5 Theories About Investor Behavior in the Stock Market

Between my day-to-day activities working with people and my unique vantage point running what has become one of the largest and longest running investing sites on the Internet for the past (approaching) fifteen years over at Investing for Beginners, I’ve come to accept that behavioral economics is the superior model for understanding investor conduct.

When I first began writing, I truly did not understand how willingly people would throw their life savings into some ill-conceived speculation, lose everything, wait awhile, then turn around and do it, again.  It took seeing it over and over for me to accept that it was not a fluke; no outlier, just human nature.  I didn’t appreciate that people would spend a few months, or maybe even years, reading books and websites to suddenly consider themselves an expert, willing to make absolute statements about areas in which they knew slightly more than average but nowhere near what a professional does, nor how emotionally vested they would get in protected their ideas even if you could prove they were based upon a mathematical error or a misunderstanding of some other concept.  I didn’t appreciate how much fashion plays a role in the portfolio construction process, just as is it does in clothing, hairstyles, or musical influences, with investors going from index funds to ETFs, SMAs to emerging market hedge funds, each defended with a religious-like zeal by their particular adherents.

These days, I have five working theories that I’ve come to think explain a lot of things as it pertains to investor behavior in the stock market.

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Stock Market Theory 1

I think almost all mistakes as they pertain to the stock market come down to a handful of things:

  1. Not knowing or understanding what you own
  2. Not knowing or understanding the terms on which you own it
  3. Not knowing or understanding the owner earnings of the assets
  4. Not knowing or understanding how the price you paid relative to the cash flows influences your ultimate result
  5. Not knowing or understanding the costs, both direct and indirect, of the asset
  6. Not knowing or understanding the risks of the asset – liquidity risks, reputation risk, volatility risk, leverage risk, technological risk, inflation risk, political risk, et cetera
  7. Not knowing or understanding the tax code and how it can be used to increase the proportion of rewards that stay in your own family’s pocketbook
  8. Not knowing or understanding how time frames influence result measurements (anything less than 5 years is largely meaningless)
  9. Not knowing or understanding basic mathematics
  10. Not knowing or understanding logical statements, logical arguments, and argument structure

Stock Market Theory 2

It seems to take about 7 years for the typical investor involved in the stock market to forget most of the lessons of the prior collapse, repeating the same foolish errors grounded in human behavioral psychology that caused the mess in the first place.  It happens because older investors die, younger investors join the workforce, and those still taking part have largely recovered the prior damage, forgetting the pain the same way an alcoholic relapses or a spendthrift starts taking out the credit card, starting the cycle all over, again.

I’ve seen a lot of chatter recently on message boards, in forums, sites like Reddit, and other places talking about “stocks being cheap” right now due to a 5% correction.  I cannot sufficiently underscore how idiotic this is.  Due to the unprecedented bull market over the past six years, people have forgotten that, in normal times, an investor should expect to see a 33% peak-to-trough loss of quoted market value on his or her equity holdings.  That’s life.  It has nothing to do with the performance of the underlying business in most cases, it’s the auction mechanism of owners buying and selling tiny ownership pieces among themselves in what amounts to a large version of eBay, Christie’s, or Sotheby’s.  Only, instead of antique candlesticks or vintage decorative tins, you’re buying the right to the proportional earnings and assets of a productive enterprise.  If you have, say, a $500,000 portfolio, it is perfectly in the order of things to watch it go to $330,000 in no time, with $170,000 in unrealized market losses screaming at you from the statement.  Provided the businesses are good, the earnings sufficient, and the dividend or buybacks flowing, this should not be seen as a problem, it should make you excited (more on that when we discuss the effect of the Great Depression recovery period in a moment).  In fact, it shouldn’t even warrant a phone call to your broker or wealth management advisor if the portfolio itself was intelligently constructed.  It’s normal.

At least two or three times in your investing life, you will see a 50% or greater peak-to-trough decline in the quoted market value of your holdings.  If this bothers you, don’t own stocks.  You have no business owning stocks.  If you need to understand the reason, go read this case study comparison examining the results of Coca-Cola and PepsiCo, especially in light of the 1987 crash.

Stock Market Theory 3

Wall Street is bound by the super power of incentive and other institutional constraints to deliver products and services that are destined to underperform after-fees, taxes, and expenses because of the first two theories.  If it actually offered products and services that helped build wealth in the most efficient way, they’d go out of business because nobody would want them.  Generally this comes in three forms:

  • Those who overpay for services, giving up far more than they need to for the assets and service they receive
  • Those who underpay for services, being penny-wise and pound foolish costing themselves much more down the road
  • Those who chase performance, plowing money into long shots, what’s attractive at the moment, or any other popular asset, strategy, security, or fad

Look at the popularity of things like “3x leverage” funds among certain retail investors who don’t know what they are doing or high-cost wrap programs at regional banks with upward of 3% of assets per annum in costs over much better alternatives such as low-cost (in some cases, free) direct stock purchase plans, dividend reinvestment plans or even white-shoe private management firms such as the one the late Christopher Browne ran before he died.  Chris would take a client with $5 or $10 million and build what amount to a global, directly-held, personalized mutual-fund-for-one (an oxymoron, but you get the idea) in exchange for a flat 1.25% or 1.50% of assets depending on the circumstances, which is an incredible bargain for the level of service.  The tax strategy, asset protection potential, and estate planning options alone – not to mention the significant reduction in risk in the underlying portfolio itself given the emphasis on firms that could survive another Great Depression event – made the 0.64% to 0.89% excess fee over the most comparable Vanguard fund worth itself many, many times over for anyone successful enough to need to worry about those things.

Vanguard provides a similar, albeit less personalized and tax efficient, service.  If you setup a $500,000 family trust fund with Vanguard, they’ll charge you a $4,500 base annual fee + a $2,500 sole or co-trustee fee + the fee on the underlying mutual funds they help you select (e.g., ranging from 0.05% to less than 1.00% depending on the specifics).  By the time all is said and done, if you choose a decent mix of passive funds, including domestic and international, you’re probably going to pay, directly and indirectly, $7,850 each year for that trust, or 1.57% of assets.

For what you are getting, this is not some greek tragedy – Vanguard is being more than fair given what regional banks charge for the same thing – but I was reading someone complaining bitterly in a personal finance forum the other day about a rock-bottom 0.75% management fee as if they were getting ripped off!  Once you move beyond a typical middle class family, your needs become more complex and sophisticated.  Everyone likes to point out that Warren Buffett himself is leaving his second wife around $100 million with 90% in the Vanguard S&P 500 fund and 10% in cash for the last few years of her life expectancy but dishonestly (or ignorantly) ignore the fact he almost assuredly has one of the most experienced and expensive law firms in the country – Munger, Tolles & Olson LLP – or a similarly experienced top 1% person or persons serving as his trustee and that he, himself, did most of the prep work for the estate plans given that he’s one of the best financiers in history.  You have to look at the all inclusive service costs of the entire investment management process.  Had Buffett himself not been doing the structural work, his estate plan would have cost a hell of a lot more to execute than people seem to think.  It’s a terrible cognition bias / error to think that what works for a $50,000 middle class family with a small portfolio scales to substantial wealth.  It doesn’t.  If you think it does, you’re going to discover very quickly how nasty life can get and probably lose it all.

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Pass away, your spouse remarries then dies in a car crash?  Guess what?  Without paying those management, legal, and advisory fees, you don’t have a QTIP trust so your kids, grandkids, nieces, and nephews are walking, talking Cinderellas.  Their step-parent just inherited the entire estate and can now leave it to that 22-year old he or she was banging as they squander your life accumulation in Vegas.  You bought that boat directly, in your name, rather than setup a company to own it and lease it to you as a customer?  Yeah, good luck with that when your kid gets drunk and kills someone.  These things happen.  A small amount upfront can save entire fortunes down the road once you become a target.  I could spend all evening writing tens of thousands of words detailing different scenarios in which someone who wasn’t a financial expert on his or her own would be better off paying the Vanguard or other fee (provided it’s below 2.00% – I know some major financial institutions push 3.00% but I think it’s morally egregious unless you’re talking about relatively tiny accounts of less than $100,000).  Vanguard is not trying to rip you off.  In fact, you should send your trustee flowers for watching out for you at such a cheap price following your death.  Include a note with it: “Dear Vanguard, thank you for charging me this 1.57% on my family’s modest trust, all inclusive.  The peace of mind and efficiency you are offering is terrific.”

