A Fossil By My Driveway
A while back, I was outside taking the trashcan to the curb when something caught my attention out of the corner of my eye, something yellow and shiny in a plastic bag.  I went over and picked it up.  It was a book, and in it were names and phone numbers.  I believe people used to refer to it as a phone book. 

I think I would have been less surprised to find the thighbone of a Tyrannosaurus Rex sitting at the end of my driveway.  I expected to open it up and find 10% off coupons for the purchase of a typewriter or an 8-track tape player.  Was someone playing some kind of practical joke on me?

R.I.P. Paper Phone Book
Although the paper phone book was once a staple of every American home, it has gone the way of the steam engine, typewriter, vinyl record and bound enclyopedia sets.  All of these products and technologies were victims of what economists refer to as creative destruction (not sure what it says about me, but I love that term!).

Creative destruction is the process of a new or better product or technology replacing an older product or technology.  Said another way, “Out with the old and in with new!”  For example, the personal computer replaced the typewriter.  The Internet replaced the paper Yellow Pages.  Digital cameras replaced film cameras.  Wikipedia replaced the paper encyclopedia (Encyclopedia Britannica recently killed its print edition after 244 years!).  

Creative destruction can be a scary thing as an investor if you believe that you need to figure out which technologies, companies and industries will be tomorrow’s winners and losers.  A quick look at the track record of most active stock pickers will dispel any illusions you might have that you, or anybody else, can consistently do this.

Making Destruction Your Friend
The good news is, buying a market-based portfolio like the S&P 500 allows you to benefit from creative destruction without having to figure out who its next victims will be.  The market, over time, will sort out the winners and losers for you.  The failing companies will shrink and eventually leave the index and the rising companies will be added to (and become a larger share of) the index over time.

For example, looking back over the last 50 years, around 1,000 companies were added to, and subtracted from, the S&P 500 Index.  If you had been invested in the S&P 500 over that time period, those changes would have happened with no investment research required on your part.  Creative destruction did the work for you.  In spite of all the ups and downs over that time, $100,000 invested in the S&P 500 Index on January 1, 1962, was worth around $9,700,000 on December 31, 2012 (including reinvested dividends).

It makes you wonder why so many people feel the need to try to outsmart or “beat” the market by deciding which companies will be in favor and which will fall out of favor.  It seems to me that rather than trying to beat the market, a better goal is to just be the market.  Be the market by buying a highly diversified, market-based fund and letting creative destruction do its work.

Easy Come, Easy Go
In his book, Why Smart People Make Big Money Mistakes, Gary Belsky relates a fable that goes something like this:

By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $1,000 gambling allowance.  That night in bed, the groom noticed a glowing object on the dresser.  Upon closer inspection, he realized it was a $5 chip they had saved as a souvenir.  Strangely, the number 17 was flashing on the chip’s face.  Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $5 chip on the square marked 17.  Sure enough, the ball hit 17 and the 35-1 bet paid $175.  He let his winnings ride, and over and over the little ball landed on 17, until he had amassed more than $262 million.  Feeling invincible, he once again bet it all on 17.  As the wheel spun and came to a stop, he watched in shock as the ball fell on 18 and he lost everything.  Broke and dejected, the groom returned to his hotel room.  “Where were you?” asked his bride as he entered.  “Playing roulette,” he answered.  “How did you do?” she asked.  To which he replied, “Not bad.  I lost five dollars.”

How’s that for creative framing?  While you may never have to present or “frame” the loss of $262 million to your spouse, we all face important financial decisions that need to be framed properly.  In the most basic terms, framing can be thought of as the way something is presented to you. 

Better Frames, Better Decisions
This is incredibly important because the way something is presented to you will change your view or perspective of that thing.   And when your view of that thing is changed, then what you believe about it can change and that belief leads to action -- because we ultimately act on what we truly believe.

The progression is subconscious, but it normally goes something like this:  Framing changes your perspective, your perspective changes your belief and your belief changes your behavior.  Because of this, framing can encourage helpful behaviors or it can encourage harmful behaviors.

Knowing that good financial decisions begin with good framing and perspective, here is what I believe is one of the most important frames that will help you make better financial decisions.

Cycles Are Normal
▪ Properly framed, you should view market cycles as a healthy part of normal economic and market activity. Improperly framed, you may view economic and market cycles as something scary and unusual.  This belief (born out of improper framing) will generally lead you to fear market cycles and to try to avoid them. This behavior will almost certainly hurt your returns over the long term.

▪ Even though market cycles are normal, it is important not to confuse “normal and expected” with “predictable and the same.”  Because of this, it is certainly a fool’s errand to try to time a cycle’s next peak or valley.  As Peter Lynch famously said, "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."

