The average investor underperforms both the markets themselves and their own investments. Today, Lou Melone of Melone Private Wealth joins RJ King of D Business magazine to break down why. Much of it comes down to behavior. Investor's thoughts trigger their emotions, emotions define behavior, and behavior determines performance.
Through 26 years of financial planning, incorporating data from Dalbar, Lou has developed a model for the anatomy of investor returns, made up of five parts.
Human nature often responds to a stimulus. And the fear response of the amygdala in our brain will bypass our higher brain functions. This is what saved cavemen from being eaten by sabre toothed tigers. Unfortunately, today, that fear comes from strategists, friends, family, and the financial media. And it takes planning, practice, and education to override this natural, fearful response.
Lou and RJ break down 5 behaviors, or cognitive biases, that plague investors. They are Loss Aversion, Mental Accounting, Anchoring, Herding, and Availability Bias.
Volatility is an often-misunderstood part of the markets and investing. Often, investors confuse market volatility with risk. Lou explains the difference, and why volatility can be a good thing.
Retention Rate is often affected by market conditions - and investors often abandon their strategies in both good and bad times. And while there's always someone claiming they can time the market, it's never worked consistently in the long term.
Finally, RJ and Lou break down returns by asset class, including stocks, bonds, T-bills, gold, and the US Dollar. Higher volatility tends to lead to larger long-term returns.
Behavioral investing boils down to psychology, and this is why it's so important to work with a Financial Planner. In our next episode, we will explore what to look for when hiring one.
Resources:
Lou Melone's book, "Unpack Your Financial Baggage:" https://www.amazon.com/Unpack-Your-Financial-Baggage-Misconceptions/dp/1948237776
Melone Private Wealth Website: https://www.meloneprivatewealth.com/
D Business Magazine Website: https://www.dbusiness.com/
RJ: Lou. It's good to see you again.
Lou: Thanks RJ. Good to have you back.
RJ: Now, the last time we spoke about the foundations of financial planning, the fundamentals of behavioral investing, and the pressure people feel. We also talked about the actual numbers that demonstrate the value of behavioral investing and the value of an advisor.
Now, we are going to take a deeper look at what makes up returns. And today's topic is the anatomy of investor returns. Give us the shorthand before we jump in Lou.
Lou: Well, I think it begins with a simple question. Why has the average investor continually, not only underperformed the indexes, but their own investments?
RJ: When you talk about average investors continually underperforming, are there historical precedents or is this a new concept?
Lou: Well, it goes actually as far back as you could go back to tulip mania in Holland, back in the year 1865, when the market price for tulip bulbs, believe it or not skyrocketed. I think the highest price was for this rare, they call a Sempra Augustus and the price was 30,000 Florins.
And what that translates to is about three times the value of an Amsterdam house at that time. You can then move forward, to the great recession of '07, '09, or more recently would be COVID. All of these have allowed the average investor to underperform, according to Dalbar, and the returns over the prior 30 years, the S&P index did about roughly 11% per year, over these 30 years.
And the average investor did about 7%. So some real quick definitions are probably needed here. So who's Dalbar? They're the financial community's leading independent expert for evaluating or rating business practices and customer performance since 1976. So the next question we have to define for everyone is how do they define the average investor? Because we're gonna be talking about them a lot.
So the average investor refers to really the world of all mutual fund investors, their actions and financial results are stated to represent a single investor. So what this does, it's allowed Dalbar the entire universe of mutual fund investors to be used as a statistical sample, ensuring the highest reliability.
RJ: So this has been going on for a while. The most logical follow up question to help solve the primary question is what encompasses an investor's return?
Lou: Well, first thought it seems to be rather simplistic concept, right? You take excess money. You place it into some form of entity. You allow that entity to grow and then over time you get your money back, plus whatever growth or interest you earned on that entity. Right?
Well, it turns out it's not quite that simple when you dissect all the moving parts that transpire between money going in and the end result.
RJ: Why is that Lou?
Lou: Well, investors' thoughts trigger their emotions, and then their emotions define their behavior and their behavior is gonna determine their investment performance.
Author Nick Murray has stated that the dominant determinant of long-term, real life returns is the behavior of the investor themselves.
RJ: What are these parts that make up the anatomy of investor returns?