If you aren’t Warren Buffett and you have $100 million you’re leaving your family, you are behaving like an absolute moron if you follow the same portfolio allocation he recommended solely by itself because you have no idea the other things he put in place and what those things cost.  The way, for example, he lowered his personal estate tax?  Who do you think is going to setup those non-profit foundations and handle the accounting and legal work so you can provide your kids influential and well-capitalized charities to serve as their personal platforms?  Look at the whole picture.

People don’t, though.  I mean, read this series of comments that was gilded multiple times on Reddit, with thousands and thousands of upvotes saying what a normal person should do if he or she won millions of dollars in a lottery.  While some things are right on the money, there is so much mediocre advice that sounds reasonable in there it’s terrifying; (this is going to be harsh but for the sake of honesty, I need to be blunt here even though the man or woman who wrote that might be a lovely, generous, kind person so I mean no personal or professional offense at all) sounding as if it were written by a middling-successful attorney who doesn’t actually rank among the top 1% so he or she is trying to shove his or her existing knowledge into a strategy that is entirely sub-optimal for someone with a very large net worth.  Why not just say, “You know, I don’t know.  Let me check with someone more experienced.”?  There is no shame in that.  The stuff about not paying a private bank to manage the money while simultaneously encouraging the winner to set aside money in trust for family members … yeah, good luck with that.  The fee you’d pay someone like Northern Trust to manage a pile of capital you are transferring to family members in the most tax-efficient way is going to be dwarfed by the those tax savings, which will far exceed the differential between the index fund and the “underperformance” of the managed assets due to those fees (which are almost assuredly integrated as part of a comprehensive plan they craft for you in conjunction with your attorneys).  Yes, it’s going to be expensive, but when viewed from a total return perspective and your goals – getting as much money, as quickly as you can, into trusts for your relatives – the ability to structure things like family limited partnerships that then use below-market fixed-rate loans and liquidity discounts to facilitate the movement of capital from one pocket to another cannot be understated.  To save 1% or 2% per year, you could cost yourself exponentially more in the long-run.  It’s foolish; the economic equivalent of turning down the services of a dentist so you can oil pull at the suggestion of a hippie.  It probably works well enough, but it’s a poor substitute for the task as defined.

Stock Market Theory 4

These other theories, combined, will result in a new cult of thought arising from time to time to serve as a counterbalance to whatever the last major burn was.  The same way early human civilizations and tribes that didn’t understand weather patterns created myths about how rain was created or what the stars were – myths that, if challenged would get you ostracized, imprisoned, or killed – certain financial dogma will become unchallenged to the point of inanity.  A good example comes from a small, vocal minority of people who adhere to the philosophies of someone for whom I have tremendous respect – John Bogle.  Like Christopher Browne, he has done so much for the money management industry and his investors, I think it’s an absolute travesty that he hasn’t, yet, received the Presidential Medal of Freedom; the highest civilian honor handed out by the United States Government for service to the country.

Bogle, whose work is solid, rational, and well-documented (including the flaws and concessions of the approach that we have talked about many times in the past – pointing out that the index fund is merely a mechanism through which low-cost, low-turnover, tax-efficient investing is achieved for investors who can’t run their own money and who would be tempted to try to pick stocks to beat the market rather than meet a specific objective, such as maximizing retirement income; that, though it’s far more tax efficient to own individual securities directly – and many of the richest, most successful clients at Vanguard do, passing those shares down through the family line – unless you have a big enough net worth to worry about it and the extensive experience to understand how to select those securities, it’s better to buy the index, methodology flaws and all.  That’s because the index relies on other peoples’ judgements as the value of companies so, like a financial parasite of sorts, it lives off their brainpower and extracts the benefit without actually investing in specific enterprises due to a belief in the underlying value of the enterprise on a financial, social, or structural level.)  It was – and is – an elegant, simple solution to the investing problem, as presented.  The entire endowment of my personal charitable foundation is split among two index funds, as a matter of fact.

You could hand these people an identical portfolio of securities that perfectly represented the S&P 500, held directly in a custody account at a 0% management fee, and because it didn’t have the magic words “index fund” on the statement, they’d reject it because they quite literally can’t tell you, in most cases, which companies they own, what the rules of the index they own are, how the methodology has changed in the past, the valuation of what they own (Bogle simplifies his rate of return projections using what he shorthands as a “speculative return” component, which is really little more than a user-friendly way of projecting implied returns at a given price based upon an expected growth in the underlying earnings – none of which the type of person I’m writing about would understand) or why they don’t follow an alternative strategy such as equal-weight or non-float adjusted.  It’s really quite extraordinary.  Some of these folks don’t know the difference between valuation and market timing so if someone follows the same rough process in determining allocation (e.g., Bogle discouraging the acquisition of long-duration bonds over the past few years given the bond bubble in which we find ourselves), they scream “market timer!  market timer!”.  It’d be funny except it’s a case of the Dunning-Kruger effect.

Case in point: I was reading a piece detailing the most successful British fund managers over the past decade or longer and every one of the half-dozen comments was something about how, “It’s a lottery picking anything other than an index because, they all underperform the index except due to luck”.  It’s a total bastardization and misunderstanding of John Bogle’s nuanced, intelligent research; conclusions drawn that he never wrote and that the numbers do not support because of what amounts to a word problem they don’t comprehend.  (It creates a paradox of sorts, too.  My first initial reaction is to correct the misconceptions but then I think, “If someone is this intellectually lazy or inexperienced, God help them because they have no business investing in anything other than an index fund.  Pointing out the error could do them harm, therefore, it might be immoral.”)  They truly don’t get that fund managers are not the same thing as funds (when Peter Lynch left Fidelity’s Magellan fund, could you really call it the same product without being intellectually dishonest?).  If Lynch emerged from retirement to run a domestic equity fund during a market crash, yes, I’d choose him over an index fund despite my high praise for index funds, preaching their virtues for smaller investors over the past decade and a half.  This is not a difficult decision.  Anyone who argues otherwise doesn’t know how to calculate standard deviations or basic probabilities.  (Which, again … means index funds are the best option for them.  It really is a rather marvelous paradox.)

It’s the same sort of math failure you see in people who confidently say foolish things like, “it took 25 years for the stock market to recover from the 1929 crash” because the market hit a high of 381.17 in September of that year, dropped to 40.56 on July 8th of 1932, and only made it back to the previous high on November 24th, 1954.  No, it didn’t.  Investors who dollar cost averaged and/or reinvested their dividends broke even in around 4 years, peak-to-trough, even though the market itself was a mere fraction of its former value.  Again, it’s basic math but people don’t think about basic math, especially if they can’t answer the bat and ball question correctly.

Stop and think about what would have happened if you lived through the Great Depression and bought in at the top.  At the bottom in 1932, which was about as dark as it got, AT&T was yielding 12.86%, Standard Oil of California (now Chevron) was yielding 13.33%, Standard Oil of New Jersey (now ExxonMobil) was yielding 10.00%, Dow Chemical was yielding 9.09%, Monsanto Chemical was yielding 9.62%, General Mills was yielding 10.71%, National Biscuit (now Mondelez International) was yielding 14.00%, Chrysler was yielding 20.00%, General Motors was yielding 13.11%, Coca-Cola was yielding 10.14%, Colgate-Palmolive was yielding 10.00%, Procter & Gamble was yielding 11.00%, Gillette was yielding 10.00%, William Wrigley was yielding 12.00%, J.C. Penney was yielding 16.15%, Macy’s was yielding 11.77%, American Tobacco was yielding 14.63%, Reynolds Tobacco was yielding 11.11%, IBM was yielding 11.32%, and Chase National (now JPMorgan Chase) was yielding 11.84%.  This was happening while the country was suffering deflation, rather than inflation so the value of each of those dividend payments was rising in real purchasing terms on top of the double-digit yields.  In 1930, 1931, 1932, and 1933, your ownership kept getting bigger as a percentage of the pie; those whopping dividend yields allowing you to gobble up far more equity so that your cost basis was drug down.

