composition of your portfolio would have changed from the original 60/40 allocation to something different. We’ll also assume that nothing else in your life changed and your goals remained the same. The only thing that changed was the market.

For our example, let’s assume that you’re using a trigger point to rebalance. Since it’s pretty common to rebalance when your portfolio allocation strays more than five percentage points off of your target, when the market fell in 2008 you would have rebalanced when your portfolio hit 55 percent in stocks and 45 percent bonds. That would have meant selling bonds to buy more stocks.

Rebalancing is not a scientific way to time the market, nor is it a magic bullet to increase your returns. It is true that disciplined rebalancing could result in slightly higher returns, but it could also lead to slightly lower returns depending on what the market does. Rebalancing also does not automatically decrease your investment risk, but again, depending on market conditions, it may slightly increase or slightly decrease your risk over shorter periods of time.

While there is plenty of debate about how to rebalance and the pros and cons of rebalancing, there is one clear benefit to employing a disciplined rebalancing strategy: it prevents you from making the classic behavioral mistake of buying high and selling low. Warren Buffett has said that the key to investment success is to be greedy when everyone else is fearful and fearful when everyone else is greedy. As we all know that is super hard to do.

It was really hard to buy in March 2009. It was also hard to get yourself to sell in December 1999 or October 2007. But if you had committed to rebalancing that is exactly what you would have done. Not because you were a market whiz and not because you knew what the market was going to do. Instead you rebalanced because it made sense to stick with your plan. Rebalancing is the only way I know of to give yourself the highest likelihood of buying low and selling high in a disciplined, unemotional way.

Rebalancing reminds me a bit of the simple checklists used by doctors. I remember going in for a routine surgery that was going to be done on the left side of my body. When I went in for surgery, I met with the doctor who knew exactly what side of my body she was operating on, but as part of her checklist, she asked me again during pre-op. After she left, no fewer than four different people came in with my chart and asked me which side they were operating on.

Each time I answered the left side, but I became increasingly curious about why they were asking me so many times. Then, as I was on the operating table and before I was put under, the doctor who I had just seen the day before asked me which side she was operating on and then handed me a Sharpie and asked me to mark the side.

When I saw her a few days later as part of my post-op visit, I asked her why they had followed such a procedure. She told me it was a simple checklist to keep them from doing something really stupid, like operating on the wrong side. It took them an extra minute or two and a Sharpie to avoid what would obviously be a huge mistake.

And that’s the real magic of rebalancing; it becomes our investment Sharpie.

Use the Tools

Nothing of outlined in this post is particularly difficult. It may take some time to work through the different options and determine the one that fits you best, it’s all doable. Too often I see people look at the tools available to them and then walk away because they don’t want to do the work. We have options, but whether it’s emotion, bad habits, or other road blocks, we end up missing opportunities to achieve our investing goals. Successful investing is hard, but the benefits to those that stick with it are so big, how can you walk away from it?

Bonus for IWT Readers

What Carl didn’t mention is that he has a new book, The Behavior Gap, coming out on January 3rd. I’ve read it and it’s an excellent deep-dive into the psychology of investing. One thing I love is his explanation of why we “know” the things we should do…yet we don’t do them. This is totally different than most “information” books, which try to convince us about things we already know. Wouldn’t you rather understand why you behave the way you do?

The first 100 of you to buy Carl’s book will get a free 8”x10” letterpress print of “Things to Focus On” (see below). Just pick up a copy at Amazon, then send your receipt and mailing address to book@behaviorgap.com. You’re going to love the book.

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I’m just back from vacation, and my brother reminded me of a line I used to use in one of my talks.

I’d joke how the only way your government bonds would become worthless is if the government defaults…”and the government doesn’t default, it just prints more money.”

Always good for a laugh. Yet the situation in Washington is becoming increasingly crazy as talk of a government default becomes very real.

Here’s my take:

First, I rarely make predictions as experts know very little. So when people hear I write about personal finance, and their first question is “Any stock tips?” I just stare at them.

Now, despite the thousands of things I hate, I’m an optimist. For a situation like the debt ceiling, all parties involved have incentives to resolve the situation. When everyone agrees that something must be done, it almost always gets done.

But there’s something even more important.

When I hear about people freaking out at macro-economic events like this, it’s not a rational, measured response to serious research. It’s fear of “OMG! The sky is falling! I better do something….maybe I should liquidate my stocks!! Or call my broker!! Or….something!!!”

