WEALTH LOGIC, LLC A Random Walk Down Behavioral Finance

Allan S. Roth, MBA, CPA, CFP ®

July 15, 2005 © 2004, 2005 Wealth Logic LLC, all rights reserved ddd

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Warning!

This is not for the faint of heart! While economically superior to traditional investing under any levels of desired risk, it will not provide emotional excitement. This style of investing is not suitable for anyone demanding entertainment from their investing.

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Presentation Goals

1.

For us all to learn something…especially me. 2. Have some fun  3. Balance between creating some controversy and getting kicked out of the Investment Club.

CONTROVERSY ROTH BOOTED FROM CLUB ddd

Warning: You do not want to hear Roth talk for 2 hours!

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INTRODUCTION

RANDOM WALK VS.

BEHAVIORAL FINANCE

The standard theory

•

The rational agent of economic theory:

– –

has consistent opinions and beliefs

uses all available information unbiased by emotion, ‘herd’ effects

– – –

has coherent preferences

tangible motives (wealth, security) unaffected by ‘framing’ of problems unaffected by regret

Source: Daniel Kahneman (Nobel Prize Economics) ddd 5

Real agents

• • • • are overconfident, and mostly optimistic are unreasonably loss-averse are risk-seeking when facing the possibility of a certain loss tend to frame decision problems much too narrowly are prone to hindsight, and are not always efficient in learning from experience Source: Daniel Kahneman (Nobel Prize Economics) ddd 6

What Kind of slogan is DARE TO BE DULL?

• Emotionless investing designed to double your real return.

• It requires a paradigm shift that’s not for the faint of heart.

• It is for any level of desired risk, but only to get additional expected return.

…AND NOW LET’S GET GOING

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Wealth Logic on Investing

3 Key Points

1.

I’m Good 2. Get Real 3. Think Dull ddd 9

When it comes to market timing and picking winning stocks, I’m really good…

Point 1: I’m Good

•

…at forecasting the past!

• I can forecast the

PAST

with nearly 100% accuracy!

• It’s the future I’m so lousy at – and so is everyone else!

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SELECTING THE RIGHT STOCKS In 1973, Burton Malkiel compared portfolios carefully selected by professionals using sophisticated techniques (technical and fundamental analysis) and research to blind-folded monkeys throwing darts at the financial pages. Since then, many academic studies have “proven” the chimps are every bit as good as the experts. Unfortunately, these academic studies are FLAWED! Comparing experts to apes is DISPARAGING and DEGRADING … ddd 11

…BUT MALKIEL HAS NEVER APOLOGIZED TO THE CHIMPS

!

REALITY Most academic studies assume a theoretical world with no emotions, taxes, or transaction costs. In the real world: •Chimps aren’t subject to the same emotional need to keep throwing the darts creating more costs and taxes.

•Chimps will work for bananas – the experts charge billions of dollars for increasing risk and decreasing return.

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EXAMPLE

Money Magazine – Oct. 03 Top Picks from 24 Top Pros – Invest in the Best • Asked some “first-rate investing minds to share their best ideas.” • “We call this gathering of wise minds the

Ultimate Investment Club

.” • The 24 top pros identified 34 domestically traded stocks as their top picks.

• Each pick was backed by brilliant and compelling logic.

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THE STORY MONEY MAGAZINE NEVER PUBLISHED BUT THE COLORADO SPRINGS BUSINESS JOURNAL DID The Ultimate Investment Club destroyed 14% vs. the Market!

First Rate Investing Minds US Stock Market -2.4% +11.5% Twelve months ended August 31, 2004. Source: Calculated from Yahoo Finance - included dividend reinvestment. This included six stock picks listed on US exchanges but not included in the Wilshire 5000 Total Stock Index.

The 28 US domiciled stocks had a -7.6% return which lagged the index by 19%.

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TWO LESSONS LEARNED

1. Track record, brilliant minds, the most sophisticated technical and fundamental analysis, and every other thing that money can buy, was of negative value.

2. 34 stocks is not enough diversification to eliminate tracking error. Malkiel is wrong here!

