Investment Plans: In Search of Discipline

David B. Jacobs, president of Pathfinder Financial Services talks about our tendency to get distracted from our investment plan in NAPFA's (National Association of Personal Financial Advisors) May 2005 newsletter.

 

He notes that we give the most weight to our personal experiences, then to what we've been told by friends, then to what we hear in the media, and we give the least weight to the statistical facts. In short, we are giving the lowest weight to the most important information and the highest weight to the information subject to the most bias.

 

Jacobs counsels investors to be disciplined - stick with their plan. Presumably, that is an investment plan that was made during a period of sane and thoughtful deliberation. Jacobs says you should stop checking your portfolio value every day, stop reading and watching the financial news, and only make changes to your investment plan when your goals change. Amen!

 

Jacobs also touches on our inability to accurately assess information. This is a topic that was well covered by my lunch partner today, Terry Burnham, in his book Mean Markets and Lizard Brains. According to Burnham, our brains are not wired to make rational calculations. Terry gives two puzzles in his book as examples:

 

Chinese families place a high value on sons, yet the Chinese government exerts extreme pressure to limit family size. Let's assume that that the chance of having a girl is exactly 50%, but every couple stops having babies once they have a son. So some families have one son, some have an older daughter and a son, some two older daughters and a son, and so on. In this scenario, what percentage of Chinese babies will be female?

 

Here's the second puzzle:

 

Imagine that you are a doctor and one of your patience asks to take an HIV test. You assure her that the test is unnecessary as only one in a thousand with her age and sexual history is infected. She insists, and sadly the test result indicates viral infection. If the HIV test is 95% accurate, what is the chance that your patient is actually sick?

 

Apparently, we all get this wrong, at least most of us do - unless you're an actuary like my husband Jim.

 

Don't believe me? When doctors and staff at the Harvard Medical School were asked the question about the HIV test, the most common answer they gave was a 95% chance that the patient was sick. The correct answer is a less than 2% chance that the patient is sick!

 

The same is true of the Chinese baby puzzle. As long as the chance of having a baby girl and each pregnancy is exactly 50%, the population will also have 50% girls. This is true regardless of any rule on when to stop having babies. But most people will answer differently.

 

So our brains are not built to do mathematical calculations. And yet, every investment plan really boils down to probabilities and mathematically determining the optimal trade-off between quantifiable factors such as risk and return.

 

Jacobs article in Planning Perspectives discusses how this lack of odds-making ability applies to our selection of mutual funds. Most people see a fund which has beaten the market averages over the last five years and infer from that that the fund manager has some uncanny stock picking skill. However, random chance would suggest that about 3% of all mutual funds, at any given time, should be beating the average over five years. But according to Jacobs, less than 3% do, which would seem to imply the opposite - that fund managers have an uncanny lack of skill!

 

When you add to this that studies have shown past performance is not predictive of the future results of a stock, mutual fund or a money manager you begin to understand the results of the Dalbar study. Dalbar has found that over the last 20 years the average stock mutual fund investor has had a return of only 2.5% during a period of time in which the S&P 500 has risen on average over 12.7%.

 

What do you think? Do you believe your brain is capable of accurately assessing the probability of success in an investment and formulating a sound investment plan based on that assessment? Or do you believe that most of the time your decision making is ruled, or ruined, by something other than logic? Leave your comments below.

 

 

PROPS:

 

1. David B. Jacobs, "Don’t Let the Media Distract You from Sticking with a Good Investment Program." NAPFA Planning Perspectives. May 2005

 

2. Terry Burnham, Mean Markets and Lizard Brains. Hoboken, NJ: John Wiley & Sons, 2005; pp 16, 17.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.