Lou: It's a model I've developed with the data from Dalbar over 26 years of financial planning, which are five different components.
One is the stimulus. The behavior, the volatility, the retention rate. And then finally the asset class, these are the five pieces.
RJ: What can it do for someone once they understand it? What are the practical applications for someone who's thinking about retirement, or even in retirement?
Lou: You know, it helps pull them out of the emotional cycle that they may be feeling regarding the retirement plan.
And it's those emotions that continually blow up their long-term returns. Here's what I mean. Human nature is a failed investor, meaning we're all emotional beings who don't make logical decisions consistently. This model provides structure and it helps refocus our mindset, especially during times of uncertainty or stress.
Unfortunately many families, they don't have a financial plan and this model can help them begin to hopefully understand why a plan is critical. If followed by their family, with their CFP, meaning certified financial planner. It can provide a pathway to financial success. Rather than what's happening now, which is behaving themselves out of a successful long-term retirement and leaving that legacy for those that they cherish most.
RJ: When people hear about this model, are they more or less likely to want to have a financial plan? Do they connect the dots, and does it put them at ease?
Lou: Most people, they know retirement is something they wanna experience at some point. they wanna have it and they wanna have that planned, right? But they don't know the anatomy of their returns, which is a component of the plan.
They know there's uncertainty and, they can't quite express the anxiety that they feel in tangible terms. So this model I feel helps address those concerns.
RJ: Why this model why is this important to you? I can hear the passion in your voice and clearly this model is personal for you.
Lou: Well, you know, there's a couple reasons. Financial planning isn't only about helping families have a plan to retire, but to stay retired comfortably.
Although today we are discussing the anatomy of investor returns. Quite frankly, the investment return is the last component in a comprehensive financial plan, which it has three components. In this order of importance, first goals, next, the plan, and only then the portfolio. Unfortunately, human nature gets it backwards with obviously the help from financial media in our conditioning.
So said another way, they think more of its ready, fire, aim type mindset. Families, what they can do is, they can craft a beautifully diversified portfolio. It's anchored to their plan and long-term goals only to blow it up in times of both market euphoria or panic. So by doing so their plan may never recover.
So this was, and is, both frustrating and fascinating to me. The model has been a blueprint to assist them in finally understanding how real returns actually work. And as a CFP, in an independent RIA with a fiduciary responsibility, I've always wanted an objective, fact driven approach to investor long term returns.
RJ: Fiduciary. Independent RIA. Tell us more about what that means. How is it different from the local brokerage investment firms? And why would someone want to work with an RIA, or someone who is a fiduciary?
Lou: A fiduciary has an obligation to do right by the client in placing the client's interest first, always. And in every aspect of the planning process.
Now, this seems like a common sense idea, right? Well, that hasn't always been the case in our industry. Let's just say, the larger broker firms aren't held to this high level of objectivity. They tend to be more... it's called product driven, rather than planning driven. We can dig into these specifics more on a future podcast, which we'll put together, called how to choose an advisor.
RJ: So how did you come up with the anatomy of investor returns? What is the origin story and what are the types of data you looked at?
Lou: You know, 26 years of financial planning has given me the experience with many different family dynamics. But a lot of the questions, the fears and the challenges people face, they're very similar. You know, the best way to explain how important the development of this model is, is that for many people, the single most important issue they face now, financially speaking is retirement. Retirement's a topic that brings relief, confusion, and fear to many people, which is why we ask, and then we help answer the question of will your money outlive you, or will you outlive your money? I also wanted to develop a model people could really easily understand. So compiling these observations, the history, data, you know, psychology and behavior how and why people make decisions in actually just listening to people.
There's so much information I looked at to really try and understand human nature.
RJ: Well, that's a lot of research. I can see now why it took this many years to develop. Why is it different than other models?
Lou: It provides the client with a simplistic understanding of why they shoot themselves in the foot, you know, repeatedly. It explains a process combining the data and human nature. For example, it's the rational brain versus the intuitive brain. And by understanding the history of rational versus intuitive behavior, you can become aware of your shortcomings cuz you know, we all have 'em.
RJ: Before we start to define the model. How has the model been received so far? Lou?
Lou: Well, knowingly and unknowingly. We find people who reacting to it positively. Oh, that's great.
RJ: What do you mean by that?