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The Value of Expert Advice

The Wall Street Journal 4/11/05 ddd 16

The Value of Expert Advice

• • June 10, 2005

latimes.com

E-mailed • THE NATION Petruno, Times Staff Writer

: Business

E-mail story Print

Long-Term Interest Rates Buck Conventional Wisdom By

Most Tom The surest bet on Wall Street a year ago was that long-term interest rates would rise, boosting the cost of home mortgages and in general making credit tougher to get.

That forecast seemed to make perfect sense because the Federal Reserve was raising its bellwether short-term rate for the first time since 2000. Long-term rates usually move in tandem.

• REALITY: The WSJ Semi-annual survey of 50 Top economists predictions of long-term interest rates have been DIRECTIONALLY correct 29% of the time. ddd 17

The Score:

1.

Money’s top Advisors Picking Stocks

Sophisticated MBAs Chimps

X 2.

Wall Street Analysts “Sell” vs “Buy or Hold” X 3.

WSJ Top 50 Economists

Score 0

X

3

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Point 2: GET REAL...as in real returns

The individual investor will give away most of their real return!

Estimated Future Portfolio Returns based on Lower Tax Rates

4.5% 1.4% 2.0% 1.1% Real Return Less Fees Less Taxes Actual Real Return ddd 19 Source: Ibbotson Associates, Charles D. Ellis - Winning the Loser's Game (1965-1994). The actual Tax cost during the Period was 2.1% and this calculation was based on the new lower tax rates.

Point 2: GET REAL! Inflation Adjusted & Reality Based Investors barely beat inflation but think they are trouncing the market

7.5% 4.5% 1.4%

REALITY DISCONNECT

2.0% Real Return Less Fees Less Taxes ddd 1.1% Actual Real Return Perceived Real Return 20

Behavioral Finance

$1 Billion 1 to the person who finds the most patterns 1 2 3 4 A XXX XXX B C D XXX XXX XXX XXX 1 Not really  ddd 21

Behavioral Finance

a.

b. 1.

Which coin toss pattern has a higher likelihood of occurring ddd 22

Dogs of the Dow

WHAT HAPPENED?

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The Highest Correlation Ever Found: Butter Production in Bangladesh!

+

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S&P 500

Performance

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Behavioral Finance

• In college basketball, what percent of the time do you think the team behind at halftime wins the game?

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Behavioral Finance

• The NASDAQ plunge from the 1999 technology bubble was predictable: T or F.

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Hindsight Bias

– Who wouldn’t want to go back 15 years and revisit a decision to invest in a product that hadn’t changed in 50 years versus the leader in a technology that would ultimately change the way we all communicate?

Hindsight is almost 20/20

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Recent Hindsight Bias

• If on July 6, you had a crystal ball and knew on the morning of July 7 that there would be a major terrorist attack, you would: A) Get out of the market.

B) Buy more stock.

Even hindsight isn’t 20/20!

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S&P 500 After the Terrorist Attack

Terrorist Attack ddd 29

Behavioral Finance

The last time I went to Las Vegas, I think I: Won overall Broke even Lost overall Never gambled in Las Vegas Over the past few years, I believe I have: Outperformed the market as a whole Performed about as well as the market as a whole Under-performed the market as a whole ddd 30

Behavioral Finance

Never underestimate our ability to believe what we want to believe. Remember the Beardstown Ladies? They were an investment club claiming that by using common sense, they earned an incredible 23.4% annual return for the 10 years ending 1992. It was an amazing and compelling story, but after writing five best selling books, someone actually went back and looked at their data. Instead of the celebrated 23.4%, their return was actually about 9%, barely more than half the market return! Anybody heard from the Beardstown Ladies lately?

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Behavioral Finance • The average AAII member reports they beat the market by 3% annually.

– Fact or the “Las Vegas Effect”?

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Behavioral Finance

1.

You have been given $10,000 and bought 100 shares of two different stocks at $50/share each. Over the next month, one stock moved down to $25/share while the other moved up to $75/share. If you have to sell one stock, which do you sell? a.

