Reed C. Fraasa, CFP®, AIF®, RLP®
“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.”
Sir Arthur Conan Doyle, Sherlock Holmes
“Everything should be made as simple as possible, but not simpler.”
Albert Einstein
If wisdom is the quality of having experience, knowledge, and sound judgment, how do we acquire wisdom with our money?
I have witnessed extremely bright, successful people second-guess themselves and make irrational choices with their money. I have also observed other intelligent people possess certain wisdom on how things work, and they can separate their investment capital from the news of the day and feel very confident in their choices.
The difference seems to be the individual's fundamental view of how the economy, capital markets, and banking system works, and a clear understanding of their circumstances. It typically comes down to trust.
Our experiences help shape our view of the world, and we often recall our experiences with biases and feelings that can alter what we adopt as knowledge or truth.
To follow Einstein's advice to make things as simple as possible, we need to accept a few theories. Most people will accept a theory when their perception of the risk is low. Still, when their understanding of the risk drastically changes for the worse, they may abandon the knowledge and rely on seeking current information that supports their fears.
The following theories are simple and essential concepts to adopt as truth, especially in times of economic and market turmoil.
THE ECONOMY
The economy is a system of making and trading things of value, both goods, and services, measured by the amount of production and consumption of goods and services. The measurement of an economy is its Gross Domestic Product (GDP).
Supply and Demand are the driving forces in an economy. Every company in an economy lives or dies based on filling a need or supplying a demand for a product or service. When demand declines for a product or service, prices will decrease. For example, if demand is high, and only one home in your community is on the market for sale, the price may bid up. However, if 50% of the houses are on the market for sale, supply may outweigh demand, and the prices will fall.
Production and consumption are the two economic factors that measure supply and demand in a country or region. Consumption in the US is primarily driven by consumer spending at about 68% of GDP, businesses account for about 16% of GDP, and government spending accounts for about 16%. Consumers have money to spend as a result of the wages they receive for the labor they provide. Labor is the single most significant factor in the economy.
THE CAPITAL MARKETS
The Capital Markets are financial marketplaces where bond and stock securities trade. There are primary and secondary capital markets. Primary capital markets are places where specific investors can purchase securities directly from the issuing company. An initial public offering (IPO) is an example. Large institutions and mutual funds are the primary purchasers in the primary capital market. Secondary capital markets are places where investors trade previously issued securities. The NYSE and NASDAQ are examples of secondary markets.
An Index is a basket of company securities traded in the secondary market used to track the value of the market or sector of the market. S&P 500 is the 500 largest US companies and is considered a benchmark for how investors view the economy by their willingness to buy or sell these stocks.
Stocks and Bonds trade in an auction market. The same economic forces of supply and demand determine the price of a security. If the demand for a particular stock is high, then the price will likely appreciate. Conversely, if there is no demand, and more people want to sell, then the price will probably fall in value until the price is so low that investors perceive value and demand picks up. Everything works this way.
The Price of a Stock or Bond is the aggregation of all the trades at any given time. Investors' independent decisions to buy or sell, based on their perception of information readily available to the public, may lead one party to want to sell and another party to want to buy.
Buy Low and Sell High doesn't need any explanation. However, it can be hard to buy when the market is in a correction unless you understand the next concept.
The Stock Market has always recovered from a recession, correction, collapse, drawdown, bear market, crisis, etc. When prices go so low, the perception of the value of the stock market changes, and sellers become buyers.
The Reason Why the Stock Market Always Recovers is because the capital market system works. There are enough checks and balances, regulations, policies, consumer oversight, freedom of information, accounting, and judicial oversight that keeps it working.
Uncertainty is the thing that causes investors to want to sell rather than buy overwhelmingly. The news can be harmful or useful, but if there is a lot of uncertainty about the outcome, the stock market will likely lose value. The stock market may also rebound when uncertainty subsides, even if the news is negative.
THE BANKING SYSTEM
The Federal Reserve Act of 1913 established the Federal Reserve System and brought all banks in the United States under the authority of the Federal Reserve. A quasi-governmental entity, the Federal Reserve, consists of twelve regional Federal Reserve Banks that are supervised by the Federal Reserve Board.
The Purpose of a Bank is to lend funds from depositor's accounts and to other people to build homes, buy land, create businesses, etc. In addition to service fees, banks make money on the spread between the interest they pay depositors and the interest they receive from the loans they issue.
The Federal Reserve Board regulates the interest rates banks pay on short-term funds borrowed between banks, and what the bank charges their prime customers. Interest rates impact the cost of money, and the cost of money affects both large companies' and individuals' decisions to save or spend or invest their capital.
The Dual Mandate for the Federal Reserve is to maintain maximum employment, stable prices, and moderate long-term interest rates.
YOUR CIRCUMSTANCES
Time Horizon is the amount of time your investment capital (portfolio) can remain invested before you intend to spend or consume your principal. Time Horizon is something unique for you only and cannot be dictated by an advisor or adopted from your cousin or neighbor. Your Time Horizon must address two critical concepts, income requirements and preservation of capital.
Income is a goal for the amount of money you will need to draw on from your portfolio, typically expressed monthly, to support your lifestyle. Think of it as a paycheck replacement. You want your income to be consistent, independent of the stock market, and to keep pace with inflation.
Preservation of Capital is the goal of balancing the desire to avoid short-term loss of capital from market volatility against the desire to prevent long-term loss of wealth from the effect of inflation. It is impossible to have both exist at the same time continuously. Your decision about the preservation of capital will influence your feelings about risk.
Risk Profile is a combination of someone's risk capacity, risk tolerance, and risk perception. Risk capacity is an objective financial planning calculation that simply defines, based on a set of assumptions, how much you can stand to lose in the stock market and still reach your goals. Risk tolerance is a subjective factor that simply asks how long you can stand to wait for a 10% or a 20% loss in your portfolio to recover fully. Risk perception is a subjective factor that attempts to understand the frequency in which you watch your portfolio or the stock market, how often you make changes, and how many regrets you have about past decisions with your money, etc.
Your Goals then determine most of the answers to the previous considerations. If you have a 10-year goal to pay for a child's education, then your time horizon is ten years, and you will need to have 100% of the capital preserved on that date, and you will liquidate the fund over four years. You may not have several years to recover from a significant recession or bear market. If, on the other hand, your goal is to provide a lifetime of income to supplement your social security income, your time horizon is your life expectancy, and you need your capital preservation to keep pace with inflation to support your lifestyle. You will likely have time to recover from a significant recession or bear market.
Don't Mix Up Time Horizons by thinking that your long-term retirement portfolio has a time horizon of one year. Unless you are planning on spending down all of your principal in twelve months, you need to keep your timeframes intact. One of the biggest mistakes we find people make is to allow their time horizon to go to zero when there is a crisis.
These are the foundational pieces of wisdom that can help you through many tough times. If you separate your money into your immediate needs (6 months living expenses), intermediate needs (spending goal within five years), and long-term needs (investment capital), you can achieve better results.
Next week I'll discuss the knowledge that supports our simple money wisdom.
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.