By Jim Whiddon
Author Russ Roberts takes an interesting tack in his new book, “How Adam Smith Can Change Your Life.” While Smith’s most famous tome, “The Wealth of Nations,” has been most popular in economic and investor circles, his other volume, “The Theory of Moral Sentiments,” contains some of the venerable writer’s most valuable insights.
One of the lessons investors can learn from this offering is that investing truly is more about behavior and less about the numbers. It’s not the charts, but our hearts that direct our decisions about money. And this concept is what Smith was so adept at teaching us.
Roberts brings this truth to our attention masterfully. Let’s take a fresh look at some of the more momentous free-market concepts that Smith endorsed, along with some astute commentary from Mr. Roberts.
Early on, Roberts addresses a widely-known notion for which Smith is duly famous: “People are fundamentally self-interested, which is not the same thing as selfish.” This famous passage from 1759 is evidence:
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self–love, and never talk to them of our own necessities but of their advantages.”
Here, Smith has identified one of the fundamental building blocks of free and efficient markets. Simply put, folks tend to look out for themselves and those they care about. This type of caring action brings together the interests of all in order to meet the needs of all. It’s not a centralized, organized plan. It simply happens naturally, in every culture with every human being, if it is allowed to do so.
When you break it down, this simple fact of human nature provides investors with something to invest in. In modern society, that often means companies where boards and executives take risk and pursue profits to meet the needs of themselves, their employees and their customers.
Secondly, there have been many excellent books written in recent decades concerning a field we investment advisors enjoy following – behavioral economics. In addressing this intersection of psychology and economics, Roberts explains the Narrative Fallacy, in which “evidence that fits a certain narrative is noted after the fact. Other evidence that doesn’t fit the narrative is discarded.” In other words, it’s a play on the well-known behavioral finance concept of conformation bias.
Roberts says, “Everyone can explain why the stock market rose or fell yesterday. No one can predict what it will do tomorrow. It’s all just ex post facto storytelling. Sometimes even the best quantitative analysis is worse than none at all because it gives the illusion of science.”
In the investing arena, active managers have diligently honed their ability to accurately tell the “story” behind why something just happened. Their goal is to then convince investors that this story-telling ability extends to events that will happen, and that this “skill” is equally valuable to their explanatory hindsight. I call this (tongue in cheek) the Crystal Ball Fallacy.
My favorite of Roberts’ citations is based on Smith’s quote, “the eye is larger than the belly.”
This one resonates with me personally because my father so often told me at the dinner table, “Your eyes were bigger than your stomach.” Who knew he was quoting a guy named Adam Smith?
This intersects with what is perhaps Smith’s most notable and popular adage:
“They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.”
The “invisible hand” gets all the attention, but I believe the most important phrase in this passage is “without intending it, without knowing it.”
Humanity’s simple and natural ambition, otherwise referred to as “greed” in its aberrant form, is such that it not only causes a person to look after his own, but the lack of satiated desire for “more wealth” unwittingly provides an avenue for those with less skill, talent and resources to also have the vocation to provide for their own on a global scale, thus taking it well beyond the local butcher or baker.
Here is the remainder of what Smith offered in this passage:
“When Providence divided the earth among a few lordly masters, it neither forgot nor abandoned those who seemed to have been left out in the partition. These last too enjoy their share of all that it produces. In what constitutes the real happiness of human life, they are in no respect inferior to those who would seem so much above them. In ease of body and peace of mind, all the different ranks of life are nearly upon a level, and the beggar, who suns himself by the side of the highway, possesses that security which kings are fighting for.”
As Roberts explains, “This is the only time that Smith uses the metaphor of the invisible hand in The Theory of Moral Sentiments. And he uses it only once in The Wealth of Nations. In both cases, it means that self-interest can lead to benefits for others—hardly the grander interpretation some place on it today.”
So Roberts (through Adam Smith) delivers a deeper understanding that:
This is an important three-part lesson to remember when it comes to our free market economic system and the benefits we enjoy. As hard as we may try in this technological algorithmic age to make investing all about the numbers, there is an inescapable connection with our actions. Both individually and collectively, our economic decisions affect the outcomes, and thus simultaneously provide the unique advantages of the “invisible hand.”
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE
Q: What are the risks of alternative yield-seeking strategies?
A: Replacing a portion of your high-quality bond or bond mutual fund holdings with strategies ranging from high-dividend stocks to oil-and-gas master limited partnerships because “rates are low” involves taking on substantially more risk. A more efficient way to increase your level of risk is to increase your allocation to a diversified, low-cost stock fund portfolio.
The simplest way to get a sense of the risk that accompanies these strategies is to look at their performance when the stock market has done poorly. The first table shows the performance of high-dividend stocks, preferred stocks, oil-and-gas master limited partnerships and high-yield corporate bonds during the three most recent quarters when the stock market performed poorly.
|
High-Dividend Stocks |
Preferred Stocks |
Master Limited Partnerships |
High-Yield Corporate Bonds |
|
| 4th Quarter 2008 |
–21.3 |
10.3 |
–20.3 |
–17.9 |
| 1st Quarter 2009 |
–23.1 |
–19.2 |
11.2 |
6.0 |
| 3rd Quarter 2011 |
–8.0 |
–7.6 |
–7.0 |
–6.1 |
This table shows that high-dividend stocks were down more than 21 percent in the fourth quarter of 2008. On average, these strategies lost almost 9 percent during these quarters when the stock market did poorly. This isn’t surprising because each strategy has direct exposure to the stock market or contains stock-like risks.