The $25/share stock b.

The $75share stock ddd 33

Behavioral Finance

Below is a brief summary of Behavioral Finance

Economists view the goal of investing as maximizing economic wealth. Yet behavioral finance shows investors are being led by their feelings and achieving sub-optimal economic gains.

Heuristic biases are mental shortcuts that cause us to make systematic mistakes. Even after we make these mistakes, we are usually not aware of them and continue to systematically make them.

Examples of these biases include:

Overconfidence and Optimism - In ourselves or expert advisors. Data Mining – Finding patterns out of randomness to predict the future. Anchoring - mentally locking in a price even though it is now irrelevant.

Hindsight Bias

– Predicting the past as if one knew what would happen.

Fear and Greed – Running from a down market and toward a bull market.

Mental Accounting – Believing we are doing better than we are.

Status Quo - Aversion to change.

Point 3: Dare to Be Dull

®

A New Investing Paradigm OLD PARADIGM Exciting & Feels Good NEW PARADIGM Dull, but Doubles Real Return

• • • • • Investing is Complex.

Your investments need constant monitoring & a big team of professionals.

Sophisticated products are superior.

Hard work pays off.

You think you are only paying 1% fees but are paying far more in hidden costs and unnecessary taxes.

ddd • • • • • Investing is radically simple.

Investing is long-term & requires little monitoring.

Simple, ultra low-cost & tax-efficient vehicles are far superior.

With a properly designed portfolio, doing nothing will be your hardest task.

Cutting fees, hidden costs, & taxes will produce wealth for you.

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What does Warren Buffet have to say?

“Over the past 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns. All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous….

Investors should remember that excitement and expenses are their enemies.

”

2004 Berkshire Hathaway Annual Report

Dare to be Dull sm Framework 1. Behavioral Finance (Psychology) 2. Efficient Investments (Mathematics ) 2a. Asset Allocation MPT 2b. Diversification 3. Pick the low hanging fruit Copyright © 2004, Wealth Logic, LLC. All rights reserved.

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Mathematically Superior Wealth Accumulation 37

1. BEHAVIORAL FINANCE (Psychology)

The entire plan is developed with an understanding of the behavioral aspects of investing for both the client and the investing public. It is important to understand that we are all programmed to do the wrong things regarding investing.

2. EFFICIENT INVESTMENTS (Mathematics)

A portfolio is designed to achieve a high expected return for a given level of risk using two tools:

2a. Asset Allocation:

Determining the client's willingness and need to take risk and then selecting non-perfectly correlated asset classes that maximize the risk return equation.

2b. Diversification:

Within each asset class, maximum diversification reduces overall risk without impacting expected return.

3. PICK THE LOW HANGING FRUIT

Most portfolios have ample opportunity to make easy changes to get greater returns without taking additional risk. Some portfolios actually have opportunities to seize guaranteed higher returns with lower levels of risk.

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MATH…and other boring stuff that can have you earn double the real return of most investors.

• RISK OF ASSET CLASSES • RISK OF INVESTMENTS WITHIN ASSET CLASSES • CORRELATIONS – BE AS BAD AS YOU CAN BE!

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What asset class has the most risk?

1. CASH 2. BONDS 3. STOCKS

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80.0% 60.0% 40.0% 20.0% 0.0% -20.0% -40.0% -60.0% Stocks - Best Stocks - Worst Bonds - Best Bonds - Worst T-Bills - Best T-Bills - Worst 1 66.6% -38.6% 35.5% -21.9% 23.7% -15.6% 2 41.0% -31.6% 24.7% -15.9% 21.6% -15.1%

Real (Inflation Adjusted) Returns 1802-1997

5 26.7% -11.0% 17.7% -10.1% 14.9% -8.2% 10 16.9% -4.1% 12.4% -5.4% 11.6% -5.1% ddd Stocks - Best Stocks - Worst Bonds - Best Bonds - Worst T-Bills - Best T-Bills - Worst 20 12.6% 1.0% 8.8% -3.1% 8.3% -3.0% 30 10.6% 2.6% 7.4% -2.0% 7.6% -1.8%

# of Years

source: Stocks for the Long Run 41

HOW DO YOU MEASURE THE RISK OF A STOCK?

