Humane personal finance guide
This article doesn’t contain any ‘pro-tips’ or ‘methods’ or ‘analysis’ on gaining from the stock market quickly. No, rather, this is an investment guide for average people who don’t — or won’t or can’t — participate actively and emotionally in the stock markets.
I will try to articulate few of my current thought patterns that have guided me on managing and thinking about my personal finance. So please tread carefully with open-minded skepticism. 🌈
The world is insanely complex
You will find academic papers, pundit blog posts, articles, smackdown on Bloomberg etc. that ostensibly came to a conclusion on a financial affair. Now ideally, you would want to review their accuracy yourself or refer to a trusted journal. But, can you trust yourself or even the journalists being completely infallible at all times?
If the answer was as ‘Nope’ as mine was, then what I tend to do now is to remind myself of the possibilities that:
The studies were conducted in a sanitized lab environment that was fed with idealized parameters in order to fit a running narrative.
The pundit and authors did not have your personal finance best-interest in mind. Why would they? They have no ‘skin in the game’ with respect to your money. They are more interested in selling in general, be it advertisement with their click-bait headline, or commission they would earn.
The media needed to dramatize their show to increase viewership and hence advertisement.
You might think that modeling methods like the Monte Carlo simulation or backtesting could guide our financial decision making. Yes, in a broad sense, modeling is really the best tool we have at our disposal to approximate the complex reality.
However, we need to be aware of its potential pitfalls:
The issue of overfitting—Having a model that seemingly traces the historical data points nicely, but extremely unreliable to predict the future.
Determination of the complexity sweet spot — for example, the number of relevant factors that we need to take into account of to make a confident prediction.
How trustworthy were the relevant factors, and how error-prone we are when estimating them? Mistakes made here will unpredictably increase risk.
Mainstream modeling also tend to ignore the main dynamic in our economics which is the human psychology or what Robert Shiller would call ‘animal spirit’. Until then, I would treat them as an exercise of theoretical purity that lacks bearing on the physical world.
Now, we have seen the following proverb commonly found in the fine print of funds’ prospectus:
The Fund’s past performance (before and after taxes) is not necessarily an indication of how the Fund will perform in the future.
But we tend to think along these lines instead:
“i swear, this time it will be different! i just know it!”
“damn! it’s been going up since last Friday! I want in on this before it’s too late!”
“oh look, this fund has had great performances year after year! I mean look at the chart, you see?!”
To understand how those thought patterns came about, we need to now shed light on our human nature that are often taken advantage by today’s special interest groups. 😧
We are born with cognitive biases
It has been well-documented that humans are prone to perceive and make judgements that are, in hindsight, irrational.
In a blink of an eye on our evolutionary timeline, we have constructed a world that is conducive to amplifying our instincts to our own detriments.
For example, the mutual fund industry has been largely driven by salesmanship, ever more so steering away from the spirit and duty of stewardship in serving investors’ best interest. And one surefire way to increase sales of fund’s shares is to trip up our emotions, perception, and fears of uncertainty. For example, a fund would commit the Survivalship Bias by removing, merging, and even renaming their under-performing funds in their report, giving the impression to potential investors that ‘wow! next year gonna be a good year too!’, thus making us well primed to buy into the fund.
Another sign of the time screaming salesmanship in the fund industry is the niche industry sector like clean-energy funds, or personality targeted ‘I wanna signal I have a moral high ground’ funds, or beta whatever it means funds. All of these products were designed to aid and abet to our worst instincts — and, we know that selling often go hand in hand with advertising, and guess who ends up paying for all that initiatives? Yes, you! The fund’s investor.
Another way our brain can play tricks on us is evident when we are looking at data like P/E ratio or uptick charts expecting it’s telling us a story or insight.
As 'big data’ and machine learning has become increasingly popular, we are now led to believe to have our decision and insights driven by the data. But 'data' alone without context is just meaningless information.
We might then be tempted to provide it context, trying to give it a 'body’, a 'persona’, a trained model that fits a data set, in short, a story that we can all rally behind to. However, during that process, we need to be extremely careful that we don’t fall for our biases to look for stories that never existed.
Now, for argument’s sake, let’s pretend we weren’t susceptible to cognitive biases at all. Which brings us to luck…
Luck is an underestimated factor in many aspects of human affair — From being born with great or average looks, savant or mediocre intellectual capacity and ability, into good or abusive family, into stimulating or slummy places, to the resultant extent of exploration or exploitation of an environment that will shape who you are and position in society, and to finally, the performances of a mutual fund manager.
It’s well known that the majority — in the ballpark of 80–90% — of actively managed funds will under-perform their benchmarks over a 5 to 10 years period. Mutual fund managers are humans too, and as discussed, they are undoubtedly shackled to their human nature in responding to fears, uncertainty, and incentives, all of which are culminated in timing the markets and huge portfolio turnover, and thereby incurring unnecessary costs and taxes on us!
