Mullooly Asset Management

There’s a stigma surrounