Listen to this blog post
I have always been a fan of the 1990s Porsche 911. The streamlined body style, go-kart like AWD handling, and rear sitting turbocharged six-cylinder engine is a sure fire recipe for enjoying a drive on the famed Highway 1 of the Pacific Coast. Having said that, I took some initiative in locating a 1990s Carrera 911 online, and much to my amazement the car has appreciated in value. The only one I can find in Northern California is currently for sale at a cool price of $114,900, and that’s $6k+ below its current market value! Sheesh. I am sure I could come up with a lot of reasons why that car is valued where it sits today, but this isn’t a post about cars, it’s about building wealth efficiently.
Our finances are similar to cars in that the end product is a sum of its parts. Some designers have a better eye than others (Ferrari vs GEO) and some engineers are more reliable in their builds and create longer lasting vehicles (Toyota/Honda). While others are aggressive and burn-out before a decade of use (I’m looking at you BMW). We are all familiar with the social norms regarding car purchases; saving for a down payment, applying for a car loan, budgeting analysis, researching the current car market, test-drives, and then the ultimate purchase complete with warranties and taxes. Nothing can go wrong, right?
To parallel that statement; some portfolio managers have more talent than others and some portfolios have lower risk and will perform within a consistent range of return for longer periods of time. While other portfolios can be higher risk with a greater probability of acceleration, but will most likely run out of steam once the market turns on a dime (like how healthcare and utilities flip-flopped this past year).
We are all familiar with the retirement savings process; earn money through your career, save money in a tax efficient vehicle like a 401k, grow that account with a diversified portfolio, and preserve the portfolio as your risk-based glide path adjusts to your ultimate withdrawal of funds, complete with estate planning and taxes. Nothing can go wrong, right?
The surprising part here is that economists would say no, nothing should go wrong, and if it does then we are misbehaving. Remember, economics is technically a social science full of theories. One core principle of economic theory is that the Homo Economicus, or the rational person, will make the most efficient and optimal decisions regarding their finances. Or as the godfather of behavioral economics, Richard Thaler, puts it;
“This illustrates an important problem with traditional economic theory. Economists discount any factors that would not influence the thinking of a rational person. These things are supposedly irrelevant. But unfortunately for the theory, many supposedly irrelevant factors do matter.
Economists create this problem with their insistence on studying mythical creatures often known as Homo economicus. I prefer to call them “Econs”— highly intelligent beings that are capable of making the most complex of calculations but are totally lacking in emotions. Think of Mr. Spock in “Star Trek.” In a world of Econs, many things would in fact be irrelevant.”
Without getting too deep into the woods of behavioral economics, or Thaler’s great work as a writer, communicator, and educator of those theories, the short story is that people are not precisely rational. Something I doubt I have to convince you of. Therefore, inefficiencies in human behavior have consequences on the markets. We are beginning to see fingerprints of behavioral economics all over the financial services industry, particularly aimed at the middle class. Functions of 401ks such as default investments which include target date funds and risk-based allocation funds, automatic enrollment, automatic contribution escalation, and automatic rebalancing are all relatively new and created to battle the inefficiencies of the retirement savings crisis. Let’s break down the four factors of building wealth which I mentioned earlier in this article and the forces at play in each decision:
I gave myself an easy one here. We need to put ourselves in the best position for success to maximize our earning potential. However, sometimes our career goals don’t exactly match up with our life goals which create cognitive dissonance. We spoke about breaking the mold and changing our life’s trajectory on our podcast (click here to listen).
This is when things start to get tricky. Let’s say you found a solid career complete with a 401k savings plan which allows you to save money for retirement in the most tax efficient structure available. Essentially, this is the vehicle that will be delivering you to your destination, and it is imperative you know what you are getting into. The main issue with 401ks is that the proverbial economist who created them assumed we are all the Homo Economicus type of rational people when selecting our investments. In reality, most people know little on how to properly invest long term, which leaves us vulnerable to a host of inefficient decisions. Fees can act like cancer on the rate of return you are achieving year over year. For instance, let’s say you average a 7% return for 30 years straight, but each year your total expense is 2%, and inflation is 3%. That means you are only netting a 2% return, which is not the fastest route to becoming the millionaire-next-door. The easiest way to find out what your 401k plan fees are is to request a “Fee Disclosure” from your record keeper (Fidelity, Voya, ADP, etc). Thinking irrationally, we may become emotionally attached to an expensive 401k plan advisor or too shy to fire them, too busy to check our fee disclosures, and ultimately technologically outdated where lower-cost/better performing funds are not available to our 401k plan. The rational person, assumed by the economist, would have replaced all of those decisions with the optimal choice.
This is arguably the most difficult task people have when saving for retirement, they thought they simply just needed to save, not invest! Well, let’s take a look at what compound interest can do for you.
As you can see, getting in early can be just as important as getting in at all. However, In all three of these instances, the investor ended up with far more than their original amount deposited. As Albert Einstein once said,
“Compound interest is the 8th wonder of the world. Who understands it, earns, who doesn’t, pays it.”
So, we agree we need to invest early to enjoy the rewards of compounding interest. The problem is that our intertemporal powers, the function in which our brain examines how current decisions effect options in the future, values today more than a future date. The furthest date away naturally holds the lowest amount of value with the closest date holding the highest amount of value. For instance, eating today has a higher priority than eating one year from today, with each date in between having its own value in our minds. We call this our inherent time preference. Our time preference is important to note as we make decisions such as saving and investing for tomorrow, especially when we are programmed to provide more rights to today. This is a concept we covered on our very first episode of the Financial Time Traveler’s Podcast, and if you want to learn more I would suggest listening to that (click here to listen).
In addition to investing as much as possible as early as possible, we also need to diversify our money properly. This includes being emotionally bulletproof as the wave of market activity is most likely going to pressure you to consider some highly irrational decisions. They work like this,
As you can see, you are constantly going to fight your reaction to market activity for 30+ years. That is why having a proven investment advisor on your side who acts as an independent, fee-based fiduciary is imperative (a fiduciary is someone who legally has to make a recommendation that is in your best interests, e.g. not an insurance salesman or broker). Getting out of the market when it reaches a bottomless pit of despair seems like the best decision, however, getting back in at the right time can be the most costly. Look at what happened to a $10,000 investment that missed the best 10 days:
We need to start saving early, with low-expense/better-performing investment vehicles complete with advice from an independent fee-based fiduciary. If you have accomplished all of those steps and are looking to start taking distributions from your hard-earned savings, it’s time to consider legacy planning. Your investment advisor should be a great resource for helping you preserve your portfolio and keep it diversified. As you account has grown, you may be qualified to invest in private offerings such as real estate investment companies or venture capital. The good news is, the older you get, the more even your time preference becomes. Tomorrow may eventually be given just as much value as today. This helps you make better decisions with your money as you have a greater experience as an observer of time. As you have built your portfolio, it is equally important to build relationships and examine who are the best resources for you at this stage of the journey.
I hope this article helped outline some of the underlying forces of nature that are in play while investing. It is important to note the expectations of economists vs. what we actually experience. If you have any questions or comments, please leave them in the section below!