Investors ask the wrong questions. Will the stock market rise or fall in the next month? What is the best place to put my money right now? Will interest rates rise or fall? Will the economy improve or get worse? What will be the best performing stock during the next year? The problem with all of these questions is that the answers are unknowable and will always be so. Dwelling on the unknowable is a fruitless quest that will not bring investors any closer to achieving long-term financial goals. Our fundamental problem is that we are using the wrong part of the brain. Cognitive Investing explains how to make investment decisions using the portion of the brain better suited for the task and answers the questions investors should be asking. What is the relationship between the economy and the stock market? What is the difference between investing and gambling? Why is selling much more difficult than buying? How important is diversification? Why do natural psychological urges lead us to make poor investing decisions? Understanding the answers to these and many more essential questions will profoundly and fundamentally transform the way you approach investing.

Cognitive Investing

The Key to Making Better Investment DecisionsBy Rich Willis

AuthorHouse

Copyright © 2011 Rich Willis
All right reserved.
ISBN: 978-1-4567-2841-0

Contents

Introduction.....................................................................................................................................................................ix1. What makes understanding the investment landscape so difficult?...............................................................................................................32. Why do stock prices go up and down?...........................................................................................................................................63. Are rising markets always good and falling markets bad?.......................................................................................................................94. What is the relationship between financial markets and the economy?...........................................................................................................125. Should my investments be based on a particular prediction of the future course of the economy?................................................................................156. Why do all these different types of financial companies want my business?.....................................................................................................187. Why is an investment process better than an investment plan?..................................................................................................................238. What is the difference between investing and gambling?........................................................................................................................269. What is the problem with treating my investments like a collection?...........................................................................................................3010. What are the characteristics of a thorough and effective investment process?.................................................................................................3311. What is the relationship between risk, reward, uncertainty, and volatility?..................................................................................................3912. What are the different types of risks one should consider when making investment decisions?..................................................................................4413. How should I determine an appropriate level of risk for my personal portfolio?...............................................................................................4714. How do the various psychological biases lead to inferior investment decisions? What should one do to avoid the pitfalls from these psychological biases?.....................5315. Spectrum #1: Simple vs. Complex..............................................................................................................................................5616. Spectrum #2: The Trees vs. The Forest........................................................................................................................................6017. Spectrum #3: Today vs. Tomorrow..............................................................................................................................................7418. Spectrum #4: Stories vs. Concepts............................................................................................................................................8919. Spectrum #5: Pictures vs. Numbers............................................................................................................................................7320. Spectrum #6: Light vs. Dark..................................................................................................................................................8521. Spectrum #7: The Middle vs. The Edge.........................................................................................................................................9022. Spectrum #8: Me vs. Everyone Else............................................................................................................................................9423. Spectrum #9: Static vs. Dynamic..............................................................................................................................................10124. Spectrum #10: Craftsmanship vs. Systematic Rules.............................................................................................................................10425. Why should investment decisions be framed as asset allocation, security selection, or market timing decisions? Which is most important?......................................10926. Why is diversification important?............................................................................................................................................11127. How important is correlation in the asset allocation process?................................................................................................................11428. How should I decide what my asset allocation should be?......................................................................................................................11730. How should I pick securities? How concerned should I be about costs? Taxes?..................................................................................................12531. Should I own individual bonds or bond funds?.................................................................................................................................13032. Should I own individual stocks or stock funds?...............................................................................................................................13533. Should I own actively-managed funds or index funds?..........................................................................................................................14034. How should I choose index funds?.............................................................................................................................................14335. Why do individual investors make poor market timing decisions and how can I avoid making similar mistakes?...................................................................14936. Should I use stop loss orders to control risk?...............................................................................................................................15237. How does dollar cost averaging work?.........................................................................................................................................15438. Why rebalance?...............................................................................................................................................................15639. How about furnishing some sample portfolios?.................................................................................................................................16540. What is so great about this portfolio management process?....................................................................................................................17441. How should these portfolios be managed over time?............................................................................................................................17842. How will these portfolios behave in the next several years? What should I expect?............................................................................................18443. How can I convert my existing portfolio to a cognitive investor's portfolio?.................................................................................................188Conclusion.......................................................................................................................................................................191Appendix.........................................................................................................................................................................193Acknowledgments..................................................................................................................................................................195Bibliography.....................................................................................................................................................................197Notes............................................................................................................................................................................209Index............................................................................................................................................................................213

