Are You Sabotaging Your Investment Returns?

“The investor’s chief problem – and even his worst enemy – is likely to be himself.”

- Benjamin Graham (Warren Buffet’s mentor)

“The stock market has a very efficient way of transferring wealth from the impatient to the patient.” – Warren Buffett

Behavioral Finance

• Capital Asset Pricing Model (CAPM) states that the expected return on an investment must equal or exceed the return on a risk free asset plus the risk premium in order to be a rational investment.

• The Efficient Market Theory states when new information is available the market quickly absorbs it and the asset is re-priced accordingly.

• CAPM and Efficient Market Theory both assume that people invest rationally and predictably.

What If We Are Not Rational?

Behavioral Finance seeks to explain some of the volatility of the stock market by better understanding how emotions and bias impact investment decisions.

How Bad Is The Problem?

DALBAR recently released a study that revealed the following returns for individuals compared to the S&P 500.Average S&P 500 Investors1984-2013 11.1% 3.7%1994-2013 9.2% 5.9%2004-2013 7.4% 5.9%2013 32.4% 25.5%

“The difference between the returns is known as the Investor Gap.”

How Bad Is The Problem?

After completing the study here is what DALBAR concluded:

“The belief that investors will make prudent decisions after education and disclosure has been totally discredited.”

How Bad Is The Problem?

Behavioral Biases

•What if we could identify the built-in behavioral biases that cause us to receive lower returns?

Behavioral Biases

• Confirmation Bias – we determine our conclusion and then seek facts to support it and ignore facts that contradict it.

Behavioral Biases

• Optimism Bias – Our confidence in our judgments is much greater than our accuracy

Behavioral Biases

• Overconfidence – According to DALBAR overconfidence leads investors to trade more often resulting in higher fees, higher taxes and lower returns.

Behavioral Biases

Loss Aversion – Studies have shown that we feel losses more than twice as much as gains. This causes us to become timid investors.• We sell winners and

hold on to losers• Aversion to cutting our

losses

Behavioral Biases

Herd Mentality – Investors tend to follow the crowd with respect to their investments.

• Bank in Singapore • Dotcom “investing” in the 1990’s

Behavioral Biases

Recency Bias – Investors tend to expect whatever happened most recently to continue in the future.• Reaction of driver’s who just witnessed a car accident• The stock market has been going up/down so now is a good

time to buy/sell

Behavioral Biases

Overreaction – Emotions tend to cause investors to overreact to good or bad news. Very quickly a proper reaction (re-pricing of an asset) can become an overreaction when it bumps into the Herd Mentality.

Behavioral Biases

Mental Accounting – This is when we separate our money into multiple accounts based upon subjective criteria.• Annual Bonus• Found Money• Gifted Money

Behavioral Biases

Gambler’s Fallacy – When an investor observes a series of random events and “sees” a pattern.• Slot Machines• Stock Rising (or Falling) for several days in a row

Okay, So What Can I Do About It?

• Create a Plan – Having a plan and knowing what you have invested in and why can settle your emotions and can allow you to maintain perspective

• Know How Your Investments Are Performing – A study by Glaser and Weber released in 2007 revealed that most investors believed they had above average investing skill and overestimated past returns.

• Trade Less Often – Studies have repeatedly shown that the more often you buy and sell the lower your return will be.

Okay, So What Can I Do About It?

• Expect Volatility – Understand that investing is a bumpy ride. It is not unusual to experience losses.

• Plan for what is likely, not what is possible

• Invest – Don’t Speculate – In our opinion, if you don't have an investment time horizon of at least 5 years we suggest not investing in equities.

Okay, So What Can I Do About It?

• Past Performance Can’t Be Relied Upon As A Prediction of Future Results – Sectors fall in and out of favor. Chasing performance results in poor investment returns.

• Be Aware Of Your Biases – If you focus on how your emotions sabotage your decisions you can create better outcomes.

Okay, So What Can I Do About It?

• Ignore “Financial Noise” – The “experts” on television and radio get noticed for making outrageous predictions. Following their advice can be detrimental to long-term investment success

• Alter How You Think – Ask yourself if the investment you are holding that has lost money is worth “doubling down” by buying more. If the answer is no then selling what you own, in our opinion, is probably the best course of action.

Okay, So What Can I Do About It?

DOs and DON’Ts

• DO Focus On - Planning, Diversification and Long-Term Perspectives

• Don’t Focus On – Short-term Performance, New Investment Products, or Market Predictions

Okay, So What Can I Do About It?

Use An Advisor – In March of 2014 Vanguard released a research report that found that working with an advisor can add up to 3% to net returns.• Behavioral Coaching – Adds up to 1.5% by helping stick to

a long-term plan• Asset Allocation – Adds up to .75% via allocation between

taxable and non-taxable accounts• Withdrawal Strategies – Adds up to .70%• Cost Reduction – Adds up to .45%• Rebalancing – Adds up to .35%

Is There a Method to Manage Emotions During Retirement?

Managing emotions during retirement is one of the most challenging issues an investor faces. Here is an illustration of how we manage assets with emotions in mind.

Questions?

Disclosures

Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment Advisory Services offered through Kestra Advisory

Services, LLC (Kestra AS).  Smith, Frank & Partners, LLC is not affiliated with Kestra IS or Kestra AS.

Asset Allocation: Using asset allocation as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Diversification: Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss of principal due to changing market conditions.

Rebalancing: Rebalancing assets can have tax consequences. If you sell assets in a taxable account you may have to pay tax on any gain resulting from the sale. Please consult your tax advisor.

S&P 500 Index is an unmanaged group of securities considered to be representative of the stock market in general. You cannot directly invest in the index.