Lou: Well, when advising clients it's applied to them daily in real time. So as a result, at least 99% of the time, They refocus on their plan.
And after the conversation, it's almost like a sigh of relief, or a comment like, okay. That's why it's good to discuss this with you. With all of my concerns, I feel so much better now. So that's the knowing or unknowing, I should say, that's getting applied to save them from themselves in these extreme times.
Both. Whether it's euphoric times or like the dot com bubble or panic bottoms, like COVID or the great recession. And that one, the great recession was, I would have to say the most challenging of my career. It took every bit of energy I had to keep 'em focused. If you remember, the markets dipped 57% over 17 months almost to the day.
So at times I think I was the only beacon of light in that end of the world, as we know an event, which was according to every media outlet out there. So they heard me say these words a lot, which was, "Don't do that. You are gonna regret this." So the knowingly is when I've presented this to groups that, that have asked me to speak about financial planning or behavioral investing, you know, the visual model puts everything together, seems easy for their clients or for them to understand.
So we've been told. That it does simplify a lot of the terms they've heard and now they can finally understand. So as an example, volatility versus risk, there's a lot of anxiety around those words, and this model breaks down volatility for what it actually is and what it's not.
RJ: When people see the data, the history, the elements. Where do you think they struggle the most with, in adapting to this kind of thinking?
Lou: It's just counter-cultural. Meaning, we're conditioned by both our past, in the financial media to believe the exact opposite.
RJ: I'm assuming we'll get into those things later. Let's get into the model. Where does it start?
Lou: Well, I think we need to look at behavioral finance or what they call neurosciences for help. A better understanding of the brain usually leads to a better understanding of economic decision making. You know, our own experiences as humans clearly suggest that we don't always act rationally according to what they call standard economic theory.
So under the influence of strong emotions, stress, or even really, for no reason, we can knowingly pinpoint, we've all made decisions that we've later regretted. Studies have shown that the pathway for the fear response in the brain bypasses these higher brain functions, including the ones we usually associate with rationality.
So basically, we fear things for reasons outside our conscious rational mind, and we do it because we have no choice. We're psychologically hardwired to do so. Whether it's the behaving, thinking, reaching conclusions, and making decisions with the effects of the emotional brain, always running in the background.
RJ: Wow. So where does this all take place?
Lou: Well, it's called the amygdala, it's a small structure that's located deep within the brain and it's the part of the brain that functions in linking, okay. "What's important?" It's linking memories to fear. It also has a direct connection to the brain stem, which is the central switchboard for all the muscles in our body.
So this neural, call it shortcut, from fear to physical movement is what allowed in the, call it the early days of man, not to get eaten by a sabre toothed tiger. Fortunately those days are gone, but, the mechanism still remains. So what's fascinating, the amygdala, it's the reason why we're afraid of things outside our control.
It controls the way we react to the certain stimuli or an event that causes an emotion, we see, that could be potentially threatening. Now this is whether it's real or just perceived to be real.
RJ: Well, let's start with the stimulus. I believe you call it the virus that affects your rational thinking.
Lou: Although we're no longer running from, as I mentioned before, the sabre toothed tigers. However, the stimulus we're running from financially elicits the same physiological response.
In other words, when it comes to financial decisions under stress, we act like knuckle dragging Neanderthals.
RJ: Why do you say that?
Lou: Just as thousands of years ago on the Sahara plains, if we heard a rustling in the tall grass, the amygdala would tell us run, because if you thought rationally about it, thinking, is that a tiger?
Or maybe it's the wind or the... Wham! The tiger took your head off. So the modern-day breed of tigers are wall street strategists or economists, short term prognosticators, also the daily headlines that pull and have that sensationalization to it, or just friends and family. So for example, if you're looking at, let's call it economic predictions, which even the best and brightest struggle, statistically, to be accurate more than 40% of the time. Yet we hang on every word spoken.
Meanwhile, the economy is uncorrelated to the markets over all periods, but the very longest. Let me explain that one. Let's say you knew in the short run, what the economy was going to do next. You'd still, as an investor, have no clue as to what the markets would do. So we're gonna go back to the great recession. So at the bottom of the great recession, if you'd been asked how the economy was, let's see, what's gonna perform over the next handful of years.
