There is a difference between luck and skill and knowing when you are just lucky and when you are successful due to skill is of paramount importance as an investor.

For instance, let’s say you correctly called the flip of a coin five times in a row. What are the odds that you will correctly call the next flip?

Correctly calling five flips in a row might be considered a “hot streak” and lead you to believe that chances are high you can correctly call the next flip. Well, assuming it is a fair flip, there is, of course, only a 50/50 chance that you will be correct because flipping a coin is a game of known probability. The fact is the coin flip has no memory of your hot streak.

And, just like a coin flip, an investor who is on a “hot streak” may simply be lucky.

With millions of investors, odds are that some of them will make winning investments numerous times in a row.

If these winning investors were, in reality, just lucky, but they think they were actually skillful, then that is when the situation turns problematic. The lucky investor may start to think they are infallible and get stubborn when the market turns against them.

Eventually, when the lucky streak ends, it will likely mean serious losses for the investor.

The best antidote we know of to the danger of confusing luck and skill is to remain humble. When our investment strategy performs well, we are very thankful. When it doesn’t perform well, we accept this as part of the market cycle.

The investment business has an uncanny way of turning hubris into painful losses. We think humility is a safer route.

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Investors are driven by the fear of losing and losing out.

Last winter, as the financial markets were seemingly in a free fall, panic and fear reigned. There was a sense that the worldwide financial system could collapse and that the problem was bigger than the government’s ability to solve it. This fear of losing spurred more selling and it became a vicious cycle – until it stopped.

Today, it’s a completely different picture.

The banking system is back from the brink. Liquidity is improving. The S&P 500 index is up about 50% from its March low. And, the economy is showing definite signs of coming back to life.

Ironically, fear is also returning to the markets. However, it is not the fear of losing money; rather, it is the fear of losing out from making a big killing as the markets recover.

Both types of fear have the ability to dramatically move the markets.

To state the obvious, humans are emotional. For example, we’re emotional about relationships, about work, about politics, about religion, about food, and, of course, about money.

As humans oscillate between the fear of losing money and the fear of missing out on making it, we tend to drive the financial markets much lower and much higher than “reason” might dictate.

The tricky question facing investors right now is, “Will the fear of missing out on a big rally drive this market even higher as investors who have been on the sideline decide they have to get in?”

Back in the late 1990s, the technology-led stock market bubble took stock prices to an unprecedented level that was far higher than justified by “fundamentals.” Could history be repeating itself?

Interestingly, as of last Friday, the S&P 500 index was 22% lower than it was 10 years ago.

For the bulls, this suggests the market still has lots of room to run higher and is in no danger of being in bubble territory.

For the bears, they point to a near 50% rise and say it’s time for a breather.

Ultimately, you should strive to take the emotions out of investing. Your investments should be a means to an end as defined by your personal financial plan.

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Sunk costs and mental accounting can be hazardous to your wealth.

Imagine you just arrived at a theater and as you reach into your pocket to pull out the $10 ticket you purchased in advance, you discover that it’s missing. Would you fork over another $10 to see the movie?

Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the theater, you discover you lost a $10 bill. Would you still buy a movie ticket?

In these two scenarios, you effectively lost $10, but here’s where it gets interesting. Psychologists Amos Tversky and Daniel Kahneman of Princeton University conducted the above study in 1984.

They discovered that only 46% of the study participants in scenario one said they would spend another $10 to buy another movie ticket. However, a whopping 88% of the subjects in scenario two said they would still spend $10 to buy a theater ticket.

Here’s what happened.

More than half of the subjects in scenario one created a “mental account” for the theater ticket. They equated the $10 they spent on buying the ticket in advance with the additional $10 they would have to spend to replace that ticket and concluded that the theater ticket actually would cost them $20. Paying $20 for a $10 ticket was a non-starter for 54% of the study participants.

Conversely, in scenario two, 88% of the study participants did not create a “mental account” that equated the $10 theater ticket with the $10 bill they lost on the way to the theater.

But, as you can see, in both scenarios, the study participants still lost $10.

So, are humans completely irrational?

Sort of. The participants who lost the theater ticket succumbed to the “sunk cost” trap. They let the price they paid for the lost ticket affect their decision to buy a new ticket even though the two are technically unrelated.

Investors frequently do the same thing.