A more useful analysis is to compare how each strategy did relative to U.S. Treasury bonds over these same quarters. This gives a sense of the additional risk an investor in these strategies would have experienced relative to high-quality fixed income.
|
High-Dividend Stocks |
Preferred Stocks |
Master Limited Partnerships |
High-Yield Corporate Bonds |
|
| 4th Quarter 2008 |
–30.1 |
1.5 |
–29.1 |
–26.7 |
| 1st Quarter 2009 |
–21.8 |
–17.9 |
12.5 |
7.3 |
| 3rd Quarter 2011 |
–14.5 |
–14.1 |
–13.5 |
–12.6 |
Each negative number represents underperformance relative to U.S. Treasury bonds, making the risk of these strategies apparent. On average, these strategies underperformed high-quality fixed income by more than 13 percent in these periods. This demonstrates that these strategies do not provide the diversification and risk-reduction benefits of high-quality bonds, and that they are more like stocks than high-quality bonds.
Data from following sources: high-dividend stock, Kenneth French’s data library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/); preferred stocks and master-limited partnerships, Bloomberg; high-yield corporate bonds, Barclays Capital Live.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
By Tim Maurer
Once you’ve abandoned the pursuit of balancing money and life in favor of integrating the two, the question still remains: Now what? How the heck do I better integrate money and life? Like most personal finance dilemmas, the answer is simple, but not easy.
It’s simple because it doesn’t require many steps. What’s more, it’s advice you’ve likely heard before, perhaps multiple times. But it’s challenging because you have to do some work—interior work. And then you have to make some difficult decisions.
Before I share the process, it’s imperative that we recognize a fundamental financial truth, often shrouded in a sea of marketing, misinformation and self-help rubbish that’s more sales than psychology.
RULE: Money is a means, not an end. Money is a tool—a neutral tool that is neither good nor evil. It may, however, be used in pursuit of either good or evil, and everything in between. Money can be well-utilized in the pursuit of goals, but it makes a very poor, lonely goal in and of itself.
Understanding—and believing and applying—this rule is the aim of the following systematic four-step approach to better integrating life and money:
Step #1: Start with why—by acknowledging and articulating your personal values.
Have you seen Simon Sinek’s now classic TED talk? With more than 19 million views, I think he’s struck a chord. Sinek implores us to ensure that what we do and how we do it is rooted in why we’re doing it in the first place. The what and the how tend to flow naturally when we know the why.
Our values are driven by our why. Values are the things in life that we want to define us, the ways in which we’d like to be remembered. They are our core motivators.
There are many ways to explore this inner territory, but all of them require some space for solitude and reflection. If I just say, “Tell me what your values are,” your answers are likely to be superficial. Author Stephen Covey recommends going back into history for an exercise reviewing the most famous set of personal values (he actually called them “virtues”) ever penned, those of Ben Franklin.
The idea isn’t to copy old Ben’s list. But you could do worse than replicating his method, writing a word filled with personal meaning, followed by a sentence or two of explanation. I try to revisit my personal list annually; it’s interesting to see how it evolves.
Step #2: Establish specific, measurable, attainable and meaningful goals, in alignment with your values.
Sorry, I know you’ve heard this before. You know that it’s important to have goals, to write them down, and to ensure they meet certain criteria that give them some heft. But if you’re anything like me, you need to be reminded regularly to think and plan this way. Especially with the advent of the email inbox, it’s all too easy to allow someone else’s goals to trump our own.
When talking specifically about financial objectives, it’s vital that your goals are genuinely your own—not those of some financial guru or your advisor. But this doesn’t mean your advisor can’t help. The advisor’s advisor, Michael Kitces, in his most recent blog post encourages financial planners to aid clients in determining what goals are actually possible. Examining the possibilities before actually setting the goal helps ensure that your goals are attainable, and this doesn’t just apply to lowering your expectations. As Kitces writes, “the problem with goals(-based planning) [is] not knowing how big to dream.”
But most importantly, ensure that your goals are meaningful—that they are in alignment with your values. If they aren’t, you’re likely to suffer one of two possible fates: you’ll either fall short on your goals because of a lack of motivation or you’ll compromise your values.
Step #3: Boldly prioritize, applying the funds at your disposal to the most important goals.
While the Fed might have broad powers to create money out of thin air, you and I don’t. This requires that we make difficult decisions—often—about how to best employ our limited means.
An aging widower wants to both buy a new car and give gifts to his adult children in a year that he incurred significant health-care costs.
A recent divorcee in her late 50s, excited to paint a masterpiece on her newly blank canvas, wants to buy a new home near her grandkids, invest in a second home at her favorite vacation spot and retire early.
A couple with young children wants to max-out their 401(k)s, go to Disney World, finally get those wills drawn up, upgrade their life insurance and save $350 per month in their children’s 529 plans—all in the same year.
As you may have guessed, what each of these real-life scenarios has in common is that they contain more goals than there are dollars. So, after discussing why they wanted what they wanted, we practiced the low-tech exercise of writing down each of their goals on paper, and then putting them in order of priority. Simple, but not easy.
It is at this point we are again tempted to imagine that having more money would eliminate all conflicts. But I assure you that with more money simply come more possibilities, more competing goals and more decisions.
Step #4: Rinse, repeat.
This exercise is not a one-and-done suggestion—it’s a process to be regularly repeated as your values morph and your goals are met or relinquished. Consider making it an annual occurrence, and revisit it after major life events.
This commentary originally appeared November 12 on Forbes.com. I’m a speaker, author and director of personal finance for the BAM Alliance.
If you enjoyed this post, let me know on Twitter or Google+, and click here to receive my weekly post via email.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2014, The BAM ALLIANCE