In the unlikely scenario that the debt ceiling isn’t increased and the doomsday ramifications come through, then we will all have larger problems.

Indeed, the very people who make these rash decisions often make similarly rash decisions as soon as the market turns a corner. From a fascinating Wall Street Journal article, Jason Zweig notes that: “…It looks as though many of the retail investors now getting back into stocks are the same people who bailed from the market just before the start of a historic bull run.”

These same people will curse the President, tax rates, Big Banks, and everyone else possible for their own poor choices, never stopping to spend one weekend reading a good personal-finance book.

Better to think long term.

Yes, it’s possible the government could default, or the stock market could tank overnight…but it’s more likely that very little will happen in the short term. So would you rather focus on the 0.05% chance…or the 99% chance?

Note that I said “focus,” not prepare for. As I write about in my book, you always want to diversify your investments so that if the worst happens, you’re prepared.

But the biggest risk is inaction, not some catastrophic macro-event.

Long-term thinking prevents this.

This is why sensible Indian people always buy 4-door cars: because they know that if you keep your car for 10+ years, you will have kids by that time. Optimize for the long term.

It’s why some people stay married for decades.

And it’s why, when you automate your finances, you’ll be preparing for the long-term…automatically.

Keep this in mind when you hear the raging rhetoric of journalists and pundits. Remember that personal finance is very different than macroeconomics. In fact, in almost every situation, your financial situation has very little to do with what Washington politicians decide.

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A recent survey shows that 44% of people plan to never invest money in the stock market again.

“Prudential, which polled more than 1,000 investors between the ages of 35 and 70 online earlier this year, found that 58% of those surveyed have lost faith in the stock market. Even more alarming, 44% said they plan to never invest in stocks. Ever.”

Think about that for a minute.

That decision is not the well-reasoned response of someone who has carefully evaluated the risk and reward ratio of investing.

It is an emotional response born out of fear (“I don’t want to lose my money!!!”) and ignorance (“this stock market is a crock!”).

Here are a few notes to consider:

• Perhaps the worst financial move you could make would be to withdraw from the stock market. These are some of the same people who will complain about money their entire lives, never stopping to realize that their own behavior — decades prior — caused their financial situation
• If you’re truly risk-averse, you have other options to mitigate risk, such as investing in lower-risk investments or changing your contribution rates. However, this assumes you are rational and will “understand” the options. The truth, of course, is that discontinuing investments is anything but rational.
• I don’t only blame these people, by the way. Although we are responsible for our own actions, the financial education in this country has failed us.
• Ironically, as the Wall Street Journal notes, “It looks as though many of the retail investors now getting back into stocks are the same people who bailed from the market just before the start of a historic bull run.” What’s the takeaway? You will never be able to time the market accurately over the long term. This is where some crackpot commenter will say, “DUH RAMIT, I SAW THE HOUSING CRASH COMING A MILE AWAY AND PUT ALL MY MONEY IN RED BRICKS!! NOW IT’S SAFE!! HA HA AHAAHAHA.” You may get lucky with timing once. But eventually, you will lose
• If you’re in your 20′s and 30′s, your time horizon allows you to withstand temporary downturns and still come out ahead by retirement age
• The idea that “I don’t want to lose my money” ignores the fact that by not investing, you will also lose money — it will just be an invisible loss that will only be realized decades later
• Older people who lost everything in the stock market should never have been in that position — their asset allocation failed them
• The investment strategy for the vast majority of individual investors should be passive, buy-and-hold investing. There’s no need to obsessively monitor investments or day-trade. I check my investments every 6-12 months as I have better things to do than micro-monitor these numbers.
• Target-date funds make sure your asset allocation is always age-appropriate with little/no effort from you. It is one of the finest automation strategies in life.

If you’re curious how to set up an automatic investing plan — including which investing accounts I use and how I chose my asset allocation — pick up a copy of my book. Here’s the print version and Kindle version.

Results from the book:

“Thanks for the advice. Have been able to build 25k in a roth, 7k in a 401k, automate all my finances and live a bliss life thanks to your book.”
–Adrian S.

“Since I bought your book, I’ve cleared five thousand in credit card debt and twenty thousand in student loans. I’m maxing out my roth and my 401k, have a savings plan and negotiated my way into six figures.”
–Nicholas C.

