Comments on The Wise Investor Podcast

During drives in the car I usually listen to either talk radio, investing podcasts, or music. Lately it has been mostly talk radio during the morning commute and investing podcasts at other times. When I recently drove to Chicago and Pittsburgh for fellowship interviews I was able to listen to a lot of investing podcasts.

My two favorites are Get Rich with Dividends and the S&A Investor Radio. I actually talked a little bit about Get Rich with Dividends on a post here: Get Rich with Dividends Podcast & Power of Reinvestment. I also added to my list another podcast called The Wise Investor Show, a production produced by Robert W. Baird. It espouses value investing and is, therefore, right up my alley.

On a recent commute I decided to listen to the episode from August 28th entitled, Emotional Investing: Why Indexing is Not Your Best Option. This specific episode is available on their archives page.

As I have time, I’ll continue to listen to a few more of the episodes, but on my first listen I wasn’t super impressed and would like to discuss my thoughts about the episode here:

I initially picked the episode about index investing because the title was intriguing. Typically when I think of indexing the word passive investing comes to mind. To me this means investing in certain sectors or the economy as a whole via mutual funds or ETFs that track the broad market. This could be done in lump sums, by monthly contributions, or even sporadically as available money allows.

I’ll recap and summarize the episode for you. To paraphrase:

The trouble with investing your portfolio passively in indexes isn’t the indexing or the passive investing, the problem is us, the investor. We have emotions. Markets do not decline in a vacuum and when they decline the news gets ugly. When you act as the portfolio manager of your investment portfolio, emotions may get the better of you. You end up listening to financial commentary tell you what they would have done (in hindsight) and you begin to question your ability to understand the markets. You typically then sell at a low and end up staying in cash when the markets may begin to rebound. Index investing is not auto-pilot…you become your own portfolio manager. The world of online execution makes it far too easy to make bad decisions and hit the eject button. I like to think that we have several layers before hitting the eject button. First, a client gets to a point of discomfort and they tune in and listen to our show. They hear why we bought that stock, which can ease their concerns. Then we might talk directly and I comfort them or at least ease their concerns a bit. And then they have to convince me to sell. 99 times out of 100, I’m going to convince them that that’s not their best option.

With a typical portfolio of 60% stocks and 40% bonds, the average annual return is 6%. However, over the long term the average portfolio will also go through huge declines and the 6% a year is not guaranteed. Issue #1: There is negative volatility and our emotions do not like that. Issue #2: Performance is discussed in returns and percentages but our portfolio is discussed in dollars. So the panic sets in way before you think it will. Say you have $1,000,000 and over the course of a year you lose 32%. At the end of the year you are at $680,000. To keep it simple you lost $27,000 a month for 12-months. Which brings you to issue #3… You begin thinking long and hard about how long it took you to save that money and all the things you could have done with it. And the fourth issue, the larger the portfolio, the more painful the loss because the longer you saved and the more dollars you lose.

That’s why it’s best for your kids coming out of college that learned in a textbook that indexing is the best option to try that at a young age because they don’t have much money to lose. And, issue #5. This market decline is not happening in a bubble. The housing market may be declining. People around you may be losing jobs. Industries are collapsing. Because of this your parents may need help with their finances since they just lost a lot of money as well. You may need to liquidate some of your retirement portfolio earlier than expected to help out. As of March of 2013, the S&P finally got back to the level it was in October of 2007. From the peak to the trough, the S&P 500 lost 57% of its value. Do you want to stomach that loss when you don’t have the luxury of hindsight?

I would suggest that your retirement account is the first place I would suggest increasing your stock exposure if you want to reduce your bond weighting. My rational is based on the following. The volatility is not as obvious because you are adding money every paycheck. And when I’m referring to volatility, I’m referring to negative volatility. None of us mind when there is volatility and its upward. Number two, when markets decline you’re buying in at lower prices which is exactly what you want to be doing for the longterm. Number three, you’re not as quick to make changes when the news turns negative. Oftentimes, your quarterly statements just get thrown in a pile to be opened at a later date. And that can sometimes be helpful. So I want to leave you with this thought. If you’re looking for opportunities in the marketplace, instead of strictly going to the S&P 500, I suggest doing some research and looking into the emerging markets because they could be a good asset class since they are negative year-to-date.

Okay. A lot of good stuff there. Some of it I agree with. However, a lot of it, including what I believe is the underlying premise, I do not. First let me say that I might be completely full of BS because I am not a financial advisor and only have taken a few economics classes in college. I also do not work in the financial industry and have no significant first hand experience that way. I’m a young 30-year-old radiology resident who is just beginning his investing career. I can say though that I am not trying to sell you any specific investing products. While adequately disclosed, The Wise Investor Show is produced by Robert W. Baird, a company which makes money by managing others people’s money.

