Reed C. Fraasa, CFP®, AIF®, RLP®
“To know thyself is the beginning of wisdom.”
Socrates
If knowledge is the fact or condition of knowing something with familiarity gained through experience or association, how do we get the knowledge that leads to such intimacy? The Greek word for this is epignosis – the full knowledge. Knowledge that you can trust in times of crisis and increased uncertainty.
Socrates didn’t come up with the phrase “know thyself.” He never wrote anything. Plato and Aristotle referenced the phrase in their writings about Socrates. The expression was so popular at the time that it was inscribed above the gate to the Temple of Apollo at Delphi, one of ancient Greece’s most famous sites.
There were three phrases inscribed at the entrance to the temple: Know thyself; Nothing to excess; and Surety brings ruin.
I believe these three phrases form the foundation for achieving financial knowledge, which leads to acquiring wisdom and realizing financial freedom. The process in which to fully experience this knowledge is through personal financial planning – mostly, a means to know thyself.
What is the Behavior Gap?
Many people make bad choices with their money—the science of behavioral finance studies how people make bad investment decisions due to their emotions and biases. The difference between the investment return of the markets and what people achieve is commonly known as the behavior gap, a phrase coined by Carl Richards. Morningstar and Delbar, each using different methodologies, provide annual research that, depending on the period tested, have shown a gap between the returns available to investors and what they achieve is between 0.51% and about 3% per year.
One of the most common causes for the disparity is the result of abandoning an investment strategy in the middle of a crisis with increased uncertainty. Essentially, selling low and buying high.
To know thyself we must be willing to explore and to wonder. The process of knowing thyself certainly includes understanding your current financial resources like assets and liabilities, income, and expenses. Still, it goes much deeper, including exploring your aspirations, dreams, and fears and then clarifying your goals, objectives, and obstacles.
At that point, an objective financial planner can quantify the cost and timing of your goals, and calculate the required inflation-adjusted, expected return to achieve your goals.
Finally, a discussion needs to take place to balance your expected return with your tolerance to experience a loss and wait for the loss to recover.
Four powerful emotional forces are at play as we navigate through the financial planning process.
These are the fear of loss, the fear of missing out, and balancing our needs and wants. A belief that we need to avoid loss to achieve our goals is frequently coupled with a fear of loss. It is a myth that we can consistently decouple risk and return to prevent risk and still make your expected return over time. Risk and return are directly interrelated to each other.
One of the most common mistakes people make is keeping long-term funds in short-term instruments because they confuse their current needs and their future needs.
I’ve had several clients tell me that if I could help them to avoid one recession or bear market, they would more likely reach their goals. When I explain there is no difference between staying invested and selling out at the beginning of the correction and buying back in after the recovery, the client will clarify that they expect to sell out at the top and buy again in at the bottom. A feat that requires a bit of fortune-telling or at least a lot of luck.
The chart below illustrates the time frame from October 3, 2018, to April 4, 2019, when the S&P 500 (orange line) lost almost 20% in two and a half months and then recovered in about four months.
Selling out of everything and buying a US treasury money market fund (blue line) on October 3 and then selling that and buying back into the portfolio on April 4 would have avoided the drawdown but would not have resulted in any significant difference. This overly simple example ignores the additional cost of taxes realized by selling out, resulting in a more extended recovery period.
Source: Kwanti: HFA 75S/25B is 75% allocation to IWV, Russell 3000 ETF, and 25% allocation to AGG, US Aggregate Bond. HFA 50S/50B is 50% allocation to IWV, Russell 3000 ETF, and 50% allocation to AGG, US Aggregate Bond. Cash is the TISXX, Federated US Treasury Cash Reserves Fund. The example does not assume any cash flows, fees, taxes, or rebalancing.
Alternatively, a portfolio of 75% US stocks and 25% US bonds (green line) held for the entire period, an investor would have seen less loss and full recovery within the same period. Further, a portfolio of 50% US stocks and 50% US bonds (purple line) held for the entire period, an investor would have seen about 50% less loss than the S&P 500 and would have recovered a few weeks ahead of the S&P 500.
The relationship between the risk and return for this example is:
A portfolio of 100% in the S&P 500 would have lost about 20% in the fourth quarter of 2018 but would have achieved an average annual return over the previous 10 years of about 15%.
A portfolio of 75% in the US stock market and 25% in the US bond market would have lost about 14% in the fourth quarter of 2018 but would have achieved an average annual return over the previous 10 years of about 13%.
A portfolio of 50% in the US stock market and 50% in the US bond market would have lost about 9% in the fourth quarter of 2018 but would have achieved an average annual return over the previous 10 years of about 9%.
Selling out of stocks in times of crisis requires two correct choices – when to sell and when to buy back in. Aborting an investment plan turns your portfolio into a game of chance, which is similar to gambling. Ironically, when we have a belief system based on the assumption that the stock market is like gambling, our choices may lead us to realize our worst fear. The stock market is not like gambling unless we turn it into a game of chance. There is a myriad of possible outcomes depending on the day we sell out of stocks and the day we buy back in.
Roger Gibson, CFP®, CFA®, advisor, and author, is known for saying that the best portfolio for a client is the one they will stick with through good and bad times. The stock market is a critical component for every portfolio at all times. The amount of exposure to stocks will determine the risk you experience and the returns you achieve over the long term.
In fact, in the example above, reducing the equity exposure from 100% to 75% reduced the 10-year annualized returns from 15% to 13%, about a 13% reduction return, but the drawdown risk for late 2018 went from about 20% loss to about 14% loss, about a 30% reduction in loss.
Likewise, in the example above, reducing the equity exposure from 100% to 50% reduced the 10-year annualized returns from 15% to 9%, about a 40% reduction return, but the drawdown risk for late 2018 went from about 20% loss to about 9% loss, about a 55% reduction in loss.
We are seeing a similar pattern now during the Coronavirus bear market, which started on February 19, 2020. The S&P 500 (orange line) lost over 33% in five weeks, and as of May 8, it has recovered about 60% of the loss in the last six weeks. However, the 75% US stocks and 25% US bonds (green line) lost about 26%, and the 50% US stocks and 50% US bonds (purple line) lost about 18% during the same time period. A 50% US stocks and 50% US bonds portfolio is only down as of May 8 about 5% to 6% from February 19.
Source: Kwanti: HFA 75S/25B is 75% allocation to IWV, Russell 3000 ETF, and 25% allocation to AGG, US Aggregate Bond. HFA 50S/50B is 50% allocation to IWV, Russell 3000 ETF, and 50% allocation to AGG, US Aggregate Bond. Cash is the TISXX, Federated US Treasury Cash Reserves Fund. The example does not assume any cash flows, fees, taxes, or rebalancing.
No one can predict when the current crisis will be over, but if we can learn from history, the stock market may likely recover before we feel better about all of the economic and medical news.
Knowing thyself involves understanding our tolerance for loss and our time horizon for our spending goals and accepting the following principal for our belief system:
Selling out of the equity portion of a portfolio designed to provide long-term, inflation-adjusted returns, will likely increase risk exposure, turning a portfolio into a game of chance. Instead of abandoning an investment policy, review a financial plan and come to a decision about how much equity is appropriate to own for all time and accept the expected return for the risk you are willing to take.
Author’s Bio
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.