▪ However, you can systematically take advantage of market cycles, not by predicting them, but by rebalancing your portfolio when market swings have significantly altered the value of various assets in your portfolio.  In essence, rebalancing helps you “buy low” and “sell high” in a disciplined way.

Pizza Anyone?
Framing is so critical because it can change your perspective, and ultimately your behavior (for better or for worse), on your important financial decisions.  Because as I said earlier, framing changes your perspective, your perspective changes your belief and your belief changes your behavior.  For this reason, good decisions start with good framing.  So the next time you have a big decision to make, stop and ask yourself (and a few friends), “Do I have this decision framed properly?”

On a lighter note (and as further evidence that framing impacts our behavior), framing can even make you feel better about the not so helpful behavior of eating an entire pizza in one sitting.  It is rumored that Yogi Berra was once asked into how many slices he wanted his pizza cut.  To which he answered, “You better make it four, I’m not hungry enough to eat eight.”

The Dark Side of Goals
Over Christmas break I was watching my three-year-old nephew having a great time playing a game on an iPad.  That is, until my son got involved.  It wasn’t that my son was trying to ruin his younger cousin’s fun - he was actually trying to be helpful.  He simply told his cousin the goal of the game, which was to finish one level in order to move on to the next.  By moving through enough levels, he could eventually beat the game. 

Apparently, my nephew did not understand that this game came with goals.  Although he was thoroughly enjoying himself, he had been playing the same level over and over again.  Even if he finished a level and could move on to the next, he would just hit reset and start the game over again.

The introduction of a goal changed everything...and definitely not for the better.  My nephew’s enjoyment quickly turned into frustration and anger because he wasn’t able to achieve his newfound goal.  Being a financial planner, I had always thought of goals as something uniformly positive, but observing this little interaction between my son and my nephew got me thinking.  Perhaps there is a previously unexamined dark side to goals that I had never really considered.  This made me think of a simple goal that I had set year after year that I had failed to achieve.

My Annual Goal
Every year I would set the goal of taking vitamins regularly (who knows if they actually work, but it just seemed like a sensible thing to do).  I would set this goal every January, when I was cleaning out my cabinet and throwing away the prior year’s 3/4-full bottle of expired vitamins (so much for that year’s goal!).  This became a bit of an annual ritual for me - throwing away the expired bottle of vitamins that I had purchased the last January and recommitting myself to the same goal I had failed to achieve.  I eventually gave up on this annual charade and ditched the goal altogether.

Mission Accomplished
Having scratched ‘take vitamins’ off my goal list several years ago, something amazing happened in 2012 - I consistently took vitamins for the first time in my life (no unused, expired vitamins in my cabinet this year!).  Without having the goal, I had unconsciously and effortlessly accomplished the goal that had eluded me for years.  Mission accomplished...without even knowing I was on a mission.

Good Bye Goal, Hello Habit
What changed?  A $4 pillbox changed everything.  I bought a $4 pillbox that I refilled each week with my vitamins for the week.  I had formed a simple, daily habit and as a result, had unknowingly achieved a goal I had given up on long ago.  So, for 2013, I do not have a goal to take vitamins regularly.  I don’t need it.  What I have instead is a simple, daily habit that will ensure that I do it.

In no particular order, here are some observations about goals and habits:

• Goals, once accomplished, are easy to quit.  Habits, once formed, are hard to break.  Goals have a beginning and, more importantly (and most detrimentally), they have an end. You start a diet and you end a diet.  You start an exercise program and you end an exercise program.  Habits, on the other hand, have no end - they eventually become a part of you rather than something you accomplish and then move on from.  Think about the difference between having a goal to lose 20 pounds versus establishing a habit of eating healthy food on a daily basis. 

• Goals are complicated. Habits are easy.  Goals require tracking and paperwork… and lots of mental energy.  Habits are easy – no assembly required.  You just do them each day and that is it.  No follow-up.  No tracking.

• Goals are focused on tomorrow.  Habits are focused on today.  Goals can cause us to live in the future with a low-grade anxiety (which, in the end, is not living at all).  We can be so focused on tomorrow that we forget to live our lives today.  Habits help us to live in and enjoy the present because they are things we do now, not in the future.

• Your success is dependent on your habits, not your goals.  A goal without the habit becomes worthless, but the habit is equally effective with or without a goal.  Think about it.  I no longer have a goal list somewhere with ‘take vitamins regularly’ on it.  Why?  Because I have something far more effective than a goal - I have a habit.   Because I have the habit, I have no need for the goal.  The beauty is that with the habit you get what you are after, even without the goal.  The habit is the key.