My first concern with the podcast is that it implies that professional money managers are needed because they are the only ones that do not succumb to the emotions of the stock market. The podcast makes it seem that if regular people were managing their own finances, any little/big, real or perceived drop in the stock market would cause us all to sell too early or incorrectly time the markets. In the podcast she says that a professional service provides a cushion between the emotional common people and their money. Having read the latest edition of Malkiel’s famous A Random Walk Down Wall Street, I learned that technical and fundamental analysis overtime produce inferior results over passive strategies. And that actively managed mutual funds vary greatly in their success rates over the long term making it statistically unlikely that an average investor would happen to select those few mutual funds which will outperform their benchmark index over the long term. Reference.

So she wants us to pay a certain percentage every year to act as our buffer from selling? It does in fact seem that it is the case. Near the end of the podcast she explains why increasing the stock percentage in a retirement account is a good thing. It boils down to the fact that you are less likely to sell based on emotions in a retirement account that you don’t really pay much attention too since you just automatically contribute to it each paycheck. Dollar-cost averaging, or the means of buying more stock when the prices drop, is also mentioned as a positive. I completely agree with these statements. However, why can’t the same logic apply to a non-retirement account? Why can’t I buy more when the markets drop? Why can’t I contribute a bit from each paycheck? Why is my taxable brokerage account susceptible to emotion but my retirement account is not?

Regarding the statement: That’s why it’s best for your kids coming out of college that learned in a textbook that indexing is the best option to try that at a young age because they don’t have much money to lose. I completely disagree with this statement. It makes it seem like we are idiots not to pay for the services of a professional. Sure, index investing may not be the most sexy or potentially lucrative investment strategy, but the way this statement is worded implies that you will lose money through it and, therefore, it is best to try this when you are young and foolish and when it can’t hurt you too much. Regular savings and investing is a great way to solidify a strong retirement. The earlier you can start putting a little money away, the better. And what better, cheaper, and easier place to put your monthly contributions than in an index fund? It will be very hard (over the long term) to beat that simply strategy of starting early, spending less than you make, and investing regularly. Professional services can be very useful and definitely have a place in the financial arena. I disagree, however, that passive investing is considered a poor strategy in this podcast solely because it doesn’t give you the protection of someone looking over your shoulder.

Lastly, I just want to comment on the phrase, “negative volatility,” which was mentioned a few times in the podcast. I thought that this was maybe stated incorrectly at first because it is a misnomer (more later), but then she goes on to use it again and explain it in terms of being “positive.” I’m referring specifically when she says

“The volatility is not as obvious because you are adding money every paycheck. And when I’m referring to volatility, I’m referring to negative volatility. None of us mind when there is volatility and its upward.”

Volatility refers to the amount of uncertainty about the size of changes in a security’s value. It is a statistical measure of dispersion of returns for a given security. The higher the volatility, the riskier the security. (Volatility reference). Volatility can not be negative. It does not refer to the direction of movement, only the size of the movement. For additional information see here: Can Volatility Be Negative? Additionally, thinking of volatility as a positive thing, i.e., “None of us mind when there is volatility and its upward,” is equally as wrong for the same reason.

The estimated volatility of a security’s price is known as implied volatility. According to Investopedia, implied volatility increases when the market is bearish and decreases when the market is bullish due to the common belief that bearish markets are more risky than bullish markets. Therefore, I feel that her use in the podcast of negative and positive volatility are wrong for an additional reason. The first reason was that volatility is an absolute and can only be a positive number. The second reason is that, at least according to the aforementioned definition, a decreasing volatility suggests a less risky and more bullish market; conversely, an increasing volatility might suggest bearish sentiments. By using the phrase negative, what does that imply? It’s obvious that she was trying to convey a bearish market meaning dropping prices given the discussion on how our emotions would react. However, could it also mean negative as in decreasing volatility? In that case, it would be used incorrectly again as a “negative”-effect on volatility would mean a decrease in implied volatility, such as what would happen in a bullish market environment, which is not the scenario occurring in the podcast.

I will have to listen to some more shows because from my first time listening I was not impressed with her argument against index investing. She said nothing at all bad with the index investing strategy, only how people’s emotions could get the better of them, something that could happen in any type of investment device. It seems like her entire argument could be summed up by saying you should think twice before selling based on an emotional reaction and that you should talk to a professional if you are unable to show restraint in that regard.

What are your thoughts? Was I wrong in my interpretation of this podcast?

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