Stock Market Theory 5 – The Catch-All – Final Thoughts

– Unless the United States finds an ideal workaround to by-pass the neurological quirks that cause all of this odd behavior – and, as we’ve discussed in the past, the pension (when properly regulated and fully funded) was the best mechanism to achieve this as it divorced effort, skill, and loyalty from capital allocation skills so a guy who was otherwise a virtuous, diligent person but terrible with money or who had no interest in finance can sleep well at night knowing he doesn’t have to think about a 401(k) or IRA – we’re going to continue to see increases in retirement inequality to the point it might become a social problem as small decisions, especially early in life, lead to wildly differential outcomes due to the power of compounding.

– Even when someone comes along and devotes his or her entire life to trying to improve investor education, like John Bogle, a significant minority of people are going to engage in something known as “greedy reductionism”, reducing the key lessons to gross oversimplifications without any understanding of the underlying phenomenon or nuance, eventually leading to the same sub-optimality – maybe not today, maybe not tomorrow, maybe not next year – that they were railing against in the first place.  As the old, oft-quoted Wall Street adage goes, “What wise men do in the beginning, fools do in the end”.

– There is no greater teacher for some people than significant, painful losses.  For still others, not even this will deter their follies into economic self-destruction.

– Most of the time, it is a waste of effort to attempt to engage in conversation about things people don’t understand.  The same reason we have click-bait infotainment on websites like CNN, demonstrating the fall of once great journalism standards, folks want easy-to-digest maxims that make up in pithiness what they lack in accuracy.

– It’s hard not to care about these things if you care about people and want what is best for them but you cannot care more about their own well-being than they do themselves unless you want to walk around a perpetual martyr.

– The twin temptations of non-restrained greed and non-controlled fear really do explain a lot.

– People want false certainty and will pay for it.  Nobody wants to hear that their investments will decline by 33% in any given 36 month period based on ordinary past experience – the same past experience that made generations of investors offensively, exceedingly rich.  They want their ears tickled.

– A respectable percentage of investors will not stick with a strategy through thick and thin, even when the mathematics are demonstrably in its favor.  I was horrified to watch how many investors on sites like Bogleheads were 100% equity when it wasn’t appropriate for their situation prior to the 2008-2009 collapse.  Then, when the world fell apart, they all but disappeared, finally cashing in when they saw 2/3rds of their portfolio vanish in a puff of smoke even though it was a temporary fluctuation; a mere blip that was meaningless in the long-run except to accumulate more.  The older, wiser message board posters who would point out this folly due to having lived through challenging periods during times like the 1970’s, were decried; told they were wrong or overly cautious.

– The people who most need to read this won’t.  (Even if they were somehow open to it, we now live in a world where information is determined based on search engine rankings that encourage short-term thinking and page views rather than reflection.)

Welcome to the do-it-yourself economy.  The older I get, the more dangerous I think it is, especially from a social and political standpoint.

  • Todd

    I had my mothers IRA money invested in American Funds , Stock funds only. In 2008 she turned 70.5 so she had to take her RMD. RMD was based on her balance as of 12/31/2007 was $149,517 she took her RMD monthly. when the market tanked she was down to $92,000 4/2009. She was very nerves and wanted to move her money out I told her that market history has shown that it will recover. I also looked at 1930’s and 1973,1974 years. I also told mom that she was not 100% invested in stock since most of her funds where holding between 5% to 15% cash. Long story short her balance as of 8/11/2015 is $159,663 and she has taken out $44,399 in RMD’s.
    Joshua what would her balance look like if she was 100% in S&P 500 index? And do you know of a web site where I can back test systematic withdrawals from different stock mutual funds?

    • What you’d have to do would be:

      1. Take the value of her IRA on 12/31/2007, or $149.517.

      2. Assume that she bought something like the Vanguard 500 admiral class index fund shares. The price was $135.15. She would have been holding 1,106.30 shares.

      3. Open a spreadsheet and manually calculate how many shares would need to be sold, at the price in effect on that date, for each RMD, while simultaneously crediting dividend reinvestment on each dividend date (for something this simple, and since it was less than 20 years ago, you can get away with using something like the Yahoo Finance history tool, even though it has some programming quirks that make longer-term analysis much less reliable).

      If you have the spreadsheet keep a running total, you could see how her account balance fluctuated over time and, upon arriving at the present day, know roughly what her account balance would have been relative to what it is now. It will take a bit of time but that’s the best you’re going to do in terms of accuracy.

      As for your question: It’s not perfect, but there’s a free online tool called portfolio visualizer that is really, really cool. You might want to try playing around with it.

      • Todd

        Thanks for the link, fun web site

        • AL

          Todd–let’s say mother had invested in my retirement vehicle–CAIBX on March 24, 2000, the date the tech bubble peaked. Let’s say she is such a generous mother that she decided to take a 5% withdrawal (more than she needed) and increases it by 3% annually. She invests $500,000 at a 2% load. She is going to help out her son and his family because she wants to see some of the good works she is doing while alive.

          By 12/31/2014 she had withdrawn $455,519.00 and it still had money left, to the tune of $756,303.00.

          Aunt Martha listened to the smart folks and had her $500,000 with the S&P 500 Index and withdrew the same amount. Right now aunt Martha has nothing in that particular account.

          Todd- you are right to see that it pays to have some diversity and maybe hold some cash. I wonder how many folks will lulled into thinking the INDEX is the be all and end all. Sure looks good on the way up that’s for sure. I wonder how many bubble stocks are now in that index? Sure were a lot in March of 2000.

        • Todd

          AL, CAIBX is one of mom’s funds glad to see that we are on the same wave length.

  • mr. q

    It appears that the image, habits and lives people have created for themselves, regardless of how flawed they may be are excused for the simple reason that the person himself has created this image. He built those habits. He built those maxims he lives by. It has become a mental offspring that has personal value beyond any physical possession. Those habits and personal truths have become his own reality despite information and data that might prove him wrong.

    The ability to objectively ask ourselves clear, though painful questions regarding our current skill set, knowledge base, patterns and temperament and then to follow it up with honest answers and life adjustments is an extremely difficult task for many.

    I sat with a guy and calculated that he was actually losing money per year from driving Lyft and Uber when factoring in the fee those companies charge their drivers plus his total insurance, repairs, fuel cost etc. He still continued to drive until his he got in an collision costing him even more money. I don’t discuss financial matters with him anymore.

    • Intellectual Jingoism

      “Patriotism is, fundamentally, a conviction that a particular country is the best in the world because you were born in it.”

      Looks like we’re the same way with our ideas!

  • Nathan

    During the 2008 crash several banks and auto makers declared bankruptcy, many investors were spooked not only by the 2/3 decline, but that stable companies are going bankrupt and investors lost money permanently. (Though with auto-makers a future bankruptcy wasn’t a secret.) They didn’t have the time, ability, or desire to learn how to evaluate if a company will be 1. bankrupt, 2. experiencing temporary tough times, or 3. fluctuations in the stock price, but not intrinsic value. These same people probably realized they didn’t know what they were doing and made the personal choice to get out of stocks. Maybe get back in later with more knowledge or switch to safer investments. I don’t think someone who sold GM stock in 2009 after a 2/3 decline and they think the company will go bankrupt, but holds Ford after a 2/3 decline because it is experiencing temporary tough times is acting irrationally. I also think your dividend yield argument during the great depression is interesting, but weak as an argument because there are numerous counter examples like GMs 9% dividend yield in 2005 prior to declaring bankruptcy in 2009.

    • I don’t think someone who sold GM stock in 2009 after a 2/3 decline and they think the company will go bankrupt, but holds Ford after a 2/3 decline because it is experiencing temporary tough times is acting irrationally.

