Posts Tagged "tendency"
Mentally Spending Your Next Raise Before You Actually Get It
One thing I’ve noticed with some people is that they get progressively more stressed about money the older they are. That should come as no surprise. But it’s also no surprise that people tend to earn more and more money as they get older too. So shouldn’t things get less stressful?
One (of the many reasons) for this phenomenon is the tendency for people to mentally spend future increases in income ahead of time, which is similar to how people will tend to spend exactly what they earn now (if not more).
If you earn $50,000 (after tax) and you spend $50,000 after tax and you know that you are getting a $5,000 raise in the next three months how likely are you to use the increased income to better your financial situation? Do you commit the extra dollars to accelerating your debt repayments or funnel it towards savings and investing? Or do you plan on spending $55,000?
I’ll offer up a compromise: take half the increased take-home pay and put it towards savings or debt repayment and use the other half to scratch your itch to spend.
Something is better than nothing, but until you break the cycle of spending every penny you have coming in the door every future raise just means the knife-edge you are balancing on is higher and higher up from the ground.
Read MorePicking investments based on past performance
Invariably people will see a ranking of highest performance funds for the last year or so and ask “Are these good funds?” Others will just go and blindly buy them. In fact, there is a huge proportion of investors out there who base most of their decision on the past performance of an investment alone. They do not research any further than the performance report for the last year. This is no different than gambling in my eyes!
To paraphrase a quote I once heard, if all that was involved in achieving the highest rate of return was looking at past performance – librarians would be the richest people on earth! Last time I checked, they were not (at least on average).
In fact there have been numerous studies that have looked at mutual fund rankings year over year. What they all find is that the #1 performing mutual fund over the last year will be very close to the worst performing fund the next year. These studies are numerous and they all have the same results. In fact, the worst performing funds also have a tendency to shoot up the rankings the following year.
So what does this tell us?: That you cannot blindly look in the newspaper and look for last year’s best performing fund and expect it to give you the same performance every year. In fact, if you take nothing else away from this post take this: Next time you see a mutual fund returning over 50% in the last year, take a look at it’s 5 and 10 year averages. If the longer term averages are, say closer to 10%, then doesn’t it stand to reason that to revert to the mean will require some dismal performance in the future?
What I’m really trying to advocate is that you should take some time to get advice and do some research on what you are buying. I’m convinced that people take more time choosing between fridges for their house than they do their long term investment selections! I realize that a lot of people are quite intimidated by the task, but do your due diligence! Again at the very least, if you are still going to go out and buy yester year’s hot performer – ask for a professional’s two cents on the fund first! Even the fund company who sells the fund will tell you not to expect the performance to continue forever!
Risk: Systematic Risk vs Non-Systematic Risk
This is an advanced level topic – you may want to skip this post if you are just finding your feet with respect to finances! It assumes a basic understanding of portfolio diversification…
With respect to any given stock market there are two types of risk (which is another word for variance according to Modern Portfolio Theory): 1) Systematic Risk and 2) Non-Systematic Risk. Systematic risk is the general ebb and flow of the market – kind of like the tendency for all stocks to get dragged down or move up in tandem at the same time to a certain degree. For example, the 1987 market decline was a Systematic event in that it really didn’t matter what you owned, it probably went down. Is it warranted? Yes and no, but a main thing to consider is that nothing probably happened to any one stock to make it lose value in and of itself that day, but rather there was a general expectation or fear of a downturn in the economy linked to the market that caused everything to move. SYSTEMATIC RISK CANNOT BE DIVERSIFIED AWAY.
Non-Systematic risk CAN be diversified away. The best way to describe it is to build an analogy. Let’s say you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned 100 stocks, and 1 comany went bankrupt you would have lost 1% of your portfolio. On the flip side, what if that one company doubled in value? You either doubled your money or only gained a measley 1% if you held 1 stock or 100, respectively. So this analogy builds a case against diversifying too much, but making sure you diversify a little. Non-Systematic risk is like the individual risk associated with the company linked to the stock – if it goes bankrupt – that is non-systematic risk and has nothing to do with the general ebb and flow of the market overall.
So, I mentioned that non-sytematic risk can be diversified away. It is generally debated as to how many securities you need to hold to get rid of non-systematic risk. You see, just as one company might go bankrupt, one company in your portfolio might double in value. And one company might increase by 25% and one might decrease by 25%. So most recent research papers tend to think that 15-20 securities is enough to get rid of non-systematic risk. They suggest that trying to diversify by adding more securities than that is pointless as you may be adding stocks that do not have as rosy a prospect as the initial 15 or 20. They further argue that for those that over-diversify by having 100 securities from the same market have bought alot of garbage for the sake of diversifying and will not reap the same long term returns as someone who has been more picky with their money.
Since it is agreed that non-systematic risk can be diversified away, and systematic risk cannot – it is plain to see that the goal for a rational investor is to do just that. So the debate is really how many securities do you need to eliminate non-systematic risk? For now, I would tend to agree that 15-20 is optimal within any given market to eliminate non-systematic risk. Anything beyond that and you are buying ”filler” and reducing your long term rate of return – truly an irrational goal! :)
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