“After buying your book, my personal finances have changed completely…all of my credit cards (which I pay off in full each month) are completely automated. I also rolled both 401ks into a Vanguard IRA.  Yesterday, I was able to put enough money into the IRA to max it out for the year 2010…something I didn’t think I’d be able to do for a few years.  I’m setting up an autopayment plan to put my 2011 IRA payments on cruise control.”
–Steve K.

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Sigh. An email I got recently.

Vito writes:

“Love your name btw. Just ram it! lol. My investment strategy is non complicated. I invest everything I have in gold and silver. 75% silver and 25% gold. Simple and effective and no need to read any books. It’s doing very well. Nobody I know has the slightest clue what’s going on. They think gold and silver is gambling or it’s too risky. LOL. Fucking illiterates. Nobody taught them shit. They trusted their politicians and bankers. They deserve what is coming. Nobody wants to hear about gold and silver. Little do they know when the dollar collapses they’re all going to get rammed up the ass and I’m going to be skating away smelling like a rose with all my money and more. I don’t bother with equities either. They’re a rip job. Investors today are fucking stupid. They react to all the talk in the media and forget about the fundamentals of gold and silver and actually sell it. That is where I enter the scene and buy, knowing full well it’s got one way to go but up, like the national debt of all western economies. Thank God for fucking stupid people!”

My response:

“probably not the best strategy for the long term.”

Vito writes:

“Gold and silver is not the best strategy for the long term? Why, if you don’t mind my asking?”

My response:

“It severely underperforms other investments over the long term. This is why you need to read a couple books on personal finance — at a minimum. What is performing really well today likely won’t perform well over the long term. I cover this in my book or there are many, many other books/free articles online.”

[We go back and forth a few times and I encourage him to read some books to dig up the data himself...]

He responds:

“Well Ramit, you can keep your data. How can a best selling financial author give out this sort of nonsense for advice? What do you think, I’m some sort of dummy? Check out the data on the debt in the US and Europe. Do you even know how high it is? And the banks, do you have any data on how much toxic debt they’re carrying in worthless OTC derivatives? Anybody that follows you blindly into equities I can unequivocally guarantee will be in for a religious experience and a world of hurt. Long term equities will destroy you.”

“You can keep your data.” Ok, I think I will.

I rarely blame people alone for their lack of financial knowledge, as there are many groups to blame — schools, companies, and Wall Street — but this guy is actively proud of not reading even one book.

As with most people, education alone is not the answer to change his behavior, as he will never allow himself to be subjected to education.

It’s interesting: People complain about their finances for nearly their entire lives — without ever reading one good personal finance book.

Yet when you collect the data, you find predictable patterns.

• In their 30s, they wish they saved more to travel in their 20s.
• In their 40s, they wish they’d saved more for a down payment in their 30s.
• And in their 50s, they wish they’d saved for one simple thing in their 40s: retirement.

Each of these groups could have done so in a period of a few weeks — then let their system automatically work for them.

But it’s easier to make doomsday predictions about the world, concoct macro-economic theories, and call other people “fucking stupid.”

* * *
Interesting reading…

1) Read more rants about dumb people.

2) I’m working on something special right now. If you’re interested in saving money on your biggest expense, I’d like to ask you about it: http://www.surveymonkey.com/s/ZBJQCDL

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1. It’s Coming: The $5 ATM fee
My thoughts: Who cares if you have a checking account that refunds 100% of ATM fees?

2. Awesome tips on dealing with contracts
My thoughts: From the article, the commenter writes: “This isn’t even a housing thing, this is just a global thing. I don’t think I’ve ever signed an employment contract without modifying it. I’ve never had my employer mention it afterwards.” I love him.

3. How to stash $1 million+ in savings
My thoughts: Predictable rage of people who complain that if THEY made that much money, they could “of course” save $1m+. Commenter Sid puts them in their place:

“For all those whiners out there who can’t save any money because you’re not radiologists exchange your “meager” salary with any one of a million starving people in Rwanda. They will happily show you how plentifully blessed you are. Do you have clean water, a peaceful neighborhood, a police force in your town, an income above 80% of the world’s population? If you can answer ‘yes’ to any one of these questions (if not all 4) then you are head and shoulders above most people alive today.

