Building wealth is a long-term process, a habit rather than a single event. Being a successful investor requires patience and determination, which can be challenging when there are so many distractions to drag us off course. 2024 is turning out to be an excellent year for investors, but there is so much uncertainty and negativity, it can be tough to maintain our focus.

Unfortunately, the more easily we are distracted from our plan, the more we are tempted to change direction with our investments. Tinkering with a long-term plan because of short-term thinking, often hampers returns rather than improves returns. The urgency of “don’t just sit there, do something!” can lead investors to do the wrong thing at the wrong time.

Election Years

This election cycle is certainly unusual and polarizing. Some people are excited about their candidate. Both sides insist there will be catastrophic consequences if their opponent wins. And, I think a lot of people are disappointed that with 340 million people in the US, these were the two best people we could find to run for president.

Yes, elections matter a great deal. The economy, taxes, laws and regulations, foreign policy, and many other things could get worse. But, change may be slow to come and could be reversed by a subsequent administrations. Regardless of who wins, a dysfunctional Congress seems likely to continue.

Nervous investors are starting to ask if they should change their portfolio or go to cash. We won’t be recommending that or making changes to our portfolio models based on the fact that it is an election year. Vanguard has found that markets performed well under both Republican and Democratic presidents, without a statistically significant difference. And election years, although volatile, had comparable returns to non-election years. (Actually slightly better, on average.) In other words, thinking about making big changes to your portfolio because of the election is likely to be a bad idea.

Behavioral Finance and Cognitive Biases

It can be difficult to stick with a long-term portfolio because we are wired to think about immediate dangers rather than growth over 10, 20, or 50 years. Our minds are incredible computers, but sometimes our mental shortcuts encourage decisions which are not in our best interest. The science of Behavioral Finance has categorized many of these cognitive biases. Even experienced investors have to guard against making decisions which distract us from our long-term wealth building process. For example,

1. Herd behavior. Everyone else is buying Nvidia, so should you! You don’t want to miss out.
2. Hot Hand Fallacy. Nvidia is up 154% over the past year, so it should continue to have fantastic returns.
3. Recency bias. We focus on the performance of tech stocks over the past 12 months, and forget about the performance of tech stocks in 2000-2001. (People remember recent events better than past events.)
4. Confirmation bias. You seek out evidence which supports your beliefs, but ignore other evidence which might challenge your beliefs.
5. Hindsight bias. Looking back on past events and thinking that the outcomes were obvious and predictable.

And then there is the GI Joe Fallacy: the mistaken assumption that knowing about a bias is enough to overcome it. So, even if you know about cognitive biases, there is no guarantee that your thoughts are not being filtered through your biases. Hopefully, though, being aware of these biases can help you continually question your thought process and decisions.

Instead, Ask Yourself

Let’s reframe our five biases above into more rational questions or statements.

1. Herd behavior: Is NVDA still a good value today or are there other stocks which might offer a more compelling return going forward? (Note, talking about the stock is not the same as talking about the company. A great company is not a good investment if the price is too high.)
2. Hot hand fallacy: NVIDIA is up 154% today. Past performance is no guarantee of future results. If anything, you might expect returns to be mean reverting, rather than continuing to go parabolic forever.
3. Recency bias: Forget about the past 12 months. What are the expected returns for the next 10 years? What can we learn from historic situations which were like today?
4. Confirmation bias: Continually ask yourself: Am I willing and able to change my mind if there was enough evidence? Seek out that evidence and review it objectively.
5. Hindsight bias: Recognize that there were other outcomes which could have occurred. Keep a journal of your decisions and review them in a year or two. (I publish my annual Investment Themes on my blog and track the results.) This will keep you humble.