A Year of Living Goal Free
I know goals are as American as baseball and apple pie, but what if there is a better, more effective way to get what you want out of life?  I believe the key to your long-term financial success lies not in how many goals you have or how big your goals are, but rather in how consistent your habits are.  So, why not take the pressure off for a year and ditch the goals, adopting a few simple habits instead.  For my fellow Type A personalities out there who just can’t let go of your goals for the year, just start thinking of your habits as goals – mini-goals that you accomplish everyday.  Maybe we can all declare 2013 the year of living goal free.

A recent study by Norwegian researchers Thomas Hansen and Britt Slagsvold found that equally sharing housework between spouses might be bad for your marriage. After analyzing data of thousands of Norwegian couples, Hansen and Slagsvold found the divorce rate was higher for those doing equal amounts of housework than in couples where the women did more of the work. My first thought after reading this was that the International Association of Married Men must have funded the study.  Okay, there is no International Association of Married Men (at least not that I am aware of), but the study and the findings are real. 

Now before every married man reading this blog picks up the phone to call his wife and tell her this amazing news (and before every married woman reading this blog sends me hate mail), please read on.

Reading the findings of this study made me think of an important financial truth that you need to be mindful of in managing your family’s finances.  Namely, that correlation is not the same as causation. Let me translate that from geek speak. I will never forget my first introduction to this truth when my statistics professor in business school told us that there was an almost perfect correlation between liquor sales and pastors’ salaries. As young impressionable students, we were all shocked, to say the least. That is, until he explained that there is a difference between correlation and causation.

In the most basic terms, correlation says that two things move together.  For example, pastors’ salaries increased at the same time that liquor sales increased. So, they were in fact correlated. Now for the more important question - did the increase in pastors’ salaries cause the increase in liquor sales? Hopefully not! You see, therein lies the danger of assuming that the one thing (increased pastors’ salaries) caused the other thing (increased liquor sales). There was correlation, but most likely not causation.

Why is this important when it comes to your financial life?  Because somebody may provide evidence that two things are correlated and then imply that one thing caused the other. Causing you to make faulty decisions.

Take the so-called “Super Bowl Indicator” for example. The indicator says that the stock market’s performance can be predicted based on the outcome of the Super Bowl that year. You see, there is in fact a high correlation between which NFL conference wins the Super Bowl and the performance of the stock market that year. The indicator says that if an NFC team wins the Super Bowl, the stock market will have a good year and if an AFC team wins the Super Bowl, the stock market will have a bad year.  It has actually been right in 33 out of the last 41 years – a success rate of over 80%.  What do the two things actually have to do with each other? Nothing! There is correlation but obviously no causation.

Assuming there is always causation where there is correlation can be hazardous to your financial life…and in the case of the Norwegian marriage study – hazardous to your marriage!

People who know me well will tell you that I tend to get in a rut when it comes to food (I prefer to think of myself as consistent).  If I’m not going out to lunch on a particular day, one of my ‘rut’ foods is a pack of tuna with some lemon.  It’s easy and inexpensive - a beautiful combination to my way of thinking! 

What is also beautiful to a numbers guy like me is walking into the grocery store and seeing that one of my ‘rut’ foods is on sale.  So you can imagine my excitement the other day when I went to our local Giant and saw that tuna fish was on sale for 4 for $5 (I’m a CPA, so my definition of exciting is probably different than yours).  For those of you not familiar with tuna fish economics, that is 30% off Giant’s regular price of $1.79 per pack.

Knowing that I am definitely going to be buying tuna at some point in the future, what would you think if I told you that instead of buying a box load of tuna that day, I decided I would wait until the price went back up to $1.79 per pack?  That would be foolish, of course!  Sadly, based on my experience of over 20 years in the financial services industry and every credible study I have seen of human behavior, that is exactly the approach most individual investors take when it comes to investing in the stock market.  If history is any guide, it seems that one sale people hate is a stock market ‘sale’.

For example, out of fear, people generally avoid buying the S&P 500 index when its price has declined but are eager to buy it once its price has gone back up.  That’s a losing formula whether you are buying tuna fish or stocks!  Just ask Warren Buffett.  He has amassed a $40 billion fortune capitalizing on this madness.  He is quoted as saying - “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”  Translation: Buffett buys as much ‘tuna’ as he can when it goes on sale and nobody else is interested in buying.  He loves a stock market 'sale' and perhaps you should too.