Now that you’ve gotten loose of your pity party you might start to think about what you do have to work with rather than griping about what you don’t have. Granted this man makes probably 4 times the average salary nationally, but he has also worked 4 times as hard with 4 times the discipline.”

4. Slow and steady still pays
My thoughts: Yet another article blowing apart the “Lost Decade” myth (00-10), this one showing a hypothetical example w/numbers

5. Lavish spending
My thoughts: Jesse writes AWESOME post on conscious spending. Calls out people who find it “ridiculous” that I spend $9/bag of chips. Compare this to “experts” who lecture you to save $2 on toilet paper and morning coffee. Denial of desire is not a strategy.

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I love the Wall Street Journal, but as I was browsing it yesterday, I found this page. Who can identify what’s wrong with it?

Why might this be a sub-optimal way to talk about personal finance? What does the typical reader think when he sees this page?

Hint: It took me about 4 years to figure this out.

[Edit]: The comments on this post are fascinating. I’ve posted my response here.

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As you know, I love mocking people who believe that we are “rational” and “logical.” These tend to be economists, engineers, and other people who are clueless about human behavior.

One of the best ways to reveal the difference between what rational people “should” do and what real people actually do is to talk about rebalancing and asset allocation.

Today, I want to demystify what most people think determines investor success…versus what actually matters.

 

* * *

The reasons for investment success are not obvious. Most people mistakenly believe that your stock choices determine your success. In reality, you shouldn’t even be picking individual stocks (though this is what men in their 40s talk about at parties…that and traffic routes). Others believe that timing the market works, which is false.

In reality, one of the most important parts of investing — perhaps THE most important part, besides starting early — is your asset allocation. This is basically the way you’ve laid out the pie chart of your portfolio: How much do you have in equities (stocks)? How much in bonds? And how does it change over time?

 

Are you in your mid-20s? Here’s a sample asset allocation for you

Look at that chart. Again, most people mistakenly believe that “investing=picking stocks” and therefore they need to worry about which stocks to buy, when in reality the actual equities (stocks) you choose are far less important than your overall asset allocation. In other word, your pie chart matters more than the actual ingredients.

Ok, so the person in the above example is 25. Under which conditions would the pie chart change?

It turns out this is one of the most important questions investors can ask themselves.

What is rebalancing?

Over time, your asset allocation will change, and so will your needs. For example, let’s say the stock market climbs for a 10-year period. You may have far more stocks than your pie chart calls for, so you’ll want to adjust back down.

Alternatively, your needs will also change: When you’re 25, you have a long time before you need your long-term investment money. Therefore, you’re risk-seeking: You have a large appetite for risk because you want higher potential rewards.

At 45, you’ll want to become more conservative and protect what you’ve acquired. You can’t afford the same risk as a 25-year old.

At 65, you are simply waiting for your inevitable death, so you become correspondingly more conservative.

I wrote about this more eloquently in my book, so here’s an excerpt. And yes, I find it remarkably fulfilling to quote myself:

 

 

How do you do that?

Who wants to monitor that?

Asset allocation and rebalancing are hard

Asset allocation is complicated. The best institutional investors in the world — like investment managers at university endowments — are hyper-focused on deciding whether they should have 13.1% or 13.3% of timber, or venture capital, or hedge funds, in their portfolios.

But asset allocation is complicated for individual investors, too — though not for the reasons you think. Since individual investors don’t have access to sophisticated alternative investments, we essentially have to decide among 3 areas of investment: Equities (stocks), fixed-income (bonds), and cash. 3 choices. On the surface, it doesn’t seem too difficult.

But over time, it becomes profoundly difficult to maintain the “right” asset allocation. Why? The reason may surprise you.

The Looming Enemy: Why you don’t rebalance

We now know that asset allocation is one of the most important factors in investing success. So why do we find it so difficult to maintain a reasonable asset allocation? Why do you find grandmas with 90% in stocks, while you also find 25-year-olds with 30% in bonds?

Since we’re wading into fairly advanced investing strategy, you might think that the primary reason is that people don’t know about complex mathematical models or fail to understand some deep nuances of investing.

Not so.

The primary reason we fail to maintain a reasonable asset allocation is human psychology. We are subject to many powerful psychological biases when it comes to investing (more about the psychology of money).

Even if we have a helpful chart like this…

…we still fail to maintain a reasonable asset allocation over time.

