Why You Shouldn't Time The Market

Buying low and selling high is the aim of the entire financial services industry, right? Yes. But that doesn't mean it's consistently possible. It just means a lot of people work really hard and spend a lot of money to convince you to try. Investors - you and me included - are subject to a lot of biases. We are affected by our emotional state, by quirks of personality, by the news of the day, and by various fallacies that can all lead to irrational decisions. If the market falls 2% in a day, should you buy? But what if it falls more tomorrow? If it reaches a new high, should you sell? What if it will keep going higher for another week? Shouldn't you try to figure it out? Remember, to successfully time the market you have to time it correctly twice: when to buy, and when to sell. In fact, to successfully beat a benchmark over the long term, you need to accurately time the market 74% of the time

The S&P500 returned 11.39% in 2014, (13.69% including dividends). The lowest close of the year - what would have been the time to buy to achieve the best possible return - occurred on February 3. Here's an example of the headlines from the middle of that day:

http://blogs.wsj.com/moneybeat/2014/02/03/mondays-selloff-by-the-numbers/

Not particularly encouraging. Sample quote: “Too much downside momentum and too little in the fear category to offer a safe entry point,” wrote a strategist (aka, a professional who tries to time the market). It certainly seemed like the selloff would continue. But you would have had to guess that this was in fact the low of the year, and this was the precise correct moment to buy, in order to time the market correctly.

The highest close of the year was reached on December 29. The headlines from that day were a snoozefest, typical of that late in the year, with light trading and no real news:

http://www.wsj.com/articles/u-s-stock-futures-fall-following-lead-of-european-markets-1419858931

But again, an investor would have had to see through the inertia to recognize their exit point - the precise moment that they should sell.

So on top of the lack of clear direction indicating the best action to take, we also learn from our mistakes. We remember the regret of missing the Feb 3 low, and don't want to miss it again. We kick ourselves for not selling on December 29 when we should have. Those emotions will inform the next decisions we make, and will often lead us down the wrong path.

This is why so many investment managers and financial planners - me included - don't time the market, and strongly discourage clients from doing it either. It almost inevitably leads to a poor outcome over time, drives up costs from unnecessary transactions, and has been shown, over and over, to work against an investor's best interest.

None of us can see the future: not average investors, not professional investors, not the media. A lucky call once or twice is rarely repeatable over time. So instead of trying to do the impossible, go back to basics: appropriate asset allocation, low cost, diversified, passive funds, regular investments, and periodic rebalancing. You'll thank yourself in the long run.

Socially Responsible Investing: Can you do well and do good?

I hate disappointing people, especially young new clients who come to me full of idealism and motivation to make a difference in the world. But that's what this post will do, so I might as well come out and say that I'm not a fan of socially responsible investing as it's normally practiced, and I usually advise clients against it. Hopefully though, by the end you'll feel better about the possibility of making an impact with your investments, even if it's not the way you thought it was going to work.

Interest in socially responsible investing (the practice of only, or primarily, investing in companies that engage, or do not engage, in certain practices) is definitely on the rise. Cerulli Associates reports that more than 50% of institutional asset managers have recently received client requests for socially responsible investing (SRI) or environmental, social, governance (ESG) mandates. Money invested in mutual funds describing themselves as investing in a socially responsible manner is one of the fastest-growing segments of assets under management. The growing interest makes sense. There's an increased focus on sustainably produced food and clothing and consumers have shown to be willing to pay a premium for local or fair-trade items, to support business models that align with their ethics. And there's no lack of headlines about corporate malfeasance, questionable business practices, lack of consideration for the environment and unfair employment policies. So the desire to put pressure on companies via investment decisions is understandable.

But the problem is it doesn't work that way. When you buy a share of stock, the money doesn't go to the company that issued the stock, but to the other investor who sold it to you (and whom you don't know). The broker who conducted the transaction gets a commission. When you sell, it happens in reverse – the money comes from the anonymous buyer to you, the seller, with a bit being diverted to the broker. The company itself isn't really affected at all by these transactions, except in a very, very vague way – you can't have sellers without buyers, and if enough people refuse to buy shares, the stock price will go down. But you can decide for yourself whether you think that will really happen.

Picking and choosing individual companies to invest in is known as active investing, and that's not a good idea. People – whether individual retail investors or professional fund managers – are irrational, make poor decisions, are subject to biases and fallacies, and let emotions get in the way. When it comes to socially responsible investing, where you might have a particular attachment to a company (say, because you know they develop green energy alternatives and have generous employee benefits), this involvement makes it even more difficult to judge an investment rationally.

