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5 Ways the Investment Industry “Optimizes on the Wrong Parameters”

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“You’re optimizing on all the wrong parameters.”

~A father to his son

 

Note: I look forward to Thanksgiving each year—good food is part of that for sure, but also as a time to focus on the things that really matter in life, and to spend time with family and friends. With that in mind, I present the following post inspired by a father's advice to focus on what matters.



Each week I receive a digital stack of investment articles to read. I read many, but for me there are few “can’t miss” authors. One of these is Mebane Faber, the Chief Investment Officer of Cambria Investment Management.

Meb earned his status on the top of my digital stack for a couple reasons: His investment approach could be summarized as “what do the data tell us?” Investing based on the evidence. The second reason is he gets that there is more to life than investing. Investing is rarely about just making the most money; it’s a means to an end, not an end in and of itself.

At Cordant we call this deliberate investing, or managing your wealth intentionally. Before you can set the “best” investment strategy for you, you really need to know what you are trying to accomplish by investing.

Filed under the “more to life than investing” category, Meb wrote an article last year titled “My Investing Mentor”—hint, it’s his dad.

In the post, Meb reveals one of his dad’s favorite lines: “You’re optimizing on all the wrong parameters.” In other words, the things you’re paying attention to are not going to get you the results you seek. They’re either things you can’t control or things that don’t matter. This is such great investing advice and life advice in general.

The investment industry is constantly trying to get people to pay attention to: things that don’t matter in achieving their goals, or the things over which they have no control. In short, the industry is good at telling people to optimize on the wrong parameters.

So with that in mind, here are 5 ways the investment industry optimizes on all the wrong parameters and some common sense advice for turning that around.

1. Placing focus on the short term while ignoring the long term.Shockingly bad investment advice

Watching the World Series this weekend, I was disgusted, but not surprised, to see an E*Trade ad with the tagline of “Shorten the distance between intuition and action.” Apparently the idea behind their “barcode scanner” app is that when you are out shopping and see a product, you will suddenly think to yourself, “hmm, maybe I should buy the stock as well.”

This is exactly the type of investing behavior that ignores the evidence. In a 2000 study titled “Trading is Hazardous to Your Wealth,” the authors summarized their findings as follows:

Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent…Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.

Wall Street wants you to focus on the short term, because it’s going to make them more money. Instead realize it takes years or decades to accomplish your financial goals, not days and weeks, and act accordingly.

2. Investing before planning

As author Ben Carlson wrote last week, “One of the biggest problems with the way many financial firms operate is that they prescribe before they diagnose.” Imagine going to your doctor and before even telling her what’s going on, she gives you a pill that is “exactly what you need” and “will solve all your problems.” It’s obvious you should turn around, walk straight out the door, then get yourself a new doctor. You should do the same with any financial advice that is prescribed before diagnosed.

Your investment strategy should be informed by your financial plan, what you are investing for. It should take into account your goals, objectives, tolerance for risk and personal idiosyncrasies. Because even the best investing strategy in the world, if it’s not something you can stick with over the long term, will not help you accomplish your goals. 

3. Perpetuating the myth that if you can only identity the ‘right’ product, it will lead to success.

Humans have a desire to seek out the latest new thing. The grass is always greener on the other side. And Wall Street exploits this desire.

Consider the following quote from ex-Goldman Sachs employee Greg Smith, “The quickest way to make money on Wall Street is to take the most sophisticated product and try to sell it to the least sophisticated client.” And as Ben Carlson puts it, “There are enough investors out there in search of the perfect investment — which doesn’t exist — that Wall Street is more than happy to continue making up ways to sell that dream to them.” 

Investing is not always easy. But, it’s better to invest in a strategy you can stick with over time than to jump from one hot product to the next.

 4. Pretending that expenses and taxes don’t matter

Turn on CNBC, Bloomberg or Fox Business, and chances are you’ll see a segment on the “top stocks to buy now” or something along these lines. What you never see is a segment on minimizing taxes and expenses. And yet, this is going to be one of the most reliable and consistent ways to increase your net returns. As we saw above with the “Trading is Hazardous to your Wealth” study, active traders typically hurt their returns. But frequent trading has another perilous price—It increases trading expenses and taxes.

In his 2014 paper “The Arithmetic of “All-In” Investment Expenses,” John Bogle, the founder and former CEO of Vanguard, estimates that the increased cost from expenses, transactions and taxes of actively managed funds over index funds is about 2% annually. Maybe 2% doesn’t sound like a big deal, but this is $20k each year on a $1mm portfolio. Expenses and taxes do matter over both the short and the long term.

5. Selling the story that the best investing strategy is somehow exciting or sexy

 At this point you should notice a theme. Wall Street exists for one reason: to make money. It doesn’t exist to help you achieve your goals or give you sound financial advice.

To do this, to sell more product, they have to keep things exciting and new. But again, this is exactly the opposite of successful, long-term investing. 

According to Nobel Economist Paul Samuelson, “Investing should be dull,” and, “investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”

And as Warren Buffett says, “Our favorite holding period is forever.”

 

Conclusion

If you’re an Intel employee and you want to optimize your retirement investments on the right parameters download, download our free eBook “Navigating the Intel Retirement Plan.” You will learn our 4-step framework for selecting the best investment in the Intel retirement accounts.

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Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.

Published on November 23, 2015

Isaac Presley, CFA

Isaac Presley, CFA

Isaac Presley is Director of Investments for Cordant, a wealth management firm serving current and former Intel employees. To learn more, you can read Isaac's full bio.

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