“This analysis assumes that for all of these portfolios, investors kept their money in the funds through the hair-raising markets of 2001 and 2002 and rebalanced the portfolios annually, returning them to their original allocation. But such disciplined rebalancing can be a tough sell, said Hersh M. Shefrin, a professor of behavioral finance at Santa Clara University in California. “We are pleasure-seeking beings who want to avoid pain,” Professor Shefrin said.

Rebalancing, he said, would have forced investors to do exactly the opposite — by making them either prune assets that had done extremely well, or to load up on assets that had disappointed them.” (via NYT)

To put a finer point on it, from a nice article in the Canadian Business Online blog:

“When stocks were crashing in late 2008 and early 2009, did you rebalance your investments? Did you actually move money out of cash and bonds into stocks?

Many did not. They either froze or dumped stocks in a panic. At least that is the conclusion of a recent study released by two finance professors, Louis H. Ederington and Evgenia V. Golubeva, at the University of Oklahoma.”

Let’s get to the nitty-gritty of what you need to know.

What you need to know about asset allocation and rebalancing

• Asset allocation is the #1 or #2 most important thing you can control when it comes to investing
• Contrary to what most people think (especially technical people), the difficulty in maintaining asset allocation is not technical skill. It is investor psychology. You will inevitably think you can out-think the market. You will fall prey to several investor biases. You will not be disciplined enough to rebalance on a regular basis. You are human. “Trying harder” in this area doesn’t work for 99% of people.
• Forget picking stocks, since investing is not about picking stocks. Again, investing is not about picking stocks. Most individual investors shouldn’t even pick one stock. Instead, they should use target-date funds (aka lifecycle funds), which choose an asset allocation based on your age and automatically rebalance for you over time.
• The media does not like to write about asset allocation because it’s complicated, scary, and you can’t easily put a picture of a guy standing in a suit with his arms crossed talking about how asset allocation helped him pay off his debt and send his kids to college. Jesus christ I am getting angry writing this
• Most people don’t even know what asset allocation is. But even those who do fail to rebalance their portfolios in a disciplined way. This is true even of professional portfolio managers!
• The best solution is to automate this process by investing in a target-date fund (aka lifecycle fund). Those funds automatically rebalance for you. And for each person who debates minutiae about the minor percentages they disagree with (“it should be 16% large-cap, not 14%!!!”), 1000x more people are helped by the automation of regular rebalancing.

Investing without an asset-allocation plan is like riding a tricycle in South Central LA, naked, blindfolded, wearing a large fanny pack full of $20 bills. It doesn’t matter how disciplined you “think” you are going to be in steering straight and true. You are still going to get your ass beat.

Most investors don’t even have a plan for their asset allocation. They simply invest randomly here or there, picking a fund or stock that catches their fancy. 40 years later, they complain about the government, taxes, and the media for their poor investing returns. (They’re not the only ones to blame, of course.)

But perhaps even more pernicious are the people who are well-read about investing — but then decide they want more “control” so they’ll manually adjust their asset allocation. This may work when they initially start investing and are highly motivated, but over time, they — like everyone else — fall prey to natural human biases and weaknesses, leaving them with an exposed asset allocation. Perhaps 1% of investors can maintain the discipline to maintain an appropriate allocation over time.

Chances are, you can’t.

I know I can’t. And that is why I use target-date funds.

Bottom line: You are human. No matter how motivated you are about investing right now, you will find other things more urgent and important later. We are all cognitive misers with limited cognition and willpower. Investing in a target-date fund lets you compensate for your natural weaknesses and biases by automating complex asset-allocation decisions.

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This post is part of a series on the Psychology of Money. For more articles on the psychology of money and investor psychology, follow the links below.

« Psychology of Money: The Last Mile of Saving

Psychology of Money

20 questions that your financially unprepared friends are afraid of »

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This is an oldie but goodie, and one of the most important videos I’ve posted in my 100+ YouTube videos.

In this 12-minute video, I show you how to set up your bulletproof personal-finance system to automate your accounts.

I cover the entire system in extreme detail in my personal finance book.

To find out about the psychology of automation — including how it affects your money — check out my section on automating your personal finances.

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Automating Your Personal Finances

Automating your money — especially entrepreneurs and freelancers »

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See the 7 lies below — plus a holiday gift at the bottom.