Less is More

There will undoubtedly be tough times in the stock market at some point in the future. I’m not here to paint a rosy picture where everything will be easy. Concerns about the elections, economy, debt, etc. have their merit. Still, I don’t know of anyone who has been able to time the market. And people who think the sky is falling have not participated in remarkable gains over the past decade. What has worked is to be a buy and hold, long-term investor. So, here is how we invest in a systematic manner to avoid the cognitive biases and errors:

1. Index funds. Buying 500 stocks is a lot less risky than buying one stock. I would rather invest in the whole market than bet on one stock. Individual companies can and do go out of business. 80-90% of stock pickers under-perform their benchmark over 5 years or more.
2. Focus on asset allocation. What is your mix of large vs. small, US stocks vs. international, and stocks vs. bonds? Most of the difference in returns is determined by your asset allocation.
3. Keep costs, taxes, and trading to an absolute minimum.
4. Rebalance. Rebalancing is a systematic way to buy stocks when they are cheap and sell them when they become more expensive. Rebalancing helps you maintain your desired level of risk.
5. Invest as is appropriate for your risk tolerance and time horizon. And then leave it alone, knowing that there are up years and down years in the market.

The news seems to be becoming more and more of a circus. The risk of distraction could scare investors to sell everything and go into cash, or to chase performance on today’s hot stocks. Our recommendation is to ignore the election hype. Educate yourself on cognitive biases and understand that markets have up and down cycles. All of this will lead you to recognize that no one can predict what the markets are going to do over the next 6-12 months. But the markets are so often growing that being out of the market for a year usually proves to be a mistake. And when the market is on a roll, there is the danger of getting too enthusiastic about individual companies and ignoring fundamentals. Avoid making big mistakes and stick with the plan!

This month marks 20 years as a financial advisor for me. A lot has changed in that time. When I started, we had to hand-write trade tickets, on blue paper for Buy and salmon for Sell, and fax them to the back office. We would photocopy account applications for our file, fax it in to our custodian, and then mail the original signature.

But a lot has not changed. Markets are still volatile. Timing doesn’t work. Investors still have biases. And good habits build wealth over time.

I am happy to celebrate this milestone, and incredibly grateful for the clients who have trusted me with their finances. I’m excited to start a third decade of service. Markets still fascinate me, and I love getting to help families build and preserve their wealth. One of my early clients passed on years ago, but now I work with their children who are approaching retirement age. And we have accounts for the grandchildren, and we have started 529 college savings accounts for the great-grandchildren. Working with four generations of one family gives you a new perspective about the significance of planning.

Learning the Hard Way

I started buying individual stocks in 1998, right at the end of the tech bubble. I had some profitable investments and some that did poorly. By the time I became an advisor in 2004, I think I had already made every mistake possible with my own investments. You can learn from a book, but the pain of losing your own hard-earned money is a more effective lesson.

After 2000, there were three years of losses in the S&P 500 Index, with the back to back shocks of the tech bubble and then 9/11 in 2001. During this time, I was looking for market inefficiencies and they were still existent back then. There were 50% more stocks than today and stock trading was still done by people on the floor of the NYSE, not on computers.

I would find tiny, small cap regional banks which traded only a couple of thousand shares a day. These stocks had a very wide bid/ask spread. For example, the market might show a bid of $20.00 and an ask of $21.00. If you entered a buy order at the market, you would buy at $21. And if you entered a sell order, you would sell at $20. Sometimes the stock would trade in the middle at $20.50, but large trades could easily move the market, and they would either pay too much to buy or get too little when they sold. Wall Street couldn’t touch these stocks and they were too small to bother.

The spread was often 5%: a $1 spread on a $20 stock. And since the expected return of the whole market was only 10% a year, making 5% on a trade over a day or two seemed pretty attractive. So, I would set a buy limit order at the Bid price of $20 and be the ready buyer for anyone who wanted to sell. And once I had shares, I would set a limit order to sell at the Ask price of $21. When this worked, I could make 3-5% in a day or two. And then once I had sold, I would try to buy back again at $20 and repeat the whole process.