And by some freak coincidence, you knew the answer, you probably would've said something like this. Let's say over the next roughly four years we'll have the slowest economic growth ever. and GDPs gonna grow. I don't know, one to 2% and unemployment's never gonna get under 7%. Now, based on that glowing outlook as an investor, what would've you have done?
RJ: Well, that doesn't sound like a good investment environment to me.
Lou: Right, exactly. And most investors park their money in a money market or checking savings account for the next four years. And this is all according to past tracking of where people actually move their money. While at the same time, the equity market actually went up about 140%.
RJ: That's interesting. Now, investor behavior, how the stimulus or virus affects your thinking, how does that work?
Lou: Try and visualize the stimuli. We just spoke about racing into your brain. Now the gears in your brain begin to turn. The first one is behavior. Again, information leads to thoughts, which leads to feelings, and result in an action when discussing investor behavior. You know, it's real helpful to first understand the thoughts and the actions that lead to what I would call bad decision making. Investor behavior is not just simply buying and selling at the wrong time.
It's the psychological traps. These triggers that cause investors to act irrationally. And that irrationality leads to buying and selling at the wrong time, which then leads to under performance. Dalbar had found actually nine distinct behaviors or what's called cognitive bias that plague investors based on their personal experiences and unique personalities.
But for the time we have allotted, I'll focus here on, on really what I would call the big five. So when we're stimulated by fearful information, we hear again, or see, that triggers that fight or flight mindset. Remember like, going back to the cavemen we discussed, which leads to behavior that reflects the uncertain or anxious or just irrational investor, it leads them. So it's leading them to react due to a short-term media driven crisis. I would say.
RJ: Where is this information coming from?
Lou: Well, it really can come from anywhere. But the primary driver is the financial media.
RJ: Well as a member of the business media, I guess we can trigger a lot of emotions and behaviors. Tell me more about the behaviors.
Lou: When it comes to assessing the stimulus, humans often fail to make rational decisions because again, our brains take these mental shortcuts, which are called heuristics. These can prevent us from making the correct choice. So let me make one more point clear for everyone here is these irrationalities I'm gonna keep and have kept bringing up.
They don't make us irrational people, right? It makes us normal human beings. So the behaviors that will talk about here are the five, the first one being loss aversion. The second one is mental accounting, anchoring, herding, and then availability bias are the ones. Now to give an example briefly of each one, is with a loss aversion studies have proven that humans feel the pain of loss two times more than the pleasure of gain.
And our brain, as I mentioned before, can't define the difference between a real0life loss or a perceived loss, which is why investors look at their statements at the end of each month. And everyone's done this and said, oh my God. I lost X amount of dollars. Well, no you didn't, but that's that loss aversion that's playing in our mind.
The next one is mental accounting. Now mental accounting is real simple. We categorize money or spending into different let's call mental buckets in our brain that can get us in trouble. And a good example of that is anyone who's ever been to Las Vegas, right? You go to Las Vegas and mentally, at some point you have in your brain, what you're willing to lose. You think you're gonna win, but you're not, but that's that mental accounting. That's your play money in your brain. And in our industry, I see this a lot with inheritance or monies that come from different generations.
So what happens is those monies are mentally, in your brain, they're put in a different category. than money that you worked for every day, meaning you go to your job and you work. So you spend those dollars differently than monies that have been inherited. Because again, I don't wanna say they're play money, but they go in that same mental bucket.
The other one would be anchoring. And anchoring really is, simplistically, we lock in a price for an item, that all future decisions are then anchored to. Now, they did studies back, which it was called imprinting, where they took baby geese called goslings. When they hatch actually the first person, it's not a person, it's their mother, right?
That they see they're imprinted to follow that person around. It's anchored in their brain. They also did that same study, the person that did it, actually the first thing the gosling had seen was this person. And they followed this person around all over the place, cuz it was imprinted in their brain, that that actually was their parent.
I’ll give you a more simple example. Smoke Detroit. RJ, you and I went to Smoke Detroit, right? Great event.
RJ: Awesome.
Lou: When they do the auction. What's interesting is they always anchor a price of what they believe or want you to believe its value is some are, say priceless. Some say whatever the figure is, but now that price is anchored in your brain. Now, Dan Ariel had did a study in his book that said, actually, those don't become imprinted or anchored until you start to contemplate, that you're going to bid on it or to buy something. So that's anchoring.