Chapter One

1. What makes understanding the investment landscape so difficult?

The most misleading words in the financial literature are "past performance is no guarantee of future results." This common phrase has been repeated so many times that it has lost its effect and investors dismiss its significance. This should be replaced with something stronger, such as, "past performance has no correlation with future results, and drawing any inferences about the future from past performance will lead to poor outcomes."

In most human endeavors, past performance is a good indicator of future results. The smartest kid in fourth grade will probably be at the top of her class in fifth grade. The dog that wants to retrieve a ball today will also want to tomorrow. The weather in your home town next summer will likely be similar to what it was this past summer. The Chicago Cubs did not win the World Series last year and won't win it this year, either. Your Democratic congressman is not going to start recommending that everyone should listen to Rush Limbaugh.

This rule, however, becomes inoperative when applied to financial markets, sometimes with disastrous results. National residential real estate prices never declined for more than 65 years after the Great Depression. And then there was the crash in 2008. Many people, including large numbers of supposedly intelligent financial professionals, made crucial financial decisions based on faulty assumptions about such past performance and will be suffering the consequences for many years as careers are demolished, homes are foreclosed, credit scores plunge, and reputations shattered.

If there is a single word that sums up the financial landscape, it is counterintuitive. The financial ecosystem operates under a unique set of rules that contradict many of the basic assumptions of how humans think things work, and how they do work in most other aspects of life. Many of these rules have become so ingrained in our lives, we aren't even aware they exist. However, when we apply them in the financial sphere, we find that the results are not what we expected. We take cues on what we should do by watching our friends and acquaintances. We buy when others are ebullient and prices are high. We sell when the outlook is gloomy and prices are low. We shy away from risks we should be taking and take other risks we don't even realize exist. We are motivated to prioritize for the short-term, ignoring the long-term effects.

Understanding the financial ecosystem requires a level of unlearning which distinguishes finance from other fields. Many other disciplines start with more of a blank slate that fills as you learn. If you know little or nothing about a topic, adding new knowledge does not conflict with prior knowledge and can be accepted easily. Most people have little prior or intuitive knowledge of cell biology, for example, so if one reads an introductory text, it is easy to accept the information presented. However, when new knowledge contradicts what we think we already know, it usually gets rejected or if not, the learning process is much more difficult, as the earlier knowledge has to be re-categorized to eliminate the conflict between the new knowledge and the old. It took many generations before people widely accepted Copernicus's idea that the sun, rather than the Earth, was the center of the heavens. Unlearning has to tear down the old and sometimes a lot of mental rearranging must occur before the new is firmly established.

We are bombarded with data about how the economy is performing, how our investments are doing, and myriad other aspects of personal finance. Much of this "information" contradicts other "information," and alternative and contradictory explanations and opinions are plentiful. Hidden and not-so-hidden agendas abound as sales pitches for various products and services are disguised as information and knowledge about how to best solve your financial problems. Filtering out the few select nuggets of knowledge from the huge amount of data and information is a daunting task.

Many participants in the financial industry profit from the relative ignorance of retail investors and thus have little incentive to educate. The financial media are focused on the new and different, which is more likely to grab your attention (their motivation), than the important and non-changing, which is what the individual investor should be focused on instead.

Another aspect that adds to the confusion is the ever-changing nature of the landscape. Prices change minute by minute. There is a never-ending stream of new products and services and people promoting them. There is an endless supply of ideas and theories about the future course of events and the actions that investors should take. Are industry trends something to endorse or to ignore? When is the right time to be a contrarian? Uncertainty abounds; this affects our decision-making capabilities. There is never an equilibrium.

The boundaries of the financial landscape are fuzzy. Many other disciplines affect investment such as politics, technology, science, ethics, sociology, psychology, mathematics, accounting, economics, marketing, communications, and history. It is probably easier to mention what doesn't affect investing than what does. No one can possibly be an expert in all of these categories, so it is important to focus on the important and relevant aspects of each. A deep understanding of key concepts from these related disciplines will have a profound effect on your financial future.

