By Jason Zweig | July 24, 2017 10:13 pm ET
Image credit: John William Waterhouse, “Ulysses and the Sirens” (1891), National Gallery of Victoria, Melbourne
So far as I know, no one has yet completely cracked the difficult problem of how to get people who say they are long-term investors to be long-term investors.
Most people who claim to have “a high tolerance for risk” just have a high tolerance for making money. As soon as the market goes down, their tolerance for risk shrivels and their idea of “the long term” withers to “a week or two.”
Almost everyone is happy to stay invested when markets are rising, but how can we lock investors in ahead of time so they will stick around even when their investments are losing money?
Back in the 1980s, Twentieth Century Gifttrust, a fund specializing in small growth stocks with high potential returns and equally high risks, required investors to sign a legally binding contract that locked them into ownership for a minimum period — often 10 years and more. Investors loved the fund during the bull market of the 1980s and 1990s, often boasting about how satisfying it was to own a fund that would protect them from their own worst instincts to bail out every time there was a temporary downdraft in the Dow. Then came the bear market that began in 2000, in which Gifttrust generated huge losses. The same investors who had liked being bound to the fund suddenly hated it. Many of them tried breaking the contracts and, when Twentieth Century understandably declined, they sued. Eventually Twentieth Century had little choice but to shut the fund down.
I think that both carrot and stick are probably necessary.
The obvious carrot: We could get investors to improve their behavior if we offered frequent rewards and incentives for doing the right thing. Instead of offering free trades to people who trade frequently, as so many online brokerages do, investment firms could offer benefits to the people who traded the least often within, say, a calendar quarter. Once those little bonuses started piling up over time, I would expect investors to be reluctant to break the chain of earning them.
One form of stick: Redemption fees that penalize people for selling prematurely appear to be effective. It’s common for mutual funds to charge a 1% or 2% redemption fee — paid back into the fund, for the collective benefit of all the continuing shareholders, rather than to the manager — on shares that an investor sells in less than 90 days. Such sticks hurt just enough to work as a disincentive to selling without deterring people from buying in the first place or unfairly limiting access to their own money. There’s no reason why those fees can’t be higher, or stretch farther into the future, to encourage investors to extend their longer-term horizons.
Financial advisors and investment committees could also try a simple technique for preventing clients from making changes out of sheer panic: erecting a physical obstacle between investors and their impulses. Every client should have an investment policy statement or IPS, a written description of the philosophy, strategy, asset allocation, and implementation of the account. That’s nothing new. However, in my opinion, advisors and committees should go beyond merely writing an investment policy statement. They should print the IPS on paper, fold up the original or master copy, and store it in a glass box (which you can buy online for less than $50) emblazoned with the words IN CASE OF EMERGENCY BREAK GLASS.
I mean it, word for word: If the market crashes and a client or member of the committee wants to sell everything or make drastic changes to the portfolio, any action must first be authorized by rewriting the previously agreed investment policy statement — which is locked in that glass box that can be opened only by smashing it with a hammer. Hand the hammer to the person who wants to take drastic action. (Trust me: This person probably will be a “he.”) Ask him if he is sure he wants to break open the glass and then to put in the work of revising the IPS to conform with his changed perception of the market. Finally, ask the other people present if they agree. If so, then give him the go-ahead to smash away. But no one can change the portfolio without first rewriting the IPS accordingly. And someone had better be prepared to clean up the broken glass.
Here’s a column I wrote many years ago, when I first started thinking about these issues.
Tie Me Down and Make Me Rich
Money Magazine, May 2004
One of the hottest self-help bestsellers right now is David Bach’s “The Automatic Millionaire.”
While it pushes some pretty daffy notions, the book also advocates a sensible idea: Every month, have a fixed amount (say, $100) beamed electronically from your bank to a mutual fund. This dollar-cost-averaging technique will painlessly boost your savings; you will never need to write a check, scrounge up an envelope or lick a stamp. You’ll save without lifting a finger.