Mutual fund managers, like Peter Lynch, who can consistently out-perform benchmark over the long term is extremely rare. Not only you need to pick the right manager, the manager herself would need to be picking stocks at the right time and place, be able to digest tons of information to build an accurate narrative consistently, and pull it off year after year. This is not something a mere mortal with 9–5 job is capable of even though for no reason they ended up on the right side of luck!
OK, so far, things are looking really bleak.
What are we going to do about it? How would an average person build her wealth and go on live her life in a world where we can’t trust ourselves and the financial charlatans out there?
Well, the answer is to just don’t play the loser’s game while keeping it extremely simple — buy and hold broad index stock and bond funds and just stay the course! That’s it. That way it keeps biases, temptation and whispers at bay while giving you the best shot at faring better than more than 80% of the mutual fund managers.
Alright, here is how we are going to do it.
Split your money into stocks and bonds
First of all, you would find some people advocating for exercising asset allocation as a first step to your investment journey. There is a few school of thoughts on how to go about it.
One popular approach is to split your fund allocation percentages based on which life stages you are on. The theory is that, each life stages could mean different level of risk capacity and risk willingness. For example, if you are in your 20s, then you might want to put more money in risky and volatile assets like stocks because of 2 reasons — one is that you would have more time to recover from mistakes and market downturns, and second, you wouldn’t have much funds to invest anyway so you don’t have much to lose.
Another popular approach is allocate a percentage of whatever your current age is into bonds, and the rest goes to stocks. For example, if you are 25 years old, then you will invest 25% into bonds and 75% into stocks.
However, I would just do 50% in bonds and 50% in stocks. You might be thinking “wut, fiddy-fiddy?? you serious?!”. But a simple heuristic like that is actually one of the few best strategies to coping in a complex world. Harry Markowitz, pioneer of the ‘modern porfolio theory’ that won him Nobel prize , alluded to this effect as well:
I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it–or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.
But, you know, you could always tilt towards stocks if it doesn’t prevent you from a sound sleep at night.
Choose a cheap broker
Now you are going to need a funds provider or broker to invest your money.
If you are lucky to have Vanguard operating in where you live, then go for it! Otherwise, choose a broker with no hidden but transparent fees.
Personally, I don’t have access to Vanguard, so I went with TD Ameritrade which charges only for a fee of 6.95USD per trade. That’s it. No inactivity fees or fees that incentivize active trading of your portfolio.
Buy broad-market index funds or ETF
OK, now you have found a place to put your money in. But whatever it is that I need to buy now?
Well, one central tenet in passive investing is to earn as closest to total stock market returns before costs. And investing in index funds or broad-market based ETF is a perfect tool to not only achieve whatever market returns to us, they also increase your net gain with their low expense ratio and tax costs.
At risk of committing the Authority Bias, here is a quote from Warren Buffett about index fund:
A low-cost fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth.
A great selection of ETF you can buy from TD Ameritrade can be found here.
Personally, here is how I have allocated all my investment money:
35% in total stock market — SPDR Portfolio Total Stock Market ETF (SPTM)
35% in total international market — SPDR Portfolio Developed World ex-US ETF (SPDW)
30% in total bond market — SPDR Portfolio Aggregate Bond ETF (SPAB)
Having built your total market portfolio, you could have a less than 5% as your ‘play money’ betting on stocks but no more than that!
Stay the course
Once you have your total market portfolio, now all you need to do is to **stay the course **and contribute a lump sum once in a while to avoid incurring broker trade fees.
It’s important to note that if you were not investing in the ‘index funds’ like those found in Vanguard, you would most likely be buying ETF, which behaves like a stock, from a broker, in which case, it’s important never to succumb to actively buying and selling them.
You could re-balance yearly or quarterly or do the tax-loss harvesting, but their benefits are, if not significant, debatable.
You are supposed to hold your market portfolio forever, only withdrawing it when you are retired. Don’t sell or buy it. Don’t touch it! 🌄
Some other advises
Pay yourself first to build a 6-month worth of ‘emergency fund’.
Put money in fixed-deposit or certificate of deposit that you might need in less than 5 years.
Maximize your EPF or employer 401k match.
Spend within your means.
Limit spending on vanity stuff.
It’s never too early or too little to start investing thanks to the power of compounding interest, which is also the reason why it beats investing late but in larger amount.
Reduce screen time and social media consumption.
Our limited capacity for ‘attention’ is the new commodity. Spend it wisely.
Stay away from debt except when buying a family house if you must.
Pay all your debts first.
Buy second-hand cars.
Save more than you spend.
Explore cheaper leisure activities like picnic or flying kite or walk in the park.
Keep learning to level up your marketable skills for higher salary(higher investment contribution too) and options in life.
Stay healthy. Eat well. Exercise regularly. Good quantity and quality of sleep. Drink more water.
Good luck and take care. ☘