Recently, while on a family trip to California, we enjoyed some time at the pool. Watching our youngest son splashing around in the pool reminded me of how obstinate he was in learning how to swim. This wasn't for lack of ability -- he just flat-out refused to learn to swim (it’s possible he takes after his father in the area of stubbornness). Needless to say, it was nerve-wracking taking him to the pool before he learned to swim.

What would you think if I told you that when we took him to the pool before he knew how to swim, the only information we asked the lifeguards for was the average depth of the pool? What if we had no regard for the deeper end of the pool before letting him go in by himself, just as long as he was taller than the average depth?

Making a decision to let our three-and-a-half foot tall son go swimming by himself in a pool whose average depth is three feet is as foolish and reckless as making investment decisions based simply on the average return of a particular investment.

Too many people find themselves enticed by the allure of the average. Before you invest, you need to understand more than just the average historical or expected return of an investment. Among other things, you need to know what the historical and expected highs and lows are. Just like two pools with the same average depth can be very different, two investments with the same average return can perform very differently over time and can dramatically affect your chances of achieving financial success.

Suppose you have a perfectly healthy 100-year-old neighbor who never exercises and smokes two packs of cigarettes a day. Would you quit exercising and start smoking two packs a day in hopes of living a healthy life into your 90s?  Would you begin living your life based on their story?  Of course not!  This could, quite literally, lead to death by anecdote.  You would be making a serious, life altering decision based on a single data point – your neighbor.  As silly as this example seems, you may unknowingly be making investment decisions based on the financial equivalent of your 100-year-old chain-smoking neighbor.

It is incredibly important to avoid making your investment decisions based on the stories and limited data presented by financial prognosticators, financial “experts”, people selling books and seminars, etc.  The stories and facts presented are generally hand selected to lead you to draw a certain conclusion.  If enough stories and facts are pieced together, you can get the false impression that you are hearing all the data.  Always remember that the plural of anecdote is not fact.  Left unchecked, making investment decisions based on stories, anecdotes and limited data can cause you to make rash decisions and abandon a disciplined and well thought out financial strategy.

Well-known risk consultant Peter Sandman wisely observed that, “The risks that scare people and the risks that kill people are generally entirely different.” Why is this? His conclusion is that it has to do with control and familiarity. It seems that we are much less afraid of things that are familiar and that we feel are in our control (even if they are, in fact, much more dangerous).

The truth of Sandman’s observation hit home for me one day as I was enjoying a juicy burger and freshly cut French fries at one of my favorite burger spots. A story about a plane disaster flashed across the television. My blood pressure rose a bit as I followed the developing story, but soon I turned my attention back to my meal. As scary as a plane crash is, as I drove home on a typically crowded Northern Virginia road, I realized that the risk of dying in a plane crash was far more remote than the risk of dying while driving home – or of the burger and fries eventually doing me in.

However, the burger is certainly not very scary (and it is tasty), and for most, driving is certainly far less scary than flying.  This makes perfect sense when you consider Sandman’s criteria of control and familiarity. When we drive, we are behind the wheel and in control, and we drive pretty much everyday, so it is familiar. Flying, on the other hand, is eminently less familiar. Tony Kornheiser probably spoke for many people when he wrote in a column: “I’m somewhat anxious about flying. I recently made a list of things that scare me most about flying, and I narrowed it down to three: takeoff, landing, and the part where we’re in the air. Other than that, I’m fine.”

After more than 20 years in the financial services industry, I have definitely observed that the things that scare people and the things that kill people (financially) are entirely different. When it comes to investing, the thing that scares people the most are the markets’ short-term ups and downs like we are currently experiencing. However scary these market fluctuations may be, having a well-constructed portfolio that is part of a well-designed financial plan can prevent those fluctuations from being deadly to someone’s financial life. What is deadly is people’s responses to these market fluctuations.

Without a good plan in place, you will be tempted to counter your fear by trying to regain the “feeling” of control by doing something. The most common “something” that I see people doing is to start selling the things that are scaring them – whatever investments are currently dropping in value.

The outcome of following this path is generally very predictable and deadly – it devastates long-term performance. The reason is simple – more often than not, you inadvertently but relentlessly jump into an endless cycle of selling low and buying high. You are selling what has recently dropped in price and buying it back later – after it has gone back up in value…and feels safe!

With a good financial plan in place, while the markets’ ups and downs may continue to scare you, you can have the confidence to stay the course and avoid potentially killing your financial future.