A much better strategy is the one I recommend to pretty much everyone: understand your risk tolerance and invest accordingly, diversify broadly, and keep fees low. You can calculate the excess return earned by the companies you find objectionable – one way is to take a look at this list, choose the fund you would have invested in or that mimics what you would have done, and compare it regularly to your actual returns. (Remember to account for fund management fees!) Then put that money to use in ways that can really move the needle: supporting political candidates that will further your causes, buying items produced or sold in ways that align with your ethics that might be more expensive than their competitors, and engaging in public education campaigns. Utilizing simple index funds allows you to capture as much return as possible by keeping fees low, and avoids participating in putting pressure on companies to deliver certain results, possibly at the expense of more costly or difficult to implement, but more fair, business practices. 

Ultimately, how you choose to invest your money is your decision, and if you decide you just can't stomach getting oil company profits, that's fine. Do what feels right to you, but make the most informed decision you can. My clients know that I constantly beat the drum of controlling what you can control – in this case, it's the fees you pay, and to whom you pay them – if you're on your own, Vanguard is a great choice because they are investor-owned; if a fee-only advisor manages your money for you, ask them to tell you more about their custodian and the custodian's practices); if you're working with a traditional commission-based advisor, take a close look at your statements and think about whether the money you're paying for your investments would be better spent going to a more worthy cause.

Emergency Savings - What You Need To Know

This has nothing to do with emergency funds. But it's funny and saving for a rainy day isn't super-exciting, so pretend Vince here is slow-clapping for you getting this done.

Should you have an emergency savings account? If so, what kind of account is best? What’s the right amount to have saved? When is it ok to dip into it?

Who needs an emergency savings account?

First things first: everyone should have an emergency savings fund. Unexpected car breakdowns, health expenses, home repairs, and emergency travel happen to everyone, and having some cash to cover them when they come up will keep you from relying on credit cards and compounding an already difficult situation. Even more importantly, a reserve works to cushion you for a while against job loss, and gives you some flexibility in choosing job offers.

What is an emergency savings account, anyway?

Now let’s define an emergency savings account. This should be a very liquid (read: basically cash) account that is easily accessed if needed, but not part of your regular budgeting. It should not be a brokerage account: bad news tends to follow itself, so you don’t want to have to sell investments and possibly incur trading losses or tax gains, making a bad situation worse. It should not be a tax-deferred retirement account (IRA, 401k or similar), since withdrawing from those will lead to taxes AND penalties. An online savings account is perfect for this kind of thing. These are FDIC insured (up to $250,000 per depositor) accounts that link to an existing checking account, making transfers very easy, and pay a bit more interest than a regular account at your local bank. Just remember, savings accounts are generally limited to 6 withdrawals or outgoing transfers in a month. You can compare current offers here: http://www.nerdwallet.com/rates/savings-account/. As long as the account offers FDIC insurance and ease of use, it’s a great choice.

How much should be in there?

So how much should you save? First, calculate a month of living expenses: rent or mortgage, utilities, insurance, car payments, groceries, all the things you can’t really put on hold. Aiming to reserve somewhere between three and six months’ worth of expenses is best (closer to three for a steady two-income household, six if there’s only one source of income, if income is irregular, or if you have kids or pets). Some clients feel more comfortable knowing that nine to twelve months’ of living expenses are covered. You can certainly save even more than that if you prefer, but with interest rates being so low, a large cash balance is probably put to better use elsewhere (accelerating debt paydown, starting an investment program, philanthropy, etc).

I can't save that much!

If you’re starting from scratch and overwhelmed at the thought of getting to the three month mark, just remember that it won’t happen all at once. Start small and just keep going. Keep an initial goal of just $1,000 in sight, and track your progress. Even $50 per paycheck is a good first step, and as always, automation is your friend: ask your payroll department at work whether you can set up multiple direct deposits, and divert a small amount to your savings account each pay period. If that’s not an option, set up the automatic transfer yourself to coincide with your pay periods. Either way, when you get used to the lower take-home amount, increase the amount diverted to savings little by little. It’s not all-or-nothing: just do the best you can, and don’t let the perfect be the enemy of the good. Even if you have just a few hundred dollars saved the next time a crisis occurs, that's a few hundred less you will have to borrow. 

When do I use it?

What constitutes an emergency? My definition: any unavoidable expense that you can’t cover with regular cash flow. Fixing the car or the boiler, getting a root canal, emergency veterinary care, buying food and paying rent when you’re between jobs and unemployment/severance isn’t enough - that’s what this account is for.

Savings of any kind - emergency, retirement, vacation, or anything else - buys you flexibility in the future. Establishing an emergency fund is one of the most important things you can do to create financial stability for yourself. It will decrease your reliance on consumer debt, allow you to hold out for a better job offer, and ultimately save you money even if no job loss occurs. I won't pretend building up a reserve is fun or exciting - after all, it's basically just money you hope to never have to spend, and that by definition won't be spent on anything fun - but the feeling of security it provides will hopefully make up for the more enjoyable expenses you may have to cut back on to get there.