Man Plans, Market Laughs

It worked as planned about half of the time. Sometimes however, the stocks kept on going up. I bought at $20, sold at $21, and then the stock went up to $25. I realized a small gain and then missed out on a big gain. Then I had to decide if I wanted to buy the stock at a much higher price or hope it came back down.

Other times, the stock would drop – I bought at $20 and soon the stock is $18. If I had 100 shares at $20, I would buy another 100 shares at $18 and lower my average cost to $19. Now, I only need the stock to get back to $19 for me to sell and break even. I would set a limit order to sell at $19 and hope I can get my money back.

If the stock would recover to $19, I’d sell. But the stock might then go to $22 and I would again have missed out on gains. Other times, the stock would continue to fall to $16, and I would buy more shares at $16 to try to average down further. But I was only increasing my losses.

At the end of the year, I’d have a lot of successful, but small trades where I had gains of 3-5%. And I would have a couple of large losses of 20%-30%, which I had magnified by buying more shares.

Lessons

Did my trading work? Sort of. I had a profit. In fact, in 2003, I was up 35% in spite of being in cash for a large number of days that year. But here are some of the things I learned:

1. I made 35% in 2003, but the S&P 600 small cap index was up 37% that year. All the hours I spent researching stocks and following the market daily were not productive. I would have been better off using an index fund and spending my time elsewhere. Everyone thinks they’re a genius when the market is going up.
2. Costs and Taxes matter. All my gains were short-term capital gains, taxed as ordinary income. With an index fund, I could hold for longer and eventually get long-term capital gains tax at 15%. Back in 2003, each trade cost $19.99 and I paid thousands in commissions that year.
3. No one can predict individual stocks and speculation will humble you. Investing is better than trading: diversify and remain a buy and hold owner. Prices going up and down are noise.
4. Let your winners run and harvest your losses. Humans are wired to do the opposite. I cut my gains short and doubled down on the losers. This comes from two behavioral biases: loss aversion and anchoring bias. I was fixated on shares getting back to even.
5. Simple is usually more effective than complex. Focus on the long-term, not the short-term.

Today, markets are more liquid and most bid/ask spreads today are 1-5 cents. This is much better for investors. In spite of the prevalence of index funds, however, there is still a lot of speculation on individual stocks. Every morning, I read about stocks which were up 4% or down 7% in the previous day. It’s interesting, but not an opportunity. And of course, I have written many times about how managed funds under-perform index funds. I understand the allure of picking individual stocks, but today I have realized that stock picking is less beneficial than asset allocation. Investors don’t become wealthy because of stock picking, but through saving and time in the market.

The More Things Change

The past 20 years have seen some remarkable market events. The Global Financial Crisis of 2008-2009. The Lost Decade of stocks. Zero Interest Rate Policy. Coronavirus and then 9% inflation. Everything seems to have been a “never-seen-before” moment. And yet somehow, what has always worked, still works. I look back to every low point and think, wow, that was such a great buying opportunity!

I’m looking forward to the next 20 years of financial planning. I have no idea what we will see. How will we fix Social Security and Medicare? What is going to happen with the global debt levels? Will inflation remain elevated? Will AI save the economy and create a productivity boom, or destroy jobs?

What the last 20 years have reinforced for me is that we don’t have to know what is going to happen. We save, invest, diversify, rebalance, and keep costs and taxes low. That formula has built wealth for generations. We will continue to learn and improve, but the foundation of the financial planning process is timeless. We are awash in information today, but in spite of all the available knowledge, wisdom still requires experience.

My three month old daughter is asleep in the next room as I write this. Having a child is the ultimate form of optimism. We must have confidence, patience, and faith in a positive outcome. Along the way, there will be ups and downs, but ultimately growth is headed in the right direction. Our years are determined by our days. If we manage our days right (and weeks and months), the years take care of themselves. But we have to think about the years, when deciding how we use our days.

And so it is with money. I remain very optimistic about the work we do for clients and about the remarkable opportunity for Americans to achieve financial independence. There has never been a better time to be alive. Thank you to everyone I have met along the way for a great 20 years!