Fama – French Three Factor Model

• Beta (& CAPM) • Market Cap • Value vs. Growth ddd 42

CORRELATIONS

Imagine you live in a simple world where a year is either sunny or rainy and there is a 50% probability of either. You review two stocks. How would you construct your portfolio?

Golden Tan, INC (GTI)

• Expected return – (+10%) • Return on sunny years – (+30%) • Return on rainy years – (-10%)

Rainy Day Umbrellas (RDU)

• Expected return – (+10%) • Return on sunny years – (-10%) • Return on rainy years – (+30%) ddd 43

The Perfect Portfolio in my “Simple World”

• A portfolio of 50% GTI and 50% RDU would earn 10% every year.

• If you did not rebalance, your expected return would drop.

– A simple average 10% return does not equate to a geometric 10% average. • Compare a portfolio that goes up 20% one year and 0% the next to one that goes up 10% each year.

– The power of rebalancing is not to be ignored.

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In the real world, the best we can hope for is low correlations

Correlations of Asset Classes (10/96 -12/04)

(R 2 )

International Small Co International Small Vaule International Value International Small Co International Small Value International Value MSCI EAFE

1.000

0.968

0.706

1.000

0.719

1.000

MSCI EAFE

0.569

0.523

0.858

1.000

S&P 500 S&P 500 US Large Value US Small Cap

0.251

0.253

0.382

0.221

0.278

0.317

Source: Dimensional Fund Advisors 0.481

0.501

0.405

0.642

0.462

0.498

1.000

0.691

0.489

US Large Cap

1.000

0.368

REITS and Metals are also great diversifiers

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Nonetheless, low correlations combined with tax and cost efficient rebalancing give you a mathematical boost!

It also makes you a contrarian investor in a way far superior to the DOGS.

Wealth Logic Investment Club

It would be so boring that even I wouldn’t join!!!

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So How Do the Leaders of Each discipline invest?

Random Walk • Investing is radically simple.

• Investing is long-term & requires little monitoring.

• Simple, ultra low-cost & tax efficient vehicles are far superior.

• With a properly designed portfolio, doing nothing will be your hardest task.

• Cutting fees, hidden costs, & taxes will produce wealth for you.

Behavioral Finance • Investing is radically simple.

• Investing is long-term & requires little monitoring.

• Simple, ultra low-cost & tax efficient vehicles are far superior.

• With a properly designed portfolio, doing nothing will be your hardest task.

• Cutting fees, hidden costs, & taxes will produce wealth for you.

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So what does this all mean!

Think like an institution and Dare to Be Dull

® 1. Understand your

emotions

on investing.

2. Stop making others rich and capture as much of the market return

capitalism

has to give. Then let the

magic of compounding

take over.

3. Keep investing as

simple

as possible and

costs dirt low

. You will

get what you don’t pay for

!

4. Quit paying

unnecessary taxes

.

5. Diversify

and understand your willingness and need to take

risks

.

6. Pick the low hanging fruit

– FREE MONEY!

7. Dare to give up the illusion

and build wealth!

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Summary

1.

I’m Good:

Like all sophisticated MBAs, I’m nearly as good as the chimps at picking stocks and market timing. Don’t pay to increase risk and decrease return.

2.

Get Real:

Think in inflation adjusted returns and be realistic on your performance. How much of an expected 4.5% real market return do you want to give away?

3.

Think Dull:

If you are getting excitement and entertainment from your investing, you are probably making other people rich.

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To those sophisticated gurus and money managers leading people to pick winning stocks and time the market:

THANK YOU!

Your seductive appeal to our basic emotions is what keeps the stock market efficient and allows us to double the real returns of those that trust in you. I need you!

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CONCLUSION

1.

If you want excitement in your life, try parachuting!

2.

But if you want to build wealth for yourself,

DARE TO BE DULL ®

To learn more, visit: http://DareToBeDull.com

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