They buy a security, watch it go down, and then tell themselves, “as soon as it gets back to breakeven, I’ll sell it.”

But, the fact is, a losing security is a sunk cost and there should be no commingled “mental accounting.” Instead, each investment decision should stand on its own and be made based on the most current information.

Remember, you don’t have to recoup a loss in the same way that you generated it. Sometimes it’s best to take a loss and move on to a more promising investment.

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Would you agree that the stock market has been volatile in the last six months?

As you may have guessed, that’s a bit of a trick question. Most people would say that, yes, the stock market has been very volatile since early November 2008.

For example, just from November 7, 2008 to November 20, 2008, the S&P 500 index dropped 19%. It then rallied 24% by January 6, 2009.

But, that was just a tease. Between January 6 and March 9, the S&P 500 index dropped a frightful 28%.

And, just when people thought the financial system was coming to an end, the index turned around and proceeded to rise a whopping 37% from the March 9 low to last Friday.

It’s enough to make your head spin.

But, let’s assume for a moment that you went into hibernation for the past six months and slept right through this volatility. Would you wake up happy or sad about your portfolio?

Well, if your portfolio performed similar to the S&P 500 index, then you’d wake up essentially the same as you went to bed, meaning, there was no net change in your portfolio. Surprisingly, from November 7, 2008 to May 8, 2009, the S&P 500 index moved less than 1%.

That’s right, after netting the 19% drop, the 24% gain, the 28% drop, and the 37% gain, the index is essentially flat.

One of the keys to being a successful investor is to get neither too depressed when the market is down nor too euphoric when the market is up. Checking your portfolio on a daily basis can lead to a daily dizzy spell while checking it on a less frequent basis may help keep you on an even keel.

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One of the biggest ironies in investing is that all the information and wisdom needed to invest successfully is readily available – but so few people ever actually use it.

Instead, we let our emotions take the lead, and color our judgment with panic. That’s why responsible wealth managers spend so much time calming clients down, and pointing them towards the wisdom they need to do well.

And that’s why I’d like to share a little of that wisdom with you today!

A  June 2008 MarketWatch article published the following 10 investment rules developed by Bob Farrell over his many decades in the investment business:

1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras – excesses are never permanent.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
5. The public buys the most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
8. Bear markets have three stages: sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree, something else is going to happen.
10. Bull markets are more fun than bear markets.

There’s never been a better moment to heed this advice than today.

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“History does not repeat itself exactly, but behavior does,” according to legendary Wall Street veteran Bob Farrell

The economy is going through a recession, as it does periodically — but this recession is different from the last few our nation has experienced. Some economists have likened it to The Great Depression — not so much in terms of magnitude, but rather its structural characteristics.

It’s nothing short of dangerous to use the excuse that “this time is different,” to justify an investment stance that makes a dramatic break from established historical perspectives (e.g., buying tech stocks in late 1999).

Does history repeat itself?

But it’s often quite true: usually something is different every time we see an unusual market event.

And it’s that ability to discern a truly unique market phenomenon from an excuse for bad decision-making that separates good investors from great investors.

While we can’t count on history repeating itself exactly, as Farrell says, we can at least count on investor behavior remaining the same. We’re only human, after all.

This is why we see investors make the same emotion-based mistakes during this bear market as they did in bear markets previous.

How do I take the emotion out of my investment choices?

Resilient investors overcome the tendency to plan investments emotionally, rather than logically.

The key is to be aware that your emotions will, at times, block your ability to make reasoned, rational decisions. With this new awareness, you can slow down your decision-making processes until you separate the “good” investing information from the “bad.”

With a little extra time and thought – and less “emotion” — you will create a solid investment portfolio that stands the test of time.
photo credit: milena mihaylova

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“I don’t have ten years to wait for the market to recover. I’m retiring next year!”

Sound familiar?

As the difficult market continues to evolve, the media doesn’t hesitate to make predictions about how long the path to recovery will be — which is why those on the verge of retirement end up petrified.

Once they dig down into the process of establishing true retirement goals and figuring out their choices, however, many near-retirees come to recognize that they can, in fact, wait for the market to recover.

Why is “selling low” such a temptation?

Many people on the verge of retirement are doing just that: selling their stock holdings, permanently locking in losses, and re-investing those deflated funds into fixed income at historically low rates.