      The irrationality is in the decision to own something you don’t fully understand, and can value, in the first place. To get to the point where you are even presented with the latter choice – to sell or not sell – without knowing the answer is only possible due to the earlier failure.

      I also think your dividend yield argument during the great depression is interesting, but weak as an argument because there are numerous counter examples like GMs 9% dividend yield in 2005 prior to declaring bankruptcy in 2009.

      There seems to be a misunderstanding. This isn’t my argument, nor is it merely anecdotal (though the illustrations I provided were for the sake of providing specifics to paint a picture). It’s one of the most studied, proven, beyond-refute mathematical realities in stock market history, repeated century after century, with the best work on the topic coming out of the Wharton School of Business at the University of Pennsylvania. In fact, it’s a pretty foundational concept in portfolio strategy, not one of the theories I mention in the title of the post, so I can’t take any credit for it.

      If I can be frank, it’s not really up for debate. There’s no question as to the phenomenon’s accuracy for anyone who has looked into the research any more than a person would question whether the Earth was flat. Things like GM in 2005 don’t disprove it as it’s included in the data set. One of the professors at Wharton went so far as to turn the findings into a couple of New York Times bestselling books in which he simplified the math for the general public.

      The Hulbert Financial Digest study looking at crashing stock markets going back to the beginning of the 20th century calculated that, once you had adjusted for changes in the value of the currency (inflation/deflation) and the rise in dividend yields, the typical recovery period was around two years. The longest, and worst, was the infamous 1973-1974 collapse. If you had put everything in at the absolute peak of the market in 1972, it would have taken 8 years to get your purchasing power back due to the runaway inflation that hit the U.S. later in the decade. The dividends accelerating your return as stock prices collapses were swamped by Congress printing money. On the other hand, if you were still dollar cost averaging, the recovery was a mere fraction even then because your cost basis was drug down.

      • Nathan

        My point was the argument you made was incomplete not wrong. You didn’t say anything about a data set failures were included in. You just picked a few companies that survived a great depression ignoring the ones that didn’t, said what the dividend yields were, and ignored companies that cut dividends. It’s a great article nonetheless. Investing and money management is something I’m new to and trying to learn all I can before investing. What is the name of the Wharton professor?

        • No worries, I understand, completely! I have such a high respect for the people who have spent a big part of their career researching that thing, I didn’t want you to think it was some light-hearted hypothesis I was throwing out there. The amount of time and effort they went to in order to prove it beyond a shadow of a doubt was monumental.

          Re your question: Dr. Jeremy Siegel (sometime in the past couple of years, there was a discussion in one of the comment threads about his body of work but I can’t recall which it was off the top of my head). I know this is going to sound a bit like hyperbole but I mean it quite literally: Make an effort to read his entire research body of work going back the past few decades. It’s among the highest quality, best data on the the mathematics of bear market experience for rational investors who stuck to a given strategy. Some of the really interesting stuff is in the subsequent performance of peak market acquisitions when confined to high quality enterprises (e.g., buying firms like the “Nifty Fifty”, while horrible in the decade that followed, actually beat the S&P 500 despite the initial handicap over the subsequent 25 years due to the power of the underlying economic engines). He also makes some powerful arguments for fundamentally-weighted index methodology over the more common market-capitalization weighted strategy.

          The two books he wrote for laymen are fantastic, both of which are available on Amazon. My favorite of the two needs to be updated for this decade but the appendices alone are worth the purchase price (he and his research assistants tracked the performance of every individual original component in the 1957 S&P 500 index to see how it would have performed).

          Read it all. While so many in financial academia get distracted by abstract models and complex ideas, he seems to be one of the few that actually looks at the real world and asks, “What is the most intelligent way to behave in light of actual real-world conditions?”. I still find myself thinking about his point that if you strip out one 10 to 20 year period a few decades ago, the entire small capitalization compounding advantage over large capitalization stocks for the past couple of centuries disappears; that there is a mathematical oddity in the numbers that, while not enough to make one change his or her position on the value of smaller firms in the mix (and I’d prefer them if forced to choose), at least acknowledging something is amiss worth further investigation.

    • Todd

      Nathan by picking one individual stock and saying the theory doesn’t hold water is not fair. I am sure Joshua has had a company blow up on him. But having a well balance portfolio one can survive a market crash and is no reason to be out of the market before, during or after a market melt down. As my early post shows even with systematic withdrawals one will recover. Note my mother started taking out about 3.8% RMD and increasing to about 4.8% RMD at age 77. From Growth & Income Funds. I will always be 100% invested in Dividend paying Stocks and through Value Mutual fund come hell or high water.

      • Sean

        Even when everything seems to be right there can be things you miss. Like underestimating the power of technological change. Like say…. The power of the kindle to transform an industry.

  • Emma

    Hey Joshua,

    I wanted to send you a mail bag question on a topic unrelated to this post but your About & Contact page doesn’t have the option of sending you a message. Please let me know how to send it.

    Thanks

    • Sorry about everything being a bit of a mess during the upgrades and redesign. I know it’s frustrating.

      You can go to this page and fill out the form, press the button at the bottom, and it will make sure the message makes its way to the inbox. If you have any trouble, let me know and I’ll see if I can figure it out sooner.

      • I think the captcha box there is broken. At least it’s been for me, for many months.

        • It’s the middle of the night (3:39 a.m. to be exact) so a quick fix is going to have to suffice. I just redid the page after reading your comment (I didn’t realize it had been so long since I updated the page so you’ll have to settle for a temporary replacement to the “hello!” image in the form of a terrible quality selfie in front of too-bright light from a family dinner today at a local Mexican restaurant after we went out to celebrate my dad being inducted as an elder at his local church, which was a big deal for him so we all went for support and congratulations). The captcha has been temporarily removed and the test message I sent went through fine. I’ll try to get back around to solving this in the coming months. Thanks for letting me know, again.

        • Cool – just sent you a test message.

        • Also, wow, clicking on links on that page made me find out about the big business news. Exciting – and congrats on making that big decision!

        • dave (nestle)

          F…!!!!!!
          I wish I never blew all that money when I was younger on fast cars/toys and faster businesses!

          Should I move or ask my parents for a bridge loan?

          Incredible, and Congradulations Mr. Kennon and Mr. Green!

        • dave (nestle)

          again with these iphone keys… (t)

          (how about “bets wishes” instead)

        • Sean

          Good luck on the new project. I can’t say I meet the minimum requirements…. Yet.

  • GS

    “If you think it’s expensive hiring a professional, wait until you hire an amateur”

  • Bill Larson

    “The people who most need to read this won’t.” So true

    • Mr.owenr

      Guess it means there are people out there who need to read this more then we do.

  • peterpatch79

    Good article. I also once likened passive indexers to a sort of parasite because they essentially free ride on the collective wisdom of active market participants. However I was corrected by a more scientific minded person and advised that indexers are actually more like commensalists because they don’t cause harm to the active traders (parasites derive benefit through harming their host whereas commensalists derive benefit but cause no harm): https://en.wikipedia.org/wiki/Commensalism.

    • I enjoyed reading that; thank you for it.

      • peterpatch79

        The thing that interests me is the effect on passive investment returns , all else the same, as the ratio of passive to active investment dollars increase. I wonder how big passive can go until it becomes better for the average investor to go active. It’s hard to tell exactly how many investment dollars are purely passive (someone can use index funds in an active trading strategy) but I would put it at a conservative 15% (in the US) based on my limited research. It’s an experiment that has never been done before so we’re learning as we go along. Indexing seems to have caught a huge wave of popularity in the last 5 years so we might get to see what happens when we get to a substantial level of indexing. What happens at 30% adoption, 40%? Imagine 50% indexing! When do the indexers start creating their own momentum through massive herd buying (during the majority DCA phase) and selling (during the majority withdrawal phase). I love this kind of stuff!

    • I recall coming across that particular thread and it makes me sad that the dogma that reigns over some people hinder them from not being able to have rational, reasoned discussions (instead acting like raising questions and facilitating discussion is like some sort of personal attack that has to be dealt with through emotion).