Therefore, what is needed is a thorough examination of the truly salient features of the financial ecosystem as it applies to the individual investor. The focus should be solely on relevant education and not a disguised sales pitch for some type of product or service. My goal in writing Cognitive Investing is to provide such an education and give you a set of guiding principles that can be used to prosper and thrive in the complex world of personal investing.

2. Why do stock prices go up and down?

Every day the media explain why stock prices went either up or down. The reasons they report are misleading, oversimplified, and usually flat out wrong. Stock markets do not rise or fall because of political events, oil prices, problems in the real estate market (or whatever the industry of the moment happens to be), speculation about the future actions of the Federal Reserve, or unexpected changes in corporate earnings. There are always events occurring that one can rationalize as being good or bad for markets. If the market goes up, the positive events are cited as the reasons. If the market goes down, then the negative events are cited. Although two events occur or seem to occur together, it does not mean that one event caused the other. Most of the time, the events have no causation and no meaningful correlation, even though they are frequently linked by the financial press. One typical example is the effect of oil prices on stock prices. When the two markets move in opposite directions (approximately half the time), oil prices are frequently listed as a cause of the stock market's direction. When the two markets move in the same direction (which happens the other half of the time) the financial press finds some other reason to explain the direction of the stock market. If one examines the actual data in a rigorous manner, one will find that oil prices and stock prices have an ever-changing correlation that explains nothing. There is no cause and effect relationship.

Another reason given for why markets go up or down is that there is a mismatch of buyers and sellers of stock. This is incorrect for the reason that every share of a traded stock moves from a seller to a buyer. Every day in the aggregate, the number of sellers must equal the number of buyers.

What does change the price in the short run is the eagerness of the buyers or sellers to undertake a transaction. If the buyers are more eager, the price goes up; if the sellers are more eager, the price goes down. The economic term for this is demand. So the real reason why stocks go up and down is simply supply and demand. In the short term, demand makes all the difference, since supply is essentially unchanged. Over the longer term, though, supply makes a big difference. A growing supply of stock will tend to depress prices if demand is relatively constant and a shrinking supply of stock will tend to boost prices if demand is constant.

Supply of stock grows via IPOs (Initial Public Offerings), secondary sales of stock, sale of stock through employee stock option and stock purchase plans, and some stock-based acquisitions. Supply of publicly-held stock shrinks through private equity buyouts of public companies, stock repurchases, bankruptcies, and cash-based acquisitions. One of the problems in attempting to predict the long-term direction of stock prices is that the supply situation is unknowable in the distant future. Without knowing the supply, one cannot accurately predict the price, even if one could accurately predict the demand.

The demand for stocks depends on many factors, perhaps as many as there are individuals in the market. Certainly one of the most important factors affecting demand is the price of potential substitute investments such as bonds or money market funds. Demand also changes as individuals change their rate of consumption of goods and services. Demand changes as people become more or less optimistic about the future of the financial markets.

So the real reason stocks fluctuate in price on any given day should be reported as something to this effect, "Stocks appreciated during today's market session because supply was relatively constant and demand increased for myriad individual reasons that will never be fully known. They declined yesterday because of different unknown reasons that resulted in a decline of aggregate demand. Investors were more optimistic today and pessimistic yesterday relative to the previous day." I don't think the financial press is going to go along with this idea anytime soon, even if it is far more accurate than the current practice of linking uncorrelated events and misleading the naive.

Why are investors most pessimistic at market bottoms and optimistic at market tops? (This is backwards if your goal is to make money.)

The answer to this question is in the question itself. The primary reason prices go up and down is because of increasing optimism or pessimism on the part of market participants. The point at which the market hits a bottom is the point of maximum pessimism. The market top is the most optimistic moment. So a market bottom is just another way of saying that investors are pessimistic. A market top is when investors are the most optimistic. So if you want to buy stocks at or near the bottom of the market, you must do it during a period when investors are far more pessimistic than average. There are usually good and obvious reasons for such pessimism, and buying during such periods is psychologically difficult. The inverse applies at market peaks, when investors are far more optimistic than average. The reasons for their optimism are likely well-reported, and selling at this time is akin to leaving a party when it is in full swing.

