Broken Logic
Why is it that you can easily fool a child into trading a one-dollar bill for three quarters?
- The aesthetics look more attractive – shine and quantity.
- Because they can’t easily compute the difference in value.
There is a similar issue going on for investors today. An investor’s portfolio is made up of risk assets and risk-free assets; one is earmarked for long-term wealth accumulation, and the other for upcoming liabilities and emergencies. Here’s the issue, some investors are trading in their risk assets for risk-free assets thinking this is an intelligible swap – just like our cheerful preschooler gladly exchanges dollars for quarters.
Shine & Quantity
Have you ever seen people shop for fruit? It’s quite a spectacle – the knocking on the melon and the repeated pick-up-and-inspect through the stack of inventory. Our shopper usually narrows down their choice to two options. Then they compare and contrast. This is how our brains work, we think in relative terms. To judge the attractiveness of one item, we need to hold it up against a comparable.
Two years ago, money market accounts yielded something close to 0%. Today, money market accounts yield something close to 5%. These are the types of investments that the finance world would categorize as “risk-free.” These accounts have some shine relative to 2 years ago, and the quantity of income (or rate) is much more attractive in absolute terms. Today, that money market melon looks juicier than the two-year-old version.
What about inflation, though? It is the rise in inflation that caused investors to demand/expect higher interest rates, no? And ultimately, investors will use that earned investment income to buy goods and services that are now a bit more expensive. So, when we account for inflation, do those rates today have more shine and quantity? They do not.
At face value, the rates will look and feel appealing, but in a real practical sense – what you can buy with that interest income – is unchanged. Based on where inflation was and is, 0% and 5% are actually the same.
Difference in Value
So, the first mistake was being fooled by the shine of those rates that, at face value, seemed more significant than they are. The second mistake is when people start adjusting their allocations and begin placing long-term monies into short-term instruments.
This is a problem. I’d actually argue that this is a BIG problem. For long-term wealth accumulation, your money needs to compound at a rate higher than inflation. We’ve concluded, based on current inflation, that those short-term investment instruments (e.g., money market) are basically at breakeven. This just won’t do.
Switching Lanes
Do you ever notice those habitual lane-changers in traffic? There is a lot of activity going on, but they make little progress. There doesn’t seem to be a correlation between how many times you switch lanes and a reduction in your drive time. Often you will observe “lane change regret.” The driver sees an opportunity, so they get over, only to then realize that their former lane is now taking off.
Investors today are trying to change lanes in traffic, and they will inevitably experience lane change regret. How do I know this? Because investors, on average – myself included – are horrible at trying to time markets, and what we are talking about is exactly that, market timing.
The peaks and troughs of markets are driven by extreme sentiment, peaking in irrational exuberance or greed and reaching a trough at levels of excessive fear. Lane-changers aren’t enticed back into markets at the troughs, yet it is a fear that lures them back in, a fear of missing out (FOMO). This FOMO, or point of capitulation, tends to come after a rise or rally in markets, which is often an expensive re-entry point.
Advice
I have two pieces of advice to offer (1) to the person yet to make this mistake and (2) to the person that needs to unwind this mistake.
First, to my blameless investor. To help you avoid this trap, you need to clearly outline your objectives for your monies. I like to bifurcate my funds into those two categories: money for today and money for tomorrow. More precisely, money that is earmarked to be spent soon (within approximately three years) or is needed in case of emergency, and money that can be left untouched to compound and grow. For me, my money set aside for taxes should not be in stocks, and my money set aside for retirement should not be in cash. I think you get the idea here – clarity is clear. When you are feeling stressed and unsure based on how markets are behaving, revert back to your plan and original intentions.
Now, to my second group. So, you made a mistake, that’s ok. We all have, and we all will. Dust yourself off, it’s time to course correct. Here’s where you need to be careful. An emotional decision got you into this mess, and you need to avoid another emotional hiccup. What’s probably the worst thing that could happen? It would be that you flip a light switch and place that cash back into the market the day before a market sell-off. You’d feel blindsided, disappointed, and full of regret. So, we need to pursue a regret minimization strategy. Dollar-cost-averaging (DCA) is a great antidote for this. Neither you nor I will know what’s the exact right re-entry point, so let’s avoid needing to make that decision. Instead, set up a systematic DCA plan where you reinvest into those risk assets over a defined time period. An important note, this isn’t a strategy intended to maximize returns but rather minimize regret and any other sort of emotion-spiking outcome.
Opportunity Cost
I remember when I used to print out a MapQuest before heading out on a road trip to a new destination. For the generation before me, it was the Thomas Guide. Nowadays, mid-trip, my GPS will give me two or three options throughout my drive to change routes and improve my ETA. My co-pilot, aka my wife, gets quite annoyed with me when I ask her to compare the options and accept the suggested changes, even if it simply reduces the drive time by a few minutes. “Can’t we just enjoy the drive!?”
Here’s the interesting thing, though, when I arrive at my destination, my GPS never tells me what the fastest route was. It doesn’t tell me that if I would’ve gone this route, then I would’ve saved this much time. My GPS focuses on real-time guidance, but it won’t detail the opportunity cost of my chosen route.
I bring up this point because neither will you. I rarely – if ever – see investors conducting a postmortem and mapping out the opportunity cost of their decisions. Sure, someone can stew on the regret of not buying that stock or this piece of property, but I am talking about real opportunity cost. Think about the investor who was sidelined in cash for the last five years because of their concerns about markets, politics, or any other common investing anxiety. That decision came at a real cost.
Yet, that opportunity cost will never be calculated or considered. The cost of bad planning or poor investment management can have a real impact on the future lifestyle you get to enjoy.
In Closing
Don’t trade a dollar bill for three quarters. It doesn’t matter how shiny those quarters are compared to the paper dollar in your pocket. This trade comes at a cost, a real and literal cost.
If current interest rates catch your eye, be sure always to relate them back to the current rate of inflation. You always want to understand/consider the returns net of inflation. The goal of investing is to minimally retain your buying power. A 1% return with no inflation is better than a 20% return in an environment of 20% inflation.
I know I’m a broken record on this one, but your investment portfolio should support and fulfill the objectives outlined in your financial plan. Your financial plan should not be based on or rely on any sort of market timing.
Moral of the story? Stay in your lane.