  • Joshua Myers

    On a bright note all of this behavior is what makes market inefficient. If a lot of people didn’t act in these ways it would be much more difficult to make money through investing. It’s not ideal, but at least there is a sliver lining for people willing to put in the work.

  • Diracwinsagain

    For those of us firmly entrenched in theory 3, do you have any textbook/book/publication recommendations? I admit to have found the Reddit lawyers advice quite reasonable.

    • Ang

      If you are talking about the tax savings on family transfers, chances are you won’t ever need that type of advice – it’s more useful as you get up into the higher networth ranges and have to deal with estate tax (>$5.43m in 2015 tax year). In other words, a good tool to have, but highly unlikely for most of the populace

      If you’re talking about QTIP and other trust structures, check out this post by Fratman: http://www.joshuakennon.com/night-grilling-and-11869-words-of-new-content-at-about-com/#comment-2167783721

    • Jeb

      I’d just recommend searching in Joshua Kennon’s blog first. I’d imagine that’s why he didn’t go too in depth because he answers it differently quite often. The first time I read through that it looked sort of okay on the surface (although I know about the wealthy Mr. Whittaker and the redditor sugar coated it so that was a red flag). Another glaring problem even to a simpleton like me is he only discusses two types of investments- stocks and government bonds -and seems to indicate any other financial advice as a cheat or scammer. A lack of diverse investments and just having a large stash of cash lying around instead of a bunch of businesses is not a recipe for long term wealth – ala nearly every professional athlete.

      Start here with Joshua’s example: https://www.joshuakennon.com/mail-bag-how-would-you-convert-a-pile-of-money-into-passive-income/

      Personally, I also wouldn’t just hand over 20% in cash to friends/family. Maybe take Joshua’s example in the link and use that $22.8m charitable contribution to buy real estate in an LLC that friends/family own the shares in and get monthly or yearly dividends. Using the example, that could generate about $185,000 per month or $2.23m per year to be distributed. If you have 22 friends/family you are dividing it amongst, that $100k per person per year could mean they could enjoy a very comfortable lifestyle. It would also provide security knowing they can’t burn through what might otherwise be a one time chunk of $1m. Additional safety in that this extra income could be basically kept a secret from people who might hound those receiving it (stealth wealth).

    • It’s reasonable in that it is much better than what most lottery winners do. I think the main danger in that post is that it presents itself as a “all you have to do is this” and you will be fine post – a comprehensive guide. But life isn’t quite that black and white.

  • Ang

    My biggest observation regarding investor behavior was referenced in your point #8 under theory 1:
    “Not knowing or understanding how time frames influence result measurements (anything less than 5 years is largely meaningless)”

    I think the biggest factor working against investors is the lack of correct temperament. To your point, a large portion of the populace doesn’t understand the influence of time frames on measurement, but even more so, there are investors who DO understand that fact, but do not have the temperament to be patient and wait out any volatility they may experience. Especially with the constant information deluge being thrown at them – something they should opt out of as to not overreact to news and resort to trading instead of investing.

    Think about the bygone eras where a casual investor might have only had access to the news through a newspaper, and then more recently radio and TV. Thirty years ago a general worker bee would wake up, walk outside and pick up his/her newspaper, then maybe listen to the radio for 30 minutes before he/she went off to work. If he chose to, he can discuss investments at work at the water cooler, but that’s not likely a subject of discussion at work unless he was a financial professional (as pensions were the default back then, removing any thinking needed for people’s retirements). Nowadays, due to the rise of talk shows, internet alerts, social networks, and smartphone apps, a casual investor can literally be tuned in every waking minute of his life. If he doesn’t possess the temperament to ignore the noise and stay the course, he will consistently become one of those statistics in the studies that reveal typical investors only make 3% when the market makes 10%.

    P.S. Is your “Final Thoughts” section intended to be stock theory #5? I only see 4 in the article

    • Derek

      I think you hit the nail on the head with your comments about temperament being the biggest factor working against most investors. It is very difficult for most people to tune out the constant barrage of stock quotes and sensationalistic media coverage of the market, and instead focus on the underlying business.

  • Grammar Nazi

    – The twin temptations of non-unrestrained greed and non-controlled fear really do explain a lot.

    That double negative is giving me a nervous tic in a spot untouched by sunlight.

  • Ang

    Joshua, really off topic but the article was just released today (or within the past 3 days) and I wanted to get your thoughts – if you have the time to read through: http://waitbutwhy.com/2015/08/how-and-why-spacex-will-colonize-mars.html

  • Sam

    Hi Joshua –

    Interesting piece.

    Made me think on a number of fronts…, but especially interested in where you criticized those who observe “it took 25 years for the stock market to recover from the 1929 crash”.

    This really peaked my interest, as I don’t understand your conclusion.

    More specifically, if you run the actual numbers you’ll find that the inflation adjusted return for someone buying and holding the S&P 500 starting in 1929 is negative over the subsequent 20 years. And yes, this includes dividends!

    As you point out, dividend yields did get very impressive for a brief period in 1932, but it was not sustained. They quickly fell back to earth. One would really have to cherry pick the data to come to your conclusion.

    Am I missing something or are you trying to make the case that the buy and hold investor always does swell. I really wish this were true, but its just not….

    Now if you’re simply saying that someone methodically adding to a retirement fund every 2 weeks ultimately does ok if they just keep on contributing through the crash, then I (sort-of) agree….

    But what about the gal who decided to retire in 1929? She really does have a long, long horrible wait to re-establish her previous high water mark….

    Furthermore 1929 is not the only problem period. 1901, 1961 and 1964 were almost as bad….

    • Hi, Sam! I happened to just respond earlier to today about this same question in this comment, so if you’ll forgive me, I’ll provide a link to it to save time. It only works if you assume dividends are reinvested and adjust for changes in the value of the currency (e.g., deflation). It accelerates significantly if you are also regularly dollar cost averaging, too, so you’re taking advantage of the crash but not everyone can do that (1 out of 4 people or whatever it was couldn’t even find work in the Great Depression, though, presumably, these were not the individuals likely to own shares in the first place so there’s a question as to how relevant that is to the broader stockholder base).

      The New York Times did a laymen’s summary of Professor Robert Schiller’s research on the data, and he found it would have taken 4.5 years to recover from the Great Depression. Specifically 4 years and 5 months after the absolute lowest point in the middle of 1932, which it looks like they confirmed with Morningstar (it matches everything I’ve ever seen on the topic).

      That piece was written in April of 2009, a month after the market had collapsed and people had thrown in the towel with what seemed like half of Wall Street going into bankruptcy or near bankruptcy.

      • Sam

        The 4.5 yr recovery sited in the NYT is a great example of cherry picking data to make a point.

        But it doesn’t change the fact that a dollar invested in the S&P 500 in 1929 was “worth” less 20 years later in inflation adjusted terms. This includes the assumption that dividends were reinvested.

        I actually downloaded Shillers data to verify this unfortunate fact.

        While its true the market enjoyed a great bounce following the 1929 crash, it was not sustained in inflation adjusted terms.

        The NYT article is therefore very misleading.

        • When you find yourself arguing with arithmetic, you should stop arguing and ask yourself why you are in that position.

        • Nathan

          There is an SP500 calculator on http://dqydj.net/. It can adjust for inflation and dividend reinvestment. Depending on what month you invested in 1929 and what month 1949 you could have had a negative return even including inflation and dividend reinvestment, for example September 1929 to June 1929. http://dqydj.net/sp-500-return-calculator/

        • joe pierson

          Sam is correct, just download the data and check yourself.

        • I find it astonishing, to some degree, that the very phenomenon I wrote about it playing out in the comment section of this blog right now. Please, please, please do not take this personally but permit me to be direct because I have something I need to go do and shouldn’t be on the site. Still, I can’t help myself. That means I’m going to be a bit more direct than I normally would because I don’t have time to soften the sentence structure.

          The New York Times isn’t cherry picking the data nor is it misleading. You’re simply looking at a different time period and pointing out a different end result based upon different inputs.