Billboard advertising has been around for thousands of years, ever since Egyptian merchants first used outdoor advertising by hammering messages about their wares into stone tablets alongside trade routes. Today, billboards alongside major highways tout a wide variety of companies, products and services.  In my mind, amongst the many billboard companies in the world, one company clearly stands out above the rest – Facebook. It is certainly the largest and most profitable billboard company of all time. Confused? Don’t think that Facebook is in the billboard industry? Read on and decide for yourself.

According to financial filings, around 85% of Facebook’s revenue comes from advertising. That may seem high, but I would suggest that it makes perfect sense. Think about it: where else would the bulk of Facebook’s revenue come from? My guess is that Facebook’s profit would probably be closer to $1 million, rather than $1 billion, if users had to pay to use Facebook. Be honest, if you got a bill for usage, you would drop Facebook quicker than a piece of burning toast that you just rescued from the toaster. Because you aren’t willing to pay to use Facebook, they have to make money some other way.

The good news is that Facebook currently owns and operates one of the busiest stretches of digital highway in the world. Hundreds of millions of people drive on Facebook road to connect with their family and friends. Because of this, companies are willing to pay for billboard space on the Facebook highway to try to attract the attention of all those drivers. The big question is, what happens to Facebook’s billboard revenue if people find a better, faster or more attractive way to their friends? If the traffic on the Facebook highway diminishes, Facebook’s billboards become much less valuable. And then, of course, Facebook is much less valuable.

Back not too many years ago, the traffic on the MySpace highway was growing rapidly and there was no end in sight. The MySpace highway was such a heavily traveled road that its billboards were thought to be incredibly valuable. So valuable, in fact, that in 2005 News Corp bought MySpace for $580 million. In 2011, they sold MySpace road and its billboards for $35 million. Yes, you read that right: they bought it for $580 million and sold it for $35 million. What happened? In a nutshell, people stopped driving on the MySpace highway and found better ways to connect with family and friends, making MySpace’s billboards not very valuable anymore.

Will the same thing happen to Facebook? Of course, nobody knows for sure and I offer this not as a prediction of what will happen to Facebook in the future.  As I have always said, trying to predict the performance of a single stock is a fool’s errand.  I offer this simply as a different take on a familiar company.

I would like to put forth my first nomination for the understatement of the year award. For this prestigious award I would like to nominate Jamie Dimon, the CEO of JP Morgan. In response to a trading bet that lost $2 Billion (yes, that is billion with a ‘B’), Mr. Dimon said that the trading bet that the firm made was “poorly reviewed, poorly executed and poorly monitored”. To my way of thinking, “poor” seems to leave the door open on the performance scale to something worse, like say, “terrible”. If a “poorly reviewed, executed and monitored” trade produced a $2 billion loss, I would hate to see what the results of a “terribly reviewed, executed and monitored” trade would be.  I for one would not be sticking around to find out.

As an investor, what can you learn from JP Morgan’s $2 billion loss?  Here are two big things -

Don't Buy Things That You Don't Understand 
In the case of JP Morgan, they said that the strategy they had been using to hedge risks "has proven to be riskier, more volatile and less effective as an economic hedge than the firm previously believed."  That's a fancy way of saying they didn’t understand what they were buying. They had a created a monster and the monster turned around and bit their head off. Let this serve as a cautionary tale - don’t buy things that you don’t understand.

Don’t Judge a Decision Based on the Outcome
If I tell you that I am about to drive 100 miles per hour on my drive from DC to New York City would you have to wait and see the outcome of that decision before you could tell me whether that was a good decision or a bad decision? Of course not. Whether I make it in record time or plow into the back of an 18-wheeler on the NJ Turnpike, it is a bad decision. The outcome does not determine the quality of the decision. 

In the same way, although it is tempting and convenient, don’t judge a financial decision as good or bad based on the outcome or the results. The quality of a decision should be judged ahead of time based on the merits and the quality of the decision itself. I will assure you that the JP Morgan trade would have been touted as brilliance if the bet had gone the other way and JP Morgan had made $2 billion. Although the facts would have remained the same - to quote Jamie Dimon, they still would have made a trade and a bet that was “poorly reviewed, poorly executed and poorly monitored”. Just like a decision to drive 100 MPH from DC to NYC is a bad decision even if you make it to NYC in record time, making a financial decision that is “poorly reviewed, poorly executed and poorly monitored” is bad even if you end up making money.

A few weeks ago in the ongoing international battle of “viral” videos, a new world champion was crowned in the five-day category. According to whoever keeps track of such things, the Kony 2012 video reached 80 million views in a mere workweek. According to the same people who keep track of such things, this video shaved off a full day from the time it took Susan Boyle (the former champion) to reach 70 million views in her video where she sang, “I Dreamed a Dream.”