1. “I want to make passive income”

I love when people say this because you can tell they have no idea what they’re talking about. It’s kind of like trying to identify people with bad taste: Just go to the local Hometown Buffett. They’re all there.

I hate to say it but most of us don’t need to focus on passive income, we need to focus on improving our active income — our jobs. How? By becoming more skilled, solving more problems for our bosses, and basically out-hustling co-workers.

A lot of people don’t like to hear this because it means that instead of reaching for some dream of $500/day in passive income, they actually have to do some work right now at their jobs. But your job is the most likely place you can significantly increase your income.

Solution: Get better at your job and negotiate your salary. Here’s how:

2. “If I just try harder, I can save more.”

This is like a fat man swearing off sugar and delicious Taco Bell. Not even swearing it off, just saying he can swear it off “some day.” The truth is, we all know we need to save money, exercise more, call our family regularly…but there are serious barriers to doing all of these.

There is significant research indicating that simply trying harder will not help you get started investing.

Solution: Automate your finances so you’re not dependent on your willpower.

• Personal finance is not about more willpower, including specific details on my automation system for your finances & a 12-minute tactical video
• The psychology of passive barriers (why we can’t seem to do things we “know” we need to do)

3. “I’m going to start keeping a budget”

Do you guys remember when I made fun of stupid frat-boy business ideas, the worst one being when a bunch of dudes get together and decide to start a t-shirt company?

This is like that, only for grownups. At some point in our lives, each one of us will get motivated and decide, “Yes! I’m going to track my spending.” This will last about 10 minutes until we realize it’s (1) really hard, (2) we don’t like ourselves when we objectively analyze our spending, and (3) it’s much easier to do nothing than to subject ourselves to the pain of budgeting.

In fact, I am going to quote a very wise man on this one: myself. Here, directly from my book, are my thoughts on budgeting:

“Create a budget!” is the sort of worthless advice that personal-finance pundits feel good prescribing…Who wants to track their spending? The few people who actually try it find that their budgets completely fail after two days because tracking every penny is overwhelming. Amusingly, in a 2007 survey by bankrate.com, 75 percent of Americans said they have a budget—which is complete nonsense. “There’s probably a lot of wishful thinking in this response,” says Jared Bernstein, director of the Living Standards Program of the Economic Policy Institute. “It’s probably more accurate to say that three-quarters think they should work on a monthly budget.” My kind of man: exposing the delusions of people everywhere!”

Solution: Create a Conscious Spending Plan that will let you spend extravagantly on the things you love, as long as you cut costs mercilessly on the things you don’t.

• Conscious Spending: How my friend spends $21,000/year going out
• Full Conscious Spending Plan (with specific recommendations on percentages for each category) is available in my book

4. “My friend goes on vacation 4x a year and he makes less than me!”

Your friend is either a highly skilled practitioner of Conscious Spending, or an idiot. What’s funny is this becomes more true as you get older, yet we get even more jealous. Think about it: How many times have you heard one of your parents ask the other one, “Why can’t we go on vacation like they do?” without understanding how their spending breaks down?

Odds are, they’re not conscious spenders, but rather overspenders.

The single-best book on this is the Millionaire Next Door, where we learn surprising facts about the average millionaire: 80% are first-generation affluent, invest 15%-20% of household income, buy used cars, and rarely buy expensive watches or suits. They’re the ordinary neighbors who are saving money instead of spending it on a new Mercedes.

Solution: Would you look at a bunch of blue whales for advice on losing weight? Then why would you look at your ordinary friends, who are making ordinary money decisions, and will end up with ordinary results — not having enough money — as role models? Refocus your financial aspirations to people you value and their conscious decisions, not showy displays of wealth from people who are poor role models. If you suspect they can’t afford it, they probably can’t.

5. “I’m different than everyone else…I don’t need to save up for a wedding/kids/car/life insurance”

This is also known as, “Ugh, Ramit, I’ve already done all the stuff you’ve told me…now what?”

People are delusional about what will happen in the next 10 years. For example, if you’re in your 20s, the next 10 years will bring kids, a new car, a mortgage, taxes, insurance, maintenance, travel, life insurance, medical insurance….etc.

Every day I get frustrated people who tell me they’ve implemented all my strategies, yet when I tell them the next step is to implement the Ten Year Savings Strategy — where they save for the most likely things they’ll encounter within ten years — they become oddly dismissive.