          The statement made by the NYT author, and supported by the data, is that it took roughly 4 1/2 years from the bottom of the market to recover (~8 years from the peak), adjusting for both inflation and reinvested dividends. That is it. That is the statement that has been made. That is the statement that can be proven either true or false by the math. Nobody gets to have a personal opinion on it. It’s either accurate or inaccurate. End of discussion.

          The NYT used Ibbotson & Associates as the data source, which is excellent because it’s been the gold standard for many, many generations. Cracking open my own copy, it looks roughly right – total return was positive from 1929 by sometime around 1936.

          You are using Robert Shiller’s data; an excellent source I use quite often myself but that you have to apply correctly. Shiller’s data actually overstates how quickly the market recovered from the 1929 peak because his data isn’t actually made up of equity prices per se, which he disclaims quite clearly. Instead, it’s a rough estimate of average closing equity prices on a quarterly basis to roughly approximate a general experience in any given period, which starts to have some crazy effects once you get more than 10 or 20 years out in measurement period. Shiller’s data shows a lump sum invested in the composite in September of 1929, with dividends reinvested and adjusted for inflation/deflation, had the investor increasing his absolute purchasing power by 0.285% by November of 1936, which is around 3 years after the bottom.

          In other words, he’s too optimistic. It took a bit longer.

          You are then coming back and basically saying, “Well, even if the Great Depression did recover quickly, it didn’t do you much good because America experienced another decline that was bad enough that 20 years after the earlier decline, you had lost money due to inflation”. This is also incorrect (though not by much, I’ll confess). While the economy had undergone a now-forgotten struggle not entirely related to the earlier problems, from September 1929 to September 1949, the twenty years you mentioned, the composite with dividends reinvested actually compounded at … 0.412% in real terms per annum.

          Does that suck? Yes. Is it something useful? Not really. If you had never saved another penny beyond dividend reinvestment, and managed to put your money in the stock market as one big lump sum when things were trading at once-in-multiple-generations ridiculous valuations, then … yeah, your recovery, though initially quick to arrive, was cut short due to a later, second collapse that happened and nobody now remembers.

          In other words, you have a narrative in your head, “If you did this [x] statistically unlikely thing, and you held on for this [x] statistically meaningless period of time, because of this [x] event, your return sucked, therefore the earlier [y] statement is not true.” Only, it’s meaningless pedantry. Who behaves like that? A vast majority of investors go through their lives buying ownership as they get older, accumulating. The people who accumulated through that period still got rich. We beat Hitler, the economy recovered, and 10 years thereafter – hey, you picked an arbitrary period of 20 years not at all related to our discussion so I’ll pick one of 30 years and we’ll call it even – all of those shares that had been bought during the bad times were revalued upward. In fact, the September of 1929 investor who held on for 30 years, not the 20 you seem intent on measuring because it is the only way you can get your thesis to work, would have had real purchasing power gains of 5.757% compounded annually pre-tax, which given they were dumb enough to buy things like National City bank at 120x earnings and Chase National Bank at 62x earnings is a damn miracle. (The only industry somewhat reasonable priced was oil at 17x earnings.) To have still been able to experience a 436%+ increase in real purchasing power despite that kind of folly … it was more than they deserved.

          In other words: It doesn’t matter. It’s useless from a strategic point of view as to how it should inform investors to behave in the most optimal way and makes you a buzzkill at cocktail parties.

          P.S. Speaking of pedantry, let me engage in a bit of my own because it’s making my eye twitch: You say, “the S&P 500 in 1929 was “worth” less 20 years later in inflation adjusted terms.” That’s not possible. The S&P 500 didn’t exist until 1957 and even that original version was materially different in methodology and composition than the one we have now so using it for historical purposes is not informative. For someone to have been able to invest in it in the 1920’s would have required bending the laws of spacetime.

        • sam

          Excellent discussion, Joshua.…..eye twitch and all ;<)

          And here is why its important, despite your final sentence in your above response:

          In the sell-the-headline world of the NYT's article discussed herein, the apparent implication is that we can safely allocate ~100% of our investment resources in the stock market.

          What's the worse that can happen?

          Even in the greatest crash (1929) of our memories, you would have been back at par in just a few years if you simply had faith in the buy-n-hold strategy.

          But there is a reason why you and I don't behave that way with our own precious dollars.

          And the reason is precisely because there is a lot of truth to the very statement you were mocking in your original post when you said:

          'It’s the same sort of math failure you see in people who confidently say foolish things like, “it took 25 years for the stock market to recover from the 1929 crash” '

          I don't believe this statement is at all foolish. I actually think its very well informed and tends to guide my own stock allocation decisions to this day.

          ….but I am always open to challenging this conclusion when someone with as much background in the topic as yourself references the NYT version of reality.

        • Ang

          Well, Joshua never says you should put 100% of investment resources in the stock market – in fact, he says time and again that he wouldn’t be comfortable with more than 30% of his networth in paper assets – see http://www.joshuakennon.com/mail-bag-what-would-you-do-if-you-woke-up-with-10-million-your-existing-knowledge-but-no-other-assets/ for an example

          Allocation wise – he has 30% to paper, 30% to real estate, 15% to cash, and 25% to businesses/MLPs/other cash generators

          Whenever he discusses stocks on the website, he is focused on the 30% aspect – of course, every person’s situation is different, so your allocation will be up to your circumstances and temperament.

        • Nobody but a dunce or people who ask for investment allocation advice from unaccountable strangers on the internet who endlessly repeat the refrain that lump sum beats dollar cost averaging, so they should allocate 100% of their capital immediately, despite valuations being high.

        • “But, here we are, having the same sort of conversation I was talking about in the post itself despite my better judgment.”

          This made me crack up Joshua. I for one would pay for the comments section alone. There’s monetization potential.

    • Todd

      Google Pioneer Fund returns since 1928. This is what I found Starting with 1000 dollars invested.
      Dividends in Cash Dividends Reinvested
      1931- $441 $536 Lowest point
      1934- $742 $1158 Took 4.5 years to get over $1000
      1942- $1140 $2898 Took 12.5 years to get over $1000 with dividends taken in cash.
      I like to use real life examples. I like looking at old Stock Mutual funds to see how they did in so called bad times. People adjust there living expense’s during hard times so I really don’t take into consideration Inflation of deflation. Just give me a steady or raising Dividends. That what Ronald Read did.

  • I guess a lot of these errors just boil down to over-confidence.

    I can’t see what other explanation there could be for people claiming to know things they do not know, whether about the tax code, operating results of companies, short or medium term direction of stocks, leveraged financial products, portfolio diversification vs concentration, market efficiency, mutual funds, trading costs, tax law, international law, securities laws, and formation of holding companies. I mean, it’s not like any of these topics are difficult, right? (I jest).

    My favorite response to questions that I don’t know the answer to is: “I don’t know.” Along with possessing a nonzero amount of knowledge, I think that is one of the marks of an educated mind. Because it is incredibly counter-productive when people pretend to have knowledge they don’t.

    Example question: What are the risks of a U.S. tech firm conducting a spin-off for purposes of tax reduction, of partial ownership of a Cayman Islands-based Variable Interest Entity that has contracts in place with a Chinese tech firm? (to mimic ownership of some of the Chinese tech firm’s earnings).

    Example answer: The vast majority of people (including me) should say “I have no idea!” The actual answer appears to be something along the lines of [1], [2], but of course I am willing to defer to any experts here. However, it appears to be necessary to understand the answers to these questions and a lot more prior to owning any substantial position in Yahoo, which partially owns Alibaba Holdings. How many people who own Yahoo actually understand this? Do they understand the Chinese law adequately, such as the precedent in VIE companies of the Minsheng Bank case, or the 2011 case of Walmart being stopped by the Chinese merger authority from using a VIE to acquire a stake in Yihaodian, a Chinese retailer? [3] Have they read the back-and-forth letters between Chinese tech companies and the SEC regarding VIE companies, such as [4]? How thorough is their understanding of the U.S. IRS Section 355 tax law, which governs corporate spinoffs?

    How many people in the world can honestly say that they understand these arcane legal areas sufficiently well? 100? Certainly fewer than the number of Yahoo shareholders. How can one even consider such an investment without asking and having well-researched answers to these questions?