The producers followed up their Kony 2012 video with the April 5 release of Kony 2012 -- Part II (apparently catchy titles are not their specialty). Following the same formula (and learning from their last runaway success), you would assume that this new video would equal (or at least come close to) the success of the first. If anyone knows how to make a successful viral video, certainly the creators of the reigning five-day world champion would. Unfortunately, it seems that this is not case. As of the 3rd week of April, the second video has 98% fewer views than the original.

Viral Videos and Money Managers
It seems that viral video producers have at least one thing in common with actively managed mutual funds – past performance is no guarantee of future results. As the following graphic illustrates, actively managed mutual funds that achieve top performance in one period typically do not repeat their success in future periods.

The stacked graph at left sorts the entire U.S. equity fund universe by cumulative five-year performance relative to each fund’s benchmark (includes only those funds with a complete return history for the period). As shown, the top performing 25% of these funds comprises 377 funds. The right box shows how these top-quartile funds performed relative to their benchmarks in the subsequent five-year period. The arrows indicate the movement of these top funds across quartiles.

Only 8% of the top-quartile funds repeated their top performance in the subsequent five-year period. Seventy-five percent of the funds dropped to the second, third or bottom quartiles. These top-performing managers showed no ability as a group to repeat their top-quartile performance. In fact, 15% of these previously top-performing funds didn’t even survive!

Investing Through the Rear View Mirror
The lesson of this illustration and the Kony 2012—Part II video? When it comes to viral video producers and actively managed mutual funds, past performance is a perfect predictor of past performance. However, it is an especially lousy predictor of future performance. So the next time you are tempted to invest based on the recent performance of an actively managed mutual fund, just remember the Kony 2012—Part II video!

Remember that old Steve Martin joke about the secret to becoming a millionaire?  "First, get a million dollars!"

Perhaps Steve will change his answer after Facebook’s announcement yesterday that it will purchase a start up company called Instagram for $1 billion.  It appears that the new secret to becoming a millionaire is to start a business that is a threat to Facebook.  The really great news is that revenue is optional.  You see, according to an article in the Wall Street Journal, Instagram has no revenue!

I think that what this provides us is an incredibly compelling answer to the question of how jumpy and nervous Facebook and Mark Zuckerberg are of new competitors and how vulnerable they think they are.  Based on this acquisition, I think we have one billion reasons to believe that they aren't nervous, they are panic stricken.  An impending IPO has a way of doing that to a guy who, by most accounts, stands to make over $20 billion when the company goes public.

We talked a bit in our last post about the importance of understanding how the firm that is managing your money is regulated and how it makes money. For those of you that zoned out a bit with the technical jargon, let me try to simplify this a bit since this is of critical importance when looking for someone to help you manage your money. Let me illustrate the difference in the Suitability Standard and the Fiduciary Standard using a much simpler product: men’s suits.

Imagine that I need to buy a new suit and there are two men’s clothing stores at my local mall - Goldman Suits and Fiduciary Suits.  Goldman Suits operates under the suitability standard and Fiduciary Suits operates under the fiduciary standard. I have $500 to spend, and my measurements indicate the best fitting suit for me is a 42 Long. 

The danger of the suitability standard becomes evident when Goldman Suits has a surplus of 56 Long suits.  They got a great deal on them and, as a result, will make a $200 profit on each one sold. They will make only $20 if they sell me the best fitting suit for me - a 42 Long. Would they legally be allowed to sell me a 56 Long under the suitability standard? Sure. Under the suitability standard they are not required to find the best-fitting suit for me, only one that is, well, “suitable." 

Goldman Suits could definitely make the case that the 56 Long suited me. It covers my body. It protects me from the elements. It keeps me warm. Unfortunately, it looks terrible on me and, by any reasonable standard, is certainly not the best fitting suit for me. The good news for Goldman Suits is that the suitability standard allows them to legally sell me the 56 Long that makes them $200 versus the best-fitting suit that would only make them $20. Good news for Goldman Suits, bad news for me. 

Across the mall is Fiduciary Suits, a men's clothing store that works under a fiduciary standard. They are required to put my interest first and do what is best for me. Because they understand that incentives drive behavior, Fiduciary Suits wants to create an environment that is most conducive to people abiding by the fiduciary standard and doing what is best for me, the client. 

To create this fiduciary friendly environment, Fiduciary Suits gets paid the same no matter what suit I buy.  No hidden markup. They charge a simple fee for helping me find the right suit. They tell me ahead of time exactly how much it will cost me to have them help me find the right suit. If I have $500 to spend on a suit, they make the same amount of money no matter which $500 suit I buy. They are not incented to sell me a suit from any particular manufacturer or a suit of a particular size or color or fabric type. Unlike Goldman Suits, Fiduciary Suits is not only legally required to help me find the best fitting suit for me, they have no incentive to do anything other than that.  So you don’t have to wonder, why are they selling me this suit?