If you think of the daily reported level of the stock market as a mood-meter, rather than an indication of anything economic, it will be a much more accurate assessment of financial reality. It will also free you to pay attention to something more worthwhile, since the daily and monthly fluctuations in investors' moods lose significance in the long run.

3. Are rising markets always good and falling markets bad?

The conventional wisdom is that a decline in stock prices is bad and an increase in stock prices is good. The truth of this assumption is more nuanced than this simple judgment. How much you have previously invested and how much you will invest in the future determine whether rising markets are better or worse than falling markets.

Imagine two different investors, at opposite ends of their investing lives. The first investor just graduated from college and has taken his first permanent full-time job. He has no financial assets to speak of. He is offered a 401(k) savings plan, which he participates in, by investing 10% of his salary. The second investor is a retired widow who has built up a lifetime of savings and investments and is using these for her living expenses. She has amassed an adequate sum for her retirement needs, and has no other source of current income. All of the dividends and interest that her investments earn are used for her living expenses. She also needs to sell some securities from time to time since her earnings from interest and dividends are insufficient to pay for all of her living expenses.

These two investors should have opposing viewpoints as to whether rising stock prices are good or bad. The first investor will be investing the bulk of his money in the future. He will be far better off financially if stock prices stay low (or go lower) for many years as he invests his money along the way, since his investment dollars can buy more assets at lower prices in a cheap or declining market. It is only near the latter stages of his investment horizon that he should start wishing for a rising or expensive market.

The second investor should hope for the opposite situation. She wants high prices while she is selling her assets and any market decline will mean that a higher percentage of her assets will need to be sold to meet her consumption requirements.

I have purposely chosen two examples of investors at opposite ends of a continuum. Most investors will fall somewhere in between these two extremes. They have accumulated some assets but are continuing to invest either by making new investments from assets earned through income or by reinvesting interest and dividends from owned assets. The investor's age plays a big role in figuring out where one is on this spectrum. Generally speaking, the younger one is, the more time there is to invest in the future and the longer the period before one relies on investment income. Thus, younger investors should prefer less expensive markets than their elders should.

The perspective of the financial press is much closer to that of the older investor than the younger one. Advances are invariably presented as being good and declines as bad. Colorful adjectives are frequently used to describe their magnitude. An alternative presentation of the same information with the younger investor's perspective would be something like this: "Over the last several months, the stock market has gotten cheaper. It has provided an opportunity to purchase assets more inexpensively than in the recent past." Or, "The stock market has gotten more expensive and investing for long term goals has gotten more expensive. If you purchase now, your long term return potential has diminished since you will be starting from a higher base."

Therefore, the answer to the original question is, as is so many times the case, "it depends." In this case, it depends on what percentage of your total lifetime investment has already been completed. Since your own future is unknowable, there will always be a fair amount of uncertainty as to whether rising prices are good or bad. They are good for your past purchases and bad for your future purchases. They are good for your future sales. We tend to become preoccupied with our past purchases and ignore the rest, but we do so at the risk of misunderstanding a fundamental characteristic of market movements.

The notion that rising markets are not always good and falling markets are not always bad, once explained, is relatively easy to accept—for your reflective brain. However, your reflexive brain isn't buying into this concept. It associates "up" with words like upbeat, upgrade, uplift, upright, upswing, and upstanding. All of these words are associated with movement in a positive direction. How can up be anything but good? Contrast this with down words such as downbeat, downcast, downfall, downplay, downswing, and downtrodden. Just reading words with down as a prefix makes you depressed. When the two parts of the brain disagree, the reflexive brain usually wins, being the path of least resistance. This lesson about rising and falling markets is easy to comprehend, but difficult to put into practice, because our intuition gets in the way. The cognitive investor forces the viewpoint of the reflective brain to supercede that of the reflexive brain.

(Continues...)

Excerpted from Cognitive Investingby Rich Willis Copyright © 2011 by Rich Willis. Excerpted by permission of AuthorHouse. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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