Two good pieces in todays WSJ. The first is from Jason Zweig's column. He profiles the investor John Laporte. The secret to Laportes success? minimal trading. This complements one of the ideas discussed in the March 4 post - that those who tame their reflexive brain and trade less tend to perform better:

http://online.wsj.com/article/SB10001424052748704869304575103471269923964.html?mod=WSJ_newsreel_personalFinance

The second article discusses the growing movement to lower 401K fees.

http://online.wsj.com/article/SB10001424052748703943504575095632895464968.html?mod=WSJ_hps_MIDDLEThirdNews

Thinking and Feeling Part I

The second chapter of TM&YB starts the exploration of our brains functioning. Zweig argues that our best financial decisions are made by drawing on both the reflexive brain and the the reflective brain.

The reflexive brain is that part of your brain that reacts to external stimuli, sometimes within a tenth of a second. It has developed to protect us from risk in our environment. It operates below the level of consciousness.

This is important to understand because your reflexive system is so fixated on change it is hard to focus on what remains constant. For example, we react to a 100 point drop in the Dow, but we don't keep it in context that it is only a 1% drop. Academic studies have shown that investors who focus on price levels outperform those who focus on price changes.

The reflective brain organizes information, categorizes it and tries to develop patterns. But, you cant depend on your reflective abilities, they are limited by your memory and the complexity of the problem. Zweig argues, that through his experience, doctors and engineers are poor investors because they try to find patterns and they miss the unforeseen event that renders their system useless.

Zweig then summarizes this tug of war with the great example of how this works when investors choose mutual funds. Most investors focus on the flashy factors when choosing a mutual fund: mutual fund manager, recent performance, reputation. They ignore fund expenses, which rigorous study has shown to be the most critical factor in predicting future performance.

The Prescient are Few

The attached link is to an insightful summer of 2008 NYT article on recent statistical evidence that supports the argument that most investors should use index funds in their investment portfolios. If you do nothing else, to help your 401K/IRA or personal investment portfolio, read the first 3 short paragraphs.

http://www.nytimes.com/2008/07/13/business/13stra.html
(copy to your address bar)

I am not Warren Buffet, You are not Warren Buffet, Therefore Index

Last year I read Snowball, the biography of Warren Buffet. While learning about Buffet I was reminded, that success rarely comes from luck, or divine gift. Rather, it is a combination of natural advantages, hard work, and sometimes, a total commitment to a goal at the expense of everything else in ones life.

The same applies to investing success - as defined by consistently outperforming the overall stock market. Few achieve this standard, and fewer do so over an extended period. Warren Buffet is one who has had long term success. He is smart, but he also worked harder than most in the business. As a young man he spent weekends studying business reports and company financials in the records room at Moody’s (a financial analysis company). He asked and reviewed information nobody requested. He went to visit companies on weekends and interviewed staff and management. During a college course on investing at Columbia he knew more about the text book examples than the author/professor of the text. He sacrificed home and family life. He was notoriously cheap. Success came with great sacrifice.

Most stock market investors don’t commit to this level of sacrifice. So what is one to do if one wants to (or should) invest in the stock market? My answer is to accept average by investing in the total market through index funds. What do I mean by index funds? An index is a pre-defined collection of stocks that are designed to represent a sector of the stock market or even the whole market. When you hear that the Dow Jones Index was up 8% you are hearing that if you owned all 30 of the Dow stocks, you would have earned an 8% return. The Dow is a group of stocks that meet the definition of being the 30 largest industrial stocks in the US. It is an index designed to gauge the US economy. The S&P 500 is the 500 largest stocks in the US. It is a measure of the total US stock market. There is even an index called the Wilshire 5000 which is the total US market.

Starting about 70 years ago, people started studying the performance of pension funds – who were the primary stock holders in the country. What the studies found was that these funds, managed by the best and brightest investing minds, did not consistently beat the average return on the US stock market. Why? Well, If you think about the return on the total market, it is simply the average return of all the investors making decisions on the value of all the stocks in the market. It is the collective wisdom of every investor – including all the Warren Buffets in the world. So, an investor needs to be consistently better than average by an amount that exceeds their investment fees in order to outperform the market. If the market return is 8% and an investor earns a return of 9% but has fees that are 2% a year, the net return is only 7%. The same holds true for mutual funds. Mutual funds rarely beat their respective index over extended periods of time. In fact, the most efficient portfolio an investor can hold, from a risk return standpoint, is the total market. No other portfolio gives an investor as much return for its given level of risk.

For these vary reasons, I recommend that the core of any stock portfolio be an investment portfolio that looks like the total market and is either total market index fund or a collection of index funds that together look like the total market.

Your Money & Your Brain - Chapter 1

From Your Money & Your Brain, by Jason Zweig, writer for the Wall Street Journal. 


Your brain effects your investment performance.

In the book, Jason introduces the reader to the field of Neuroeconomics -the combination of imaging technology and psychological studies that have lead scientists to better understand humans reactions to risk. It explains why our investing brains often drive us to do things that do not make logical sense but make perfect emotional sense. Our brains were developed to survive - to react to risk. Our logical brain is no match for our reactive, risk protecting brain.

Scientists have found:

* Monetary gain or loss has a profound physical effect on the brain and body.

* The neural activity of someone making money is indistinguishable from that of someone high on cocaine.

* Financial losses are processed in the same areas of the brain that responds to mortal danger.

* Once people believe that an investment return is "predictable" their brains respond with alarm if the pattern is broken.

The key for investors and investment professionals is to understand the above psychological effects and better manage them. Many recent supporting studies indicate that the average investor severely under performs market benchmarks because of these effects.