Sadly, the overwhelming majority of the financial industry works under the suitability standard and has incentive plans that are not designed to encourage advisors and brokers to do what is best for you. The good news is that there are financial services firms out there that operate like Fiduciary Suits. A great place to get more information on this unique breed of financial advisors is www.NAPFA.org.

If you don’t know what standard the firm you are working with is operating under, or fully understand all the ways the firm makes money, you may be buying your suits at Goldman Suits.

Skeptical about whether gross conflicts of interest exist at the largest full-service investment firms? Reading an Op-Ed in the New York Times written by former Goldman Sachs employee Greg Smith might change your mind. A quote from the Op-Ed drives this point home: "I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact."

While there is certainly no perfect, conflict-free business model, the largest full-service investment firms appear to have settled on a business model that doesn’t even try to minimize or neutralize conflicts of interest. Instead, their business models appear to be petri dishes that foster the growth of a toxic, “client-last” culture that Smith describes so well in his Op-Ed. They have way too many products, lines of business, compensation models and ways to make money off clients all housed under one roof. As the icing on this distasteful conflict cake, some would argue that the way these firms are regulated fosters their “client-last” cultures. These firms are regulated under what is called the Suitability Standard.

Under the Suitability Standard, clients must simply receive recommendations that are suitable, or appropriate, to their circumstances. The gaping hole in the standard (and what creates the breeding ground for conflicts of interest) is only obvious when you consider what is missing from this standard—any mention of doing what is in the best interest of the client. They are not required to find what they believe is the best product for you, simply a product that is suitable.

The Suitability Standard does little to help control, minimize or eliminate conflicts of interest. Sadly, and almost inexplicably, this standard makes no reference to doing what is best for the client. Because the Suitability Standard sets the bar so low, and as the Goldman article illustrates chillingly well, there can be a very wide gap between what is legal and what is in the best interest of the client. The suitability standard fuels a mindset of what can the firm legally get away with while maximizing profits to the firm.

But do not despair—there is an alternative. You can find a firm that operates under what is called the Fiduciary Standard. When it comes to finding someone to manage your money, the Fiduciary Standard is probably the most important term you’ve never heard of. While not perfect, the Fiduciary Standard holds many independent advisory firms to a much higher standard. An advisor who works under the Fiduciary Standard is required to put your interests first and do what is best for you. My next post will illustrate with a simple example the difference in the Suitability Standard and the Fiduciary Standard.

Previously, we discussed overconfidence and its dangers when it comes to investing and making financial decisions. In this post, we want to talk about some fairly simple things you can do to combat overconfidence.

One of the best therapies for overconfidence is feedback. In a nutshell, feedback allows you to compare what you thought would happen with what actually happened. In some cases, life can give us feedback immediately. For example, you touch a hot stove, you get burned—quick feedback.

The world of sports can provide immediate feedback as well. In basketball, when you take a shot, you expect to make the shot. The good news (and the bad news, perhaps) is that you get feedback right away: The shot goes in or it doesn’t. This feedback is an important part of the calibration process. The goal of calibration, over time, is to shrink the perception gap - the gap between your perception of reality and actual reality. Take enough shots in basketball, and eventually you will probably become well calibrated regarding your basketball skills (or in deep and obvious denial).  The gap between your perception of your basketball skills, and your actual basketball skills, should shrink over time.

Based on my observations, the root of overconfidence in the financial realm is a result of people being poorly calibrated. In other words, there is a big gap between people’s perception of their stock picking and market timing skills and their actual stock picking and market timing skills.  I think this stems from a lack of feedback due to people generally being really bad financial record keepers with incredibly selective memories. We have a mind like a bear trap when it comes to remembering our winners, but have acute amnesia when it comes to our losers.

Fortunately, there’s hope if you use my incredibly inexpensive feedback mechanism--a pen and pad of paper. That’s all you need. Then, simply write down your predictions and feelings regarding the markets or a particular stock at any given time. Most importantly, write down your predictions when you feel most strongly about something, as that is probably when you are most susceptible to a case of overconfidence. Then go back and regularly compare what you wrote down with what actually happened. Over time, I am fairly confident (okay, hold the snarky overconfidence comments!) that this will be a humbling and eye-opening experience. Over time, this feedback will help you to become better calibrated when it comes to your financial decisions.