When stocks are cheap, your $100 will buy more; when they’re expensive, it will buy less. As the years pass, those slow but steady purchases should grow into a tower of wealth.
And yet, at T. Rowe Price, only 10.3 percent of investors with taxable accounts use an automatic investment plan. At Vanguard, roughly 3 percent do. All this got me thinking: Dollar-cost averaging is indisputably a great idea, so why is it so hard to do?
Don’t fence me in
First of all, the numbers are not as bad as they look. If, like most investors, you have a 401(k), then you’re already dollar-cost averaging, since the money from your paycheck gets invested right after payday like clockwork.
But something else is going on. A team of economists, including Andrew Caplin of New York University, recently conducted a fascinating survey. They asked some people to imagine winning a sheaf of gift certificates for dinner at any fine restaurant. The certificates would expire in two years.
Caplin’s team asked whether anyone would be tempted to use so many certificates in the first year that they might kick themselves in year two; 25 percent admitted that they would. The researchers then asked how many people would be willing to accept certificates that were usable only in the second year. Just 7 percent said they would.
In short, we know darn well that we ought to set something aside for a rainy day; we just don’t want to.
“People don’t like tying their own hands,” says Caplin. “That notion that you’ve lost some flexibility can be overwhelming.”
And automatic investing exposes you to a potential regret. “When you choose [to invest] slowly over time,” says Santa Clara University finance professor Meir Statman, “You’re concerned that in hindsight you’ll find out that you could have gotten rich quick by putting all your money in at the beginning.”
Fill your buckets
University of Chicago economist Richard Thaler points out that people will sign up for a 401(k) and then use their other accounts “to park any money that happens to be left over. For most people, most of the time, that means zero.”
In other words, we have a hard time setting money aside without a specific purpose in mind. Thaler’s argument is bolstered by data from T. Rowe Price and Vanguard, both of which report that a third of their college savings accounts use dollar-cost averaging. In Vanguard’s case that’s 10 times the rate on its ordinary accounts. And that suggests some ways to help yourself save automatically.
Designate a targeted purpose for your automatic investing account. “This is for our down payment,” for example. (Funds and brokers could help by letting investors name accounts this way.)
Put an expiration date on it. Plan to invest automatically until, say, 2009. It may be easier to start if your commitment isn’t open-ended.
Start small. You don’t need $1,000, $500 or even $100 a month. The TIAA-CREF funds, among others, allow automatic monthly investments as low as $50.
The great satirist Ambrose Bierce defined the future as “that period of time in which our affairs prosper, our friends are true and our happiness is assured.” By summoning the courage to put your investing on autopilot, you can turn Bierce’s words inside out and make the future work for you.
Source: Money Magazine, May 2004, http://money.cnn.com/2004/04/22/funds/funds_automatic_0405/
For further reading (introductory, intermediate, advanced):
♦ Definitions of EXPECTED RETURN, INVEST, LONG TERM, PATIENCE, RISK, and THE PAST in Jason Zweig, The Devil’s Financial Dictionary
♦ Chapter Four, “Prediction,” in Jason Zweig, Your Money and Your Brain
♦ Meir Statman, “Dollar-Cost Averaging: A Behavioral View” (Wealthfront blog)
♦ Chapter Eight, “The Investor and Market Fluctuations,” in Benjamin Graham, The Intelligent Investor
♦ Gharad Bryan et al., “Commitment Devices“
♦ Brian Knutson and Scott A. Huettel, “The Risk Matrix” (Current Opinion in Behavioral Sciences)
♦ Uri Gneezy et al., “Evaluation Periods and Asset Prices in a Market Experiment” (Journal of Finance)
♦ Richard H. Thaler et al, “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test” (Quarterly Journal of Economics)
♦ John Ameriks et al., “Measuring Self-Control Problems” (American Economic Review)
♦ George Loewenstein et al. (eds.), Time and Decision: Economic and Psychological Perspectives on Intertemporal Choice