Unfortunately, this very emotional reaction is the result of:

• Not properly defining retirement goals
• Buying into negative media forecasts – which are often based more in hype than reality
• Believing there is no time to wait out a market recovery

While your principal may be safe in fixed income investments, your purchasing power is not. The income from these investments simply cannot keep up with the rate of inflation at 3.6% in 2008 and 4.02% over the last 30 years.

What should your real retirement goals be?

Your true retirement time frame shouldn’t resemble the panicked quote at the beginning of this article. Unfortunately, many line up their retirement goals with the difference in time between today’s date… and their retirement date.

Instead, think of the day you retire as the day you begin achieving your goals. You want to prepare to:

• Generate income over 20 to 30 years or more
• This income must increase purchasing power each year

In other words, a wise retirement goal time frame extends decades beyond the retirement date. If you want to create an income stream that provides you with purchasing power every year, you’ll need to craft a diversified investment strategy.

A fixed income investment strategy will simply not work.

Can you really wait for the market to recover?

As I write this on February 17, 2009, the S&P 500 closed at 789.17, down from the October 9, 2007 high of 1565.17.

Suppose the market takes ten years to return to this level.

In order to make this happen, the market’s annualized return would need to be 7%, based on price alone, and not including dividends. The S&P 500 currently yields 3.20%. If you add in dividends, the total return is 10.20%.

That’s right — by waiting for the market to recover, you give yourself (and your retirement income) the chance to earn much more than any fixed income investment could over the next ten years.

Of course, market returns are not guaranteed and will vary going forward. But.

The truth is, you can and should wait for the market to recover if you are planning to retire.

By defining wise retirement goals, building a diversified portfolio — and understanding the deep impact of media “scare tactics” on your perspective — you’ll be on your way to a more comfortable, productive retirement planning process… and becoming a resilient investor.

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How would you like a guaranteed return of 13.25% per year for 25 years?

Sound too good to be true?

Well, yes… in today’s market? That is too good to be true.

However, about 25 years ago, that’s exactly the kind of return the U.S. government offered.

On May 15, 1984, the Treasury department auctioned off $5 billion of 30-year bonds (callable after 25 years) with a fixed coupon rate of 13.25%.

You could have purchased bonds — with the backing of the U.S. Government — that would have guaranteed a double-digit return for at least 25 years.

In the context of today’s financial landscape — with 30-year Treasury bonds yielding less than 3% — that is nothing short of incredible.

How was the 1984 bond market possible?

So exactly why were government bond yields so high back in May 1984?  How has everything changed so dramatically in the meantime?

In the 1970′s, phenomena like the energy crisis, double-digit inflation, stagflation, recessions, and a general malaise were deeply ingrained in the national psyche. This reality, coupled with the failure of Continental Illinois National Bank and Trust that same month, made investors reluctant to lock up their money at a fixed rate.

To entice money out of the proverbial mattresses of wary investors, the government had to offer a high interest rate.

Hindsight being 20/20, buying and holding that 30-year government bond would have been a brilliant investment.

However, today, we face almost the exact opposite predicament with the 30-year bond. Though it promises to yield less than 3%, investors are climbing over one another to buy it.

So are investors who buy 30-year bonds at today’s low yields making the same mistake as investors who were too scared to buy 30-year bonds at a 13.25% yield 25 years ago?

Are they doing the wrong thing at the wrong time, yet again?

As advisors, we gain an invaluable education from watching how times and investor behaviors change — and how fear tends to play a prominent role in the value of investments.

Back in 1984, people feared locking their money up at a historically high interest rate because the memory of the previous decade’s bad news was still fresh in their minds. And that same fear of losing money has driven down the yields of 30-year bonds to near historic lows, because investors are ardently seeking out the safest investments possible.

At the end of the day, it’s quite possible that declines in the stock market over the past year have led us to a situation similar to the May 1984 bond market.

More specifically, a climate of fear — along with a legitimate economic crisis — has caused a dramatic and undeniable drop in the stock market. But will we — perhaps 10 years from now — look back and say, “I wish I’d bought stocks back in 2009″?

We may not know the answer to that question for a while yet – but as with everything, it’s important to view present-day events within a historical context.

As George Santayana said, “Those who cannot learn from history are doomed to repeat it.”

photo credit: allyrose18

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