When it comes to your investments, there are three things that can get you into trouble:
Let's spend a little time talking about each one.
You and I, as human beings, are funny creatures. To paraphrase Robert Heinlein, the famous science fiction writer, we are rationalizing creatures, not rational ones. Think about that for a bit. We know that smoking is bad for us, yet we do it anyway. We know that chips and salsa are to be eaten sparingly, but the US is now about the most obese nation on the planet. We know that if we just walked around the block a few times after dinner - while we wouldn't look like the guys and gals on the fitness commercials - we would be reasonably healthy. But we don't do that either. My point is that what we know isn't all that important. It's what we do with what we know that's important.
Back in 2002, an interest thing happened in the world of finance. Daniel Kahneman, a psychologist from Princeton University, won the Nobel Memorial Prize in Economics. A psychologist - a psychologist, I say again - won the Nobel Memorial Prize in Economics. And why? He won for his groundbreaking work on Behavioral Economics. If you want a fun and interesting book, check out Thinking, Fast and Slow. It's the book on his research and it became a best seller a few years ago. You'll learn how we are swayed in various directions based on how issues are framed, how we anchor to certain things, and how we see patterns that aren't really there...among others.
When it comes to investing, investments and money, our behavior can and often does get us into trouble.
Let me give you an example with one of my favorite stories. It involves tuna fish.
Imagine that every Saturday, you go grocery shopping. Normally, tuna fish is selling for $1/can, but on this particular Saturday, it's selling for $3/can. Now, how many cans of tuna fish are you going to buy at that price? Assuming the kids aren't starving, the answer is probably "NONE", right? Of course that's right!
Let's change the story a little bit. Imagine that the tuna isn't selling for $3/can, but three cans for $1. Now, how much will you buy? Odds are, you'll buy as much as you can store in your pantry! Why? Because it's on sale and it's a deal!
Why is it that we behave so differently with investments though? Why is it that we only want to invest when the prices have incrementally increased over the years...to the equivalent of $3/can? And then we don't want to buy when the investments are the equivalent to "three cans for a $1?"
Remember - at the end of the day - it's all tuna fish!
When you invest, it's important to pay attention to costs. And the fees that many active managers charge are very high. When you pay big fees, you clearly are paying out dollars that could otherwise have been yours. There's a bigger cost though....the opportunity cost of those fees.
By way of example, let's assume you have a $1,000,000 and can chose between portfolio A and portfolio B. Both portfolios earn the same 8.5% gross rate of return, but portfolio A is actively managed and has expenses of 1.5% year. Portfolio B is passively managed with expenses of 0.50% per year. At the end of 20 years, portfolio B is worth $791,272.68 more than portfolio A because of its lower cost.
When it comes to your investments in taxable accounts, there are five types of taxes you have to deal with...just at the federal level. When it comes to active vs. passive investing though, two of those taxes become particularly important.
One of the reasons that active investment management can be problematic is that, because of all of the trading, active managers turn what could be a long-term capital gain into short-term capital gain. For high income tax payers, that means that your tax bill can nearly double from 20% to 39.6% (not including the Net Investment Income tax).
When using evidence-based passive investing strategies, because of the lower investment turnover inherent in the approach, capital gain is more likely to be long-term capital gain.