    [1]. http://www.bloombergview.com/articles/2015-01-28/yahoo-would-rather-not-pay-taxes-on-its-alibaba-shares
    [2]. http://thediplomat.com/2014/09/no-one-who-bought-alibaba-stock-actually-owns-alibaba/
    [3]. http://dealbook.nytimes.com/2014/05/06/i-p-o-revives-debate-over-a-chinese-structure/
    [4]. http://www.sec.gov/Archives/edgar/data/1329099/000119312513280488/filename1.htm

  • Karen

    Dear Joshua, wow — this piece is so loaded with content, I love it! We pay for advice, a small flat fee at Motley Fool Pro, and I believe in listening to smart people — it’s why I follow your blog. The index or die crowd is obnoxious. I agree it’s not worth the time to argue about and it’s not like there is open mindedness on the other end. I loved reading about trusts — we may never get to the level of needing one — is it $10 million for a couple? But it is nice to know what is at the next level, just in case. We have 3 kids and Iove when you talk about legacy. Thanks for sharing your knowledge and thoughts.

  • Nirav Desai

    Great post!

    I remember seeing the thread on the bogle forum where someone who sold his business for $50mm was asking for advice on choosing an advisor. So many responses were along the same dogmatic lines that you mentioned. Like you, I’ve also realized that it isn’t worth it to correct those people. It’s like wrestling with a pig!

  • Mr.owenr

    Yeah ok I get it, I don’t know jack about stocks and I cannot value one to save my life. So index funds are probably my best bet but how am I supposed to understand and value an index fund when I can’t even value a stock? It’s like a whole basket of stocks now.

  • Todd

    There was truly not a S&P 500 until 1957, in 1923 there was only 90 stocks in the so called S&P 500. I guess it proves that Active funds out perform S&P 500 index fund example Pioneer fund EXT. So did Gold , Bonds and Cash do better than S&P 500 including Inflation during those years? Which asset did the best.

  • sam

    Thanks Nathan!

    I certainly wish I had met you before spending 4 hours figuring out how to download Shiller’s data!

  • Don’t you love the smugness and self-satisfied nature of the below link?

    https://www.reddit.com/r/financialindependence/comments/3hhpgx/an_index_card_made_by_professor_harold_pollack/

  • Ang

    Admittedly I only scanned the top few posts, but what’s wrong with it?

    It’s perfectly good advice for the average person of the population. Perhaps if your wealth were far above the 8 figure mark, you would get more benefit from different advice, but this seems to be a great starting map for someone who is trying to learn how to put their financial life together.

    I followed the opening link and this is what Adams had to say about his own advice:
    “Does Adams live by his financial rules? For the most part he does. Adams said he’s allergic to debt and makes a habit of saving half of his income.

    I found that people who had massive credit card debt were asking me how they could invest in stocks, or how they could borrow money from their credit card to invest in stocks,” the cartoonist recalled.

    However, Adams said he no longer follows his rule to invest 70% in a stock index fund and 30% in a bond fund. The best-selling author says he invests primarily in municipal bonds today, which are tax-exempt, and also owns land in his adopted home state of California.”

    So it seems that he realizes that there comes a point where the standard cookie cutter advice doesn’t fit anyone, but that level of wealth (over $10m currently) is out of reach for I dare say more than 99% of posters on Reddit, as $10m is the top 0.2% of US households.

    I will say that I do detect smugness in the way you phrased your question/post, it’s as if you are attempting to ridicule the posters in the reddit thread

    • I do not like it when people set arbitrary hard rules and then command others to follow them. I think that is arrogant. For example, why should people save exactly 20% of their money every month? And what if, as is the case with many 401(k)s out there, there is only junk in there? (In that case, it is possible the best choice is to invest up to the match and no more.)

      I think that kind of thinking is “mannerism” in letting form dictate function. It may work most of the time, but it rubs me the wrong way.

      • Ang

        Fair enough, I guess I see it as a launching point for the “followers” to ask questions – why should I save exactly 20%? What’s the benefit of a 401k, etc. I see it as the responsibility of the advice taker to dig further

        Fine balancing act between presenting too much information upfront and losing your audience’s attention span and dictating function that may not be 100% optimal, you know?

        • I get what you’re saying, but the implication when someone says a notecard has “all you need to know” is that those are rules that you just follow. It looks like the Ten Commandments or something! Or laws mandated by the government. But they’re just a way of doing things, in some cases set quite arbitrarily.

  • “He himself thinks he knows one thing, that he knows nothing.” – Cicero

  • Steve Roberts

    The Federal estate tax exemption is $5.43M (per person) for 2015 so $10.86M per married couple.
    I think you missed the point about Trusts. It’s not to be free of estate taxes, but to protect your money from untimely death/scenario (like the person who remarries) or to protect your children from using the principle as a one time lottery winning upon receiving it. Instead they would only getting a 4% payout each year that might vary depending on market conditions. Joshua has spoken to it much better than I could. Hopefully I didn’t misread what you were saying.

    How do you find a good lawyer to do a trust? (Maybe I am now miss reading what he is saying)
    Will – Check
    Large Term Life Insurance Policy super cheap – Check
    Trust – No Check. I have no idea where to start. The few lawyers I have talked to have talked presented fees so large I walked away. I get intimidated easily I guess.

    • Karen

      Steve, how large is your term policy? Honestly I have been cheap about doing life insurance, we are in some people’s views even underinsured. My spouse and I each have $500k which is enough to cover our outstanding mortgage (about $100k) and then build us up to enough of a nest egg to have a reasonable living income, nothing extravagant at all — it would be less income than we have now. Of course, I don’t expect either of us to die, either! It might even be a tad tight but every year we’re getting a little better off as we go. Some folks say 10x annual income but we are really just around 5x. What did you choose to do and why? I am a total putz and we do not have long term disability, I’m a moron, I need to get this fixed but I have been cheap about it and reluctant to open the wallet.

      • Karen

        Here’s my list.

        Will – no
        Life insurance – minimal
        Disability insurance – no (doh!)
        Trust – we aren’t rich enough…. yet.
        Healthcare power of attorney, etc — no.

        Gosh I’ve been neglecting the important stuff. I used to be on the young side to worry about it but the years are advancing quickly, so quickly! I am not sure I understand about trusts because I thought Joshua was talking about tax savings in the article. I get that there is an element of control and stewardship and that is great. I obviously have other work to take care of before thinking of trusts. For the will, I need to start a relationship with a lawyer (would you do a DIY will for a basic family?) Maybe that would be a fine start. Need to set a deadline to get these things settled and cared for.

  • Steve Roberts

    The Title says “5 Theories about investor behavior” but I only see 4. What am I missing?

    • Mr.owenr

      You’re missing the fifth theory obviously.

  • Todd

    This is for Joshua to, Has there every been a equity market in the world ever shut down for good or long periods of time say months. My Allocation is 100% equities, if the stock market closes that would mean every thing would be bad real estate, cash would have no value. How would people pay you there rent. If equities had no value that would mean banks would be closed. Think about equities are part of a economic food chain if they go the chain breaks. Only ones ability to grow food would survive. Call me crazy I am sticking with equities. Dividend payers of course. The real threat to ones money is there spending habits.

    • Yes. Including right here in the United States. The biggest example is July 31st – November 27th, 1914, when the stock exchange remained closed to investors who wanted to buy or sell due to the breakout of World War I. Such a thing was unthinkable even back then but it happened. The last major closure in the United States was the September 11th terrorist attacks.