Why? Because it’s not sexy. They want advanced “tips” and “tactics” to do something cool…even though saving money for the things they will almost certainly need is the most pragmatic thing to do. They actually say things like this (a real comment):

“First of all, I’m not getting married. No, this isn’t just the talk of someone who can’t see far enough into the future. We all know the only benefit of getting married is in avoiding divorce.”

Solution: If you think you’ve already optimized your finances 100%, use my Ten Year Savings Strategy and ask a few people 10 years older than you what they wish they’d saved for. Then do it. Oh yeah, and if you’re “sure” you’re not going to have kids or get married because it always ends in divorce, just go hang out with your 14-year-old friends and come back here in 10 years.

• The Ten Year Savings Strategy: Saving money after you’ve already handled the basics
• Why do delusional people think their spending will be different than other people’s?

6. “I’m going to invest in stocks”

I am getting so mad typing this that I don’t even know where to start. First of all, let me acknowledge that fewer than 5% of people will probably ever say this, since most people don’t invest at all, then turn 40 and get scared, call their HR rep, set up some kind of mis-allocated 401(k) plan, and then go on their merry way whistling and eating walnuts.

 

So if you’re thinking about this, it’s actually a good thing — it means you’re probably thinking about investing far sooner than others.

Unfortunately, “investing” does not mean picking stocks. It also does not mean buying a house, but that’s another story.

Even the fanciest portfolio managers fail to beat the market most of the time, which is why I argue for target-date funds, where you simply pick a fund determined by your age, set up automated payments, and get on with your life.

It’s also critically important to note that your asset allocation is more important than the individual investments you make. Think about it like this: If you write a book, your Table of Contents is more important than any individual word you write. Yet people obsess about the words instead of spending the bulk of their time on the TOC.

Solution: Stop trying to pick stocks. Instead, automate your investments with target-date funds or, if you really want to control your investments, a group of low-cost index funds.

• Behavioral psychology/economics on why you are not a good stock-picker
• Full chapter on why investment “experts” are overrated and hilariously wrong in my book, along with another chapter on specific ways to automate your investments with sensible, long-term investments

7. “Money is just for greedy people…I don’t need to worry about this stuff”

No it’s not. This is the excuse of lazy people who don’t want to spend a weekend learning about money, but instead worry and complain about it for the rest of their lives. I’ve said it since this site came out: “Rich” isn’t just about money, it’s living a rich life, whether it’s buying nice clothes, traveling around the world, spending extravagantly on your hobbies, or spending as much time with your friends/family as possible.

But part of that is money. If you haven’t optimized your money — whether you earn $35,000 or $350,000 per year — it doesn’t mean you’ve taken a principled stand against consumerism. It means you’re lazy.

Solution: Take one weekend to learn about your personal finances. Once you automate your money, you’ll never worry about it again.

• Automate your money
• Some of my favorite books on money
• My Scrooge Strategy premium tips, which will save you hundreds of dollars per year

 

* * *

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This post is part of a series on the Psychology of Money. For more articles on the psychology of money and investor psychology, go to the index page, or follow the links below.

« Use barriers to prevent yourself from spending money

Psychology of Money

Why do delusional people think their spending will be different than other people’s? »

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As you know, I have strong opinions on buying a house, and most people don’t know what they’re talking about when they talk about real estate being the “best” investment.

So when a Wharton professor wrote a Washington Post column pointing out common myths of homeownership, I laughed at some of the comments.

• “Wow is this a poorly written and intentionally misleading piece of b.s. I wasted countless thousands renting apartments before wising up and buying a house. The author would rather have us all in housing collectives or government owned communes. Home ownership is still the American dream; don’t let this joker fool you.”
• “…Housing is a great long-term investment. Yes, it is. Because what the author doesn’t mention is that you have to have a place to live. If you rent, you have a place to live but the return on your ‘investment’ when you pay rent is 0.”
• “this guy gets paid for this s^^t?”

Newspaper sites have the worst commenters in the world.

But there was a comment that made my jaw drop. Can anyone spot the multiple problems with this comment?

“Another story: My father bought our family house in NJ for about $27k in 1964; sold it for $350k in 2000. Home ownership is terrific long-term investment.”

(Need a hint? This and this will help.)

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