Unfortunately, there is no cure for overconfidence or any of these natural tendencies. They are deeply ingrained in us and are part of what it means to be human. The best you can hope for is to put on some constraints to manage yourself and keep overconfidence at bay. As a substitute for the bad investment behaviors often caused by overconfidence, try adhering to less glamorous, but far more reliable, time-tested principles of investing, such as the boring but effective diversification, dollar-cost averaging and rebalancing.

The next time that a friend or neighbor confidently tells you where the market is headed or that Facebook is a no-brainer investment, you can politely nod, knowing that you are probably witnessing a real-life occurrence of overconfidence. Perhaps, as a friend, you could suggest that he or she buy a pen and a pad of paper.

Well, this chart pretty much says it all about human beings not being naturally inclined to make good financial decisions.  For those of you that don't like charts, I will summarize - individual investors are prone to sell when they should be buying and prone to buy when they should be selling.  Over the last several years, as stocks have been rising, individual investors have been pulling funds out of stocks (yes, those outflow numbers are in billions!):

Click here for the full article in the Wall Street Journal.

We often misjudge ourselves and overestimate our abilities. In a word, we are overconfident. If you are confident that you are not overconfident, then I would suggest that you might want to keep reading!

One of my favorite examples of overconfidence was a survey where a group of people was asked to rate their driving abilities. Approximately 90% of the respondents rated themselves as above average drivers! It doesn’t take a Ph.D. in statistics to know that this is statistically impossible (unless, of course, you live in Lake Wobegon). In Why We Make Mistakes, author Joseph Hallinan said it well: “Almost all of us walk around with the private conceit that we are better than average.”

My apologies to my male readers, but Hallinan went on to point out that studies show that men, on average, tend to be more overconfident than women. He referenced one study where people had to estimate their IQs: Men almost always overestimated their IQs and women almost always underestimated their IQs. This overconfidence is particularly prevalent in male-dominated fields such as the military and finance. Unfortunately those are areas that have incredibly serious consequences to overconfidence.

In my experience, a propensity toward overconfidence starts at a young age. As a Little League coach, I witnessed the overconfidence of a child predicting a home run as he walked up to the plate. At those times, I chuckled to myself, thinking a more realistic goal would be to simply hit the ball. But at times as adults, that “I’m going to hit a home run” syndrome causes us to overestimate our capabilities.

For financial decisions, overconfidence can trick us into believing we can hit a financial “home run” by identifying the next “sure thing.” For example, the buzz around Facebook could lead you to conclude that Facebook is a sure thing. Here are some telltale signs that you may be falling victim to financial overconfidence:

• Practicing market timing
• Concentrating assets in one or a very limited number of holdings
• Abandoning investment disciplines, such as diversification
• Never establishing, or deviating from, a sound investment strategy

When it comes to your personal finances, overconfidence can cost you dearly. Fortunately there are things that you can do to help counter your natural tendency to be overconfident and help you be a better investor and make better financial decisions. We will cover a few of these items in future posts.

Currently, Facebook is the hottest and most in demand IPO we have seen for some time. In my experience, the hotter and more “in demand” the investment opportunity, the more inclined we are to fall prey to some common investment mistakes. Why? Because one of the keys to not making mistakes is to pause, take a deep breath and then pause again! In other words, we need to be deliberate and thoughtful. But with hot stocks like Facebook, we tend to get excited and throw caution to wind and go with our gut. But our gut, of course, takes its cues from our brain.

Research in brain science has consistently confirmed that we are not wired to make good financial decisions. In Why We Make Mistakes, author Joseph Hallinan makes the point (as does mountains of other research) that if you make mistakes, or are prone to make certain mistakes, you are certifiably sane and completely normal. To me, that’s the good news/bad news conundrum when it comes to investing: If you are inclined to make mistakes, you are normal, but being normal can cost you dearly when investing and making other financial decisions.

If you are beginning to buck at the thought you are naturally inclined to make mistakes, you should know that this has nothing to do with intelligence. The basic conclusion of all the research that I have read is that regardless of your IQ, your natural instincts betray you when it comes to making sound financial decisions and being a successful long-term investor.

We must be vigilant in recognizing when our mistake-prone brains could push us to make a bad financial decision. A critical step in making good investment and financial decisions is to recognize our natural tendency to make mistakes. Admitting you have a problem is the first step towards recovery. Remember the adage: A problem well-defined is a problem half-solved!

Over several blog posts, I’ll cover some common financial mistakes, such as overconfidence, anchoring and mental shortcuts that can trigger bad investment decisions. So drop back by soon to learn how you can overcome your natural tendencies and make better financial decisions.