      Stock markets can and are shut down locking investors out of liquidity for extended periods of time without spreading to real estate or banks. It would absolutely be possible to face a situation where we wake up tomorrow and can’t buy or sell stocks for 6 months or longer. That’s why people like Charlie Munger make comments such as, “I wouldn’t be able to sleep at night if my net worth were $5,000,000 and it happened to be parked in 100% equity in a margin-able brokerage account”. And why he augmented his substantial Berkshire Hathaway fortune with major real estate holdings, too. It’s why his business partner, Warren Buffett, has personal holdings outside of Berkshire Hathaway that include buildings in New York City as well as working farmland to which he could escape and grow food to survive. (Go back and look at Buffett’s personal and business fortunes once he was rich. He never again returned to a 100% equity allocation and in many decades, was far from it. Even today, with bonds in a bubble and him having reduced the fixed income component of Berkshire’s balance sheet to the lowest in the 50+ years he’s been running the place, he still holds a massive amount of money in combined cash, cash equivalents, and fixed income securities. Mathematically, if you look at the Ibbotson data, you can almost get 100% equity returns without giving up hardly anything by adding a 10% to 20% fixed income weighting. It drastically reduces portfolio volatility and, in the event of a Great Depression providing credit quality is good, the deflationary environment means they appreciate in real purchasing power, giving you a stream of interest to buy up now-firesale-priced stocks.)

      It’s also beneficial because when stock market close, those who hold other assets can get their hands on shares for dirt cheap. In 1914, for example, a secondary gray market – if you want to call it that – developed where private buyers and sellers would get together and manually exchange ownership stakes based on negotiation. If you owned a building, you could swap someone a year worth of rent for blue chip shares worth 5x that amount were you inclined to be avaricious. People need food, shelter, medicine, and defense far more than they need stock certificates.

      • Todd

        Joshua Thanks for opening up my eye’s. It something like in the dust bowl of the 1930’s when farmers sold there mineral wrights to get by because they had no crop to sell and the one’s that bought the mineral wrights there family’s got rich. Bakken Oil Fields. I guess I am crazy I better fix that.Thanks

  • @peterpatch79: Interesting points.

    On one hand the efficient markets hypothesis or even simple math would suggest that indexers on average should always outperform active investors on average. But how stable is the math if the percent of indexers becomes too high?

    Suppose that tomorrow, the percent of people doing indexing suddenly rises to 90%. It seems intuitive that this could create some demand shocks and potentially destabilize the pricing system. Because, for example, the active investors could hypothetically all be holding, while the indexers are just relentlessly buying, thus driving prices that were initially established rationally by active investors substantially higher. Then if the next day the percent of indexers falls to 10%, this could create shocks the other way. Mathematically one would usually describe such systems as “ill-conditioned” or having bad stability properties. Or one could see momentum effects as you mentioned during accumulation and withdrawal phases of savings and retirement.

    Moreover, even if the proportion of indexers is stable at a high percentage (say 90%) for many years, the price system might still become unstable if the real buying power of different generations varies, which it tends to do (e.g. compare Japan’s demographics and Japan’s stock market index).

    By “unstable prices” I suppose that I mean the prices would still incorporate peoples’ utility, however the utility might not accurately forecast the future cash flows of holding the underlying assets. Peoples’ utility might instead be “I just want to buy some stocks just for the sake of it; the same as everyone else;” or “I just want to sell some stocks, just for the sake of it.”

    Of course, on average active investors correspond to much of the volume in the stock auction process, so their opinion has a strong weight in price. Whereas index investors tend to have very low volume, so their opinion has relatively little effect on price. So we don’t see these instabilities that much, except over long time scales such as the 2008 financial crash or the 2015 highs in the Shiller P/E. But one could imagine the instabilities might happen more often as more people do indexing, and more trading is done algorithmically, since algo traders tend to stop providing liquidity when there are pricing instabilities (e.g. the Flash Crash).

    • peterpatch79

      One thing to consider In the case of a 90% passive world is that we’d be looking at a massive atomization of corporate power. Corporate governance would be massively spread out, which I think would be a net negative. Corporations have, on average, worked out very well as mini empires with concentrated control over the individual entities. For example Apple wouldn’t be as great as it was today if it was started by 300 million americans voting in a CEO. You’d probably see some wicked misuse of company resources in the 90% scenario at a scale beyond anything we have seen historically. I don’t think it could go on for very long unless it was somehow forced due to government intervention. Imagine a situation where the government socializes all US businesses by ceding 90% of all business ownership , through index funds, in equal proportion to all citizens. Then at some point these citizens are allowed to trade their ownership stakes in the index funds and underlying businesses. It might be something for communist countries to consider when they go capitalist but I doubt the 90% passive ratio would last long after trading rights were established.

      It would be like trying to predict what would happen if we found ourselves in a 90% tax environment. Something like the Laffer curve can only indicate the optimal point between Tax revenues and Tax rates, it can’t tell us what the world would be like at the extremes, however interesting it is to speculate on but hard to predict. I do however think that with study and data collection we’ll eventually know , approximately, the point at which passive investing breaks down due to it’s own proportions.

      • @peterpatch79:disqus: I agree that in the “90% indexing” situation, actually making any meaningful decisions in a corporation would be much harder because of passive, diffused, and uninterested ownership. On the flip side, because owners do not care, it will be much easier for executives to rob owners (through for example, executive stock options).

        One way to combat this would be to offer some advantage to active shareholders, i.e. those who participate in voting, communicate with investing relations, etc. The reasoning being that a diffused but active ownership still has social benefits over an utterly uncaring ownership.

        I wonder whether little perks would already make a difference, e.g. sending out some coupons or vouchers for active shareholders to use for purchases in the business, or give away to friends and family.

  • Caleb

    Joshua,

    You wrote:

    “Welcome to the do-it-yourself economy. The older I get, the more dangerous I think it is, especially from a social and political standpoint.”

    When more correctly, it should be stated “Welcome BACK to the do-it-yourself economy …”

    Until the Socialist influences and rise of Big Gov — mainly with FDR — and the social security scheme, it has always been do-it-yourself. The problem is they lied. And a whole generation of Baby Boomers believed the Gubment would be there for them when they retired, that social security was actually a “Fund” that would help them, etc …

    Of course, gubment did what gubment does and squandered the money.

    Am I excusing those baby boomers? No, not at all, the writing was on the wall — and something as important as taking care of your family in old age means you don’t trust, you verify, analyze and adjust as needed — but when you spend 12 years in mandatory Government indoctrination (public education) and they tell you that FDR was God’s gift to America and the Gov is for the people and will protect, serve, and help you …

    Then you probably tend to believe it.

    A lot of people didn’t believe it back then, fended for themselves and are all the better for it as we know …

    It’s one heck of a wake up call for those of that generation who always used SS as an excuse not to build up other forms of retirement — all the eggs in one basket so to speak — anyways, that’s how I see it — looking at the actual long view.

    P.S. not to mention 1914 was the start of income tax and the Fed … which led to the bretton woods system, then total detachment from the Gold standard in the 70’s — making inflation — and more and more central bank intrusions into the market — another mighty force that most all people back then lived through, but didn’t understand what was happening.

    Think about it, they all lived through the things we understand and take for granted now because we can read books on what happened, and it’s like a timeline or a movie we look at/watch, but at the time trust in Government was an all time high — and there were only what? Two major sources of information/media — the newspaper and radio, then TV — and it’s not like there were 1,000’s of different places to get timely info — that wasn’t somehow biased one way or the other — to understand the world happening around you (in my opinion).

    Anyways, it’s all very interesting … but I don’t think it’s dangerous.

    I hope it’s an awakening for my generation — and the return of the indpendent, self-reliant individual will return when the country wakes up to the fact their government is a bunch of crooks and you can only rely on yourself (talk to people in any third world country and ask them if they would trust their gov for retirement, etc … which is weird because they know they’re all corrupt but they tend to embrace socialism … which may point to the power of human behavior in choices right? Something for nothing is so sexy … but I digress).

    ANYWAYS, I guess my overall “Thesis” that I’m trying to prove here is … It has ALWAYS been a “do-it-yourself” economy. People are just now realizing it. You can’t stop it, nor should you IMHO, liberty demands the privilege to fail royally too. The inevitable failure of social security and other “do nothing for yourself” schemes is just now proving that it has been that way all along.

    Would you agree?

    • Ang

      I think you missed the part where he talks about private employer pensions – most workers relied on a defined benefit pension in the past, nowadays with the popularity of 401ks, there’s not that invisible decision maker in the background guiding your retirement/pension investing decisions anymore, and as a result, people have to do it themselves. It has nothing to do with the government

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