Herding. It's real simple. We've all heard the herding mentality is when we're uncertain about what to do, we look to others for direction. So, you know, in the animal kingdom, it's real simple. Going back to the Sahara. If you're a zebra, you wanna be on the inside of that herd because you're afraid that you're gonna get attacked. Or how about highway construction? If you've hit the highway construction in an area and there's cones all over the place, guiding you, you tend to follow the traffic right?
Of where they're going, hoping they're going the right way. That's kind of that herding mentality. And then finally the availability bias. Now availability bias... Our thinking is most influenced by whether it's relevant or recent or especially dramatic events we've experienced. So simply. We remember the potential pain.
So two examples of that, the great recession. I remember right after the great recession that when the market dipped temporarily. That availability bias pulled that relevance or recency of that painful event or the great recession and everyone got nervous. I'll give you another one. Shark Week. Everyone knows Shark Week. That comes up and is, I think it's a Discovery Channel when Shark Week comes out.
People believe because of the recency of the Shark Week that they just watched, there's a higher probability, dramatically, a higher probability of getting eaten by a shark only because it's recently plugged into their mind because it's available. So, you know, it's a good time to start to kind of paint or refresh the formula here for the investor returns.
So the stimulus enters, and as that investor behavior begins to increase. Volatility begins to increase which again, the next gear begins to turn.
RJ: So speaking of volatility, Lou, can you walk us through how investor behavior affects market volatility?
Lou: Volatility is perhaps the most misunderstood part of financial planning, investing in the markets.
It's a major component to feeling financially secure, no matter the new "end of the world" crisis that they're talking about. It's the understanding of not only what volatility is, but what most investors believe it to be in the primary misconception, comes with confusing risk with volatility.
RJ: Okay. So we have risk and market volatility that seem interchangeable and both can be perceived to be bad. When the media uses these terms, and as humans, we tend to not like volatility because of its unpredictable nature. And we tend to avoid risk because it seems dangerous, you know? We generally talk about smoothing out volatility or lessening risk. Lou, does market volatility, equal risk, or perhaps more importantly. How do you define risk and volatility?
Lou: The short version is volatility is the day to day fluctuations. And risk is your money runs out before you do, or not reaching your goals. That's risk. However, the widely held misconception in the investor's mind is that market volatility or the, we call it the current roller coaster, equals market risk. The current volatility that can be brought on by everything from, COVID concerns, high inflation, whether it's interest rate increases they're talking about or government spending or whatever comes next, what they've done is all this, these areas have pulled the market back as much as close to 24% from its peak, just as we speak.
With this temporary pullback comes, again, I would call the siren song of the financial media that it's Armageddon and it's time to move to cash. However, what's interesting is market volatility may be the thing that helps the long-term investor in their journey through retirement. And by hoping away volatility the investor's unknowingly trying to remove the primary determinant that provides an income they cannot outlive. What always makes me laugh is when a market strategist or whoever from some wall street firm gets interviewed by a host on CNBC. Who's trying to get shocking information about the market, and where it's gonna go.
Of course, that day where it's gonna go. Then ask something like, what do you see happening here? It's interesting. You watch a strategist and they pause as if to give some new earth-shattering profound information. And they say something like, I think we'll have a 10% drop sometime this year. Soon, the host looks amazed, obviously for the audience, of course.
And they say something like, "Really?" as if they just got the breaking headline of the day.
RJ: Why is that amusing to you?
Lou: Because according to JP Morgan, they had this guide to the market's research and since 1980. It's very important. Since 1980, on average, the market pulls back. Again, drops temporarily about 14% per year from peak to trough, meaning top to bottom.
So again, at some point since 1980, every year between January 1 and December 31st of that calendar year, you get a dip. Again, it's temporary. Now my amusement to this response is always, really, oh, how genius of a person this must be. You know, this is as common as waking up in the morning. So it's time to turn the channel.
Remember that over those same years, again, going back from 1980 to the end of last year, the equity market has been positive 32 of the 42 years. I mean, that's close to 80% of the time. So what we have here is, say it with me, is volatility. It's not risk. And volatility is what Warren Buffet has been quoted to saying, something to the effect that a market downturn doesn't bother us.
