I took my annual look at my investments this week, and boy did I get it wrong. A few years ago, I determined I should have about 70% of my investments in equities. Instead, as of yesterday, I had less than 60%. Most of the excess was in cash, earning essentially nothing and missing out on the 2.5% returns of stocks this year, my procrastination penalty.
As an (ex-)investment banker who has made a career of applying the latest research in behavioral economics and decision science to real world problems, how could I explain (if not excuse) this lapse? More importantly, how could I prevent it from happening again?
I think there are several hurdles that I failed to clear. Maybe some of them will be familiar to you too:
- Loss aversion: I didn’t want to lose money. Putting my dollars in equities to get my allocation would mean risking a loss;
- Default heuristic: It was easy to stick with the default choice of doing nothing last year;
- Procrastination: I knew last year that I needed to update my financial plan, which, for me, required a lot of heavy-duty thinking and a big Excel model. I told myself I didn’t have the time;
- Mortality aversion: Thinking about retirement naturally means making assumptions about life expectancy and what my later (declining) years may be like. Yuck;
- Choice overload: There are 1,400 ETFs and 7,200 mutual funds. Investment decision-making can be simply overwhelming;
- Mistrust: Flash-crashes, Ponzi schemes, unreliable Federal Reserve forecasts, regulations that limit financial market liquidity, sometimes makes me wonder whether those that run the financial system really know what they’re doing; and
- Financial media: as usual, the media offered noise and distraction, focusing on historical performance and making essentially worthless forecasts for the coming year.
Since I’ve been thinking about decision tools, I decided to build a pretty simple one to help me clear these hurdles. Here’s how it works:
- Estimate monthly income and expenses until a few years after our life expectancy.
- This results in annual additions to, and then withdrawals from, savings (after retirement).
- I made an assumption that I would use more equities to save for withdrawals in the distant future than in the nearer future. For the mid-term I’ll use bonds and for the short-run, cash (see chart below).
- Then, I multiply the allocations by the future withdrawals and add each up to get the amounts I need to invest today in each asset class to cover my future spending.*
- Finally, I make some very conservative investment return assumptions and adjust our spending (or delay retirement) so that I don’t run out of money.
The best investors understand how to minimize their own irrationality…**
That’s it. Now that the architecture of my annual planning is set up, it should be easy for me to update and rebalance pretty automatically, reducing the risk of procrastination. In essence, this plan is my new default. I have already written about how robo-advisors can make this automatic. If I had automatically kept to my 70% equities target, that would have more than paid the fees last year. That said, I think I can use this plan avoid making the same mistake next year and save those fees. Or am I (still) suffering from overconfidence?
PS. If you’d like a copy of the Excel model I described to play with, just drop me a line.
*Actually, I calculated a present value, discounted on the asset class’ expected returns.