A Building-Block Of Understanding For Market Participation

by: Roger Nusbaum

The Pragmatic Capitalist had a very interesting post the other day (hat tip to long time reader RW) that explores what might be a realization that many people are not the investors they think they are but are actually savers with the big difference between the two (as defined in the post) that the saver should target a far more humble goal of a positive real return. The post further posited that for most people, their equity exposure represents an allocation of savings.

Part of the equation is the basic cognitive and behavioral quirks that we all have that serve to hurt returns. There was also a plug for taking a more holistic approach to life of which investing (or saving) should only be a small part. This last bit is interesting to me but the post didn't go very far in this direction.

The building block for the saver/investor issue is one we've discussed many times here. An adequate savings rate, going along for the market's ride, proper asset allocation and not doing anything stupid will get the job done for most people. Another point we've gone over is that not everyone is comfortable with normal stock market volatility. Anyone choosing an asset allocation with a less than normal exposure to stocks (maybe a range of 50-75%) should understand that something will have to give as a trade-off for forgone growth opportunity. The simple answer is a higher savings rate.

Often when I post this sort of commentary someone will say that I am making the case for indexing and of course someone disposed to indexing will see it that way. Again though, I would call it a building block of understanding to start figuring the manner in which you will participate in markets. You may buy one index fund for stocks and one for bonds or you might spend your day scalping nickels on 2000 share trades but the starting point is the same. If you start as an indexer and become impatient then you will probably try to learn about alternatives. If you scalp nickels 20 times a day and do no better than market-equaling returns then you might look for a strategy that gets a similar market-equaling result with less work, time and expense.

I look at this building block and conclude that the chart (I drew the chart on Paint, it is not real) above is my objective. It is a visual representation of what I have referred to as smoothing out the ride. If one can be successful with this approach then they are less likely to panic (avoiding the full brunt of large declines) and an unlucky (in terms of timing) emergency withdrawal should have less of an impact. For example someone having an emergency in March 2009 would do less long term damage taking out 15% if the portfolio was down 30% instead of 56% (the SPY bottomed out with about a 56% decline).

As far as balance in our lives such that investing is only a part of what we do, investing obviously has an element of problem solving embedded in the task. The need to problem solve is ongoing in investing. I believe that problem solving in things unrelated to investing enhances our ability to problem solve in things that are related to investing.

In the last three months our fire department has had three structure fires, one wildland fire, several medical calls and a search and recovery call. Setting aside that our department has never been that busy since I've been on board, each type of call requires situational awareness to interpret and process what is happening, know the capability of your resources, know what external resources are available, remember your training and of course perform the actual task required. Well that is a lot of problem solving and hopefully it helps with my day job.

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