It's a great opportunity to increase our ownership of great companies in good prices. So as a side note, if you're gonna listen to someone on long-term investing, he's the guy. His return, believe it or not, has been 20% per year since 1965. And the index, the S&P, has done about 10%. So let me say it one last time. Volatility is the normal everyday fluctuations that the equity markets experience. Common is dirt. It's been happening since Noah's been looking for tar to caulk his boat. Embrace it.
RJ: That's a good one. Now you talked about data and numbers. It would be great to put a number on volatility and the emotions we feel. Is there such a thing, Lou?
Lou: Yeah, it's actually called the VIX index, or more commonly known as the investor fear index. And VIX is a symbol for, it's the Chicago board options exchange, CBOE, volatility index, which it shows the market's expectations of 30-day volatility. Now that data shows that there's a direct correlation between the VIX spiking like it did in COVID and the increased volatility in the markets, which in turn leads to a pullback.
When you chart these things one above the other. It's interesting to see as one spikes, meaning the VIX, the other, the market drops almost every single time. So you've heard the phrase surprise is the mother of panic. This is its proof. It's graphed out so close even an engineer would be impressed by its accuracy.
RJ: So next up is retention rate or how volatility affects your retention rate. Could you walk us through that Lou?
Lou: Sure. So over the past 10 years, equity mutual fund investors have rarely managed to stay invested for more than four years. When they've done so, it's been during periods of bull markets.
Remember bull markets are good markets. Historically, the data shows that the average mutual fund investor lacks the patience to stay invested for a long enough period to execute a long-term strategy. So typically. It's just for a fraction of this market cycle. As a more recent example in, let's say in 2019, marketing conditions caused an expected effect on retention rates, which was an increase in all areas.
And it was due to low volatility. Unlike 2020, when the retention rates plummeted as a pandemic hit, which increased the volatility and uncertainty, it dropped to an all-time low. It actually came close to the 1987 crash, which was 0.8, which was eight months according to the data from Dalbar. So what tends to happen is investors withdraw funds when markets decline or there's a fear of a crisis.
So again, whether that is real or just perceived to be real, the effect of the increased withdraws, it reduces the retention rate. So when retention rates decrease, that asset class, let's say equities or stock funds, no longer provides the investor the returns it has historically given. Hence my saying of behaving themselves out of the returns that they deserve.
RJ: So Lou, you mentioned earlier asset class and how retention rate affects your asset class return. What has been the historical returns on each asset class we choose to own?
Lou: Well, according to professor Jeremy Siegel from the Wharton School, he has a book titled "Stocks for the Long Run." Now, if you ever wanna know the facts about asset class returns, this is the book.
I mean, it goes far back with its data, back to 1802, believe it or not. And what that data reveals is the following: Stocks, the broadest index of stocks tracked back then the total real return. Now, when I say real return, I mean, after inflation. So the total real return on the broadest index of stocks available since then has been 6.8% per year since 1802.
Again, that's after inflation. If we look at bonds, the total real returns on an index of us government bonds, has been about 3.6% per. If we look at bills, T-bills, total real return of US Treasury bills has been about 2.6 per year. Gold. The real return on gold has been 0.7. That's a point. 0.7 per year. And the dollar, if we track just the dollar, the purchasing power of one US dollar has averaged negative 1.4% per year.
Although, you know, I touched on this earlier. It's a good refresher to remember that the long-term return of each asset class is historically tied to the level of volatility that it's going to endure.
RJ: So what do you mean by this Lou?
Lou: Think of it this way. Let's say your money market or checking savings. Okay. How much volatility do these have? I mean, none. And they shouldn't because you need those dollars to pay your bills every day, right? So as a result, how high of a return do you receive on those dollars that are invested in your checking savings? I mean, as expected, it's basically zero. Now it's coming up a little bit, but it's basically zero.
Now we go to bonds or what we call fixed income, right? What type of volatility do bonds exhibit? Now it's higher than money markets, your checking, savings, but usually nowhere near the daily swings that stocks provide. So as a result, what has been the historical return of that asset class? Again, it's been about 3.6% after inflation.
Now we move to stocks, right? Call it the S&P 500 index. So if you look at their volatility in the short run, just look at this year. Massive amounts of volatility can happen with much higher swings than both bonds and cash as a result. What has been the return on that asset class?
Historically, like I said, it's been 6.8, so almost 7% per year after inflation. Now, if you wanna know the return, the gross return add roughly about 3%, all those numbers I've given you because inflation historically has been about 3%. So allow me to further explain. So a reason equities...and we talk about stocks when I say equities... have historically provided better returns compared to other asset classes, such as bonds or cash, can be directly correlated to its volatility. So let's step back a moment when we break it down. So if an asset class doesn't have, or has little volatility, its price movement becomes correlated to a fixed asset, such as cash. You know, again, thinking of your checking savings now, knowing this historical correlation and understanding the average retired couple retiring at age 62 today will have a high probability that one of them may live another three decades in retirement. As the cost of living continues to rise again through these decades, the only rational conclusion is that they need the market volatility of an asset class that can provide the historical growth that's necessary for them to maintain their lifestyle in retirement. Simple example, take a look at the cost of a US Postage stamp in 1946. Why? 1946. It's really the beginning of the baby boom generation.
Now look at it. Now in 1946, the US Postage stamp was 3 cents. Today it's like 60 cents. This is real life chewing away at your purchasing power. Conversely, what happens is many investors. They go into retirement knowing that they have a set lifestyle, right? That expense to cover, but they feel uncomfortable with the volatility that those equities bring.
So as a result, they place way too much money into fixed income assets because they feel better today. What they don't understand is that they're increasing the probability they're comfortably going broke, over what could be three decades of retirement.
RJ: So what do you mean by that?
Lou: So again, a fixed investment portfolio. What happens is it lacks potential for growth. Typically that's required to keep up with those rising costs of living. And this is one of the real risks of retirement, outliving one's income. I know what the audience may be thinking. Did he just tell us and put a hundred percent of our money in stocks and retirement?
No, the answer is no, I did not just say that. You need to speak to your advisor, preferably your planner, to build the correct diversified portfolio for you. However. I believe it needs to have equities be a component of the overall mix, because it has to battle that beast of inflation, meaning again, the cost of living.
So these simple facts, the market volatility may not equal risk and understanding the difference between the two will hopefully allow the average investor to be able to not only stomach the current ups and downs of the markets, but actually hope for more ups and downs. With this, I guess we could leave you with one more of the Warren Buffet quotes, which is he states that something to the fact that look at market fluctuations as your friend, rather than your enemy. And author Nick Murray, he's always said that there is a direct correlation between an asset class's volatility and its historical long-term return. And there is an inverse relationship between certainty and return. So the more uncertainty the investor can stomach, the higher that investor's long-term return has been historically speaking. So simply stated if you wanna hire long term return, you must embrace uncertainty.
RJ: That's great Lou. Now it sounds like investor returns are dependent on, and I'll sort of break it down into five parts. One. How do you let the stimulus or virus affect you? Two, your behavior after exposure to the stimulus. Three, market volatility as a result of your behavior. Four, what your retention rate is, and five, an understanding of what asset class you should own.
Lou: You got it. I mean, the psychology that drives investors is always essentially the same. Investor behavior is triggered by some form of stimulus. Again, either a geopolitical event, previous market experience, these news stories, the tips, and again, it distracts investors from their long term. that outside stimulus. Again, we could call it wall street, strategists, economists, financial media, triggers your unconscious behavior, which then increases the overall volatility in the markets.
Now, due to that increased uncertainty volatility, investors begin to sell their most volatile investments and they leap into what? Bonds and cash. When the herd then piles all of their portfolio into bonds and cash. Their long term return is going to be reduced based on the historically lower level of returns, again, after inflation, that that asset class has provided according to Jeremy Siegel back to 1802.
So what we're doing here is we're now confirming the data that Dalbar has provided over the last 30 years. Meaning the average investor has behaved themselves out of close to 40% per year. Once again, sad, but true, as history shows us. Now, you know why financial planning is essential.
RJ: That was a great encapsulation Lou. Turning to our next conversation, what will we cover on the next podcast?
Lou: The next step we need to take is really, is your advisor actually planning for you? Or selling to you? We'll talk about what to look for when you're ready to hire a financial professional. What that title, so to say, that they have really means. And always a big question is how do they get paid for their services? And everyone would definitely wanna know that.
RJ: Well, thank you, Lou. That concludes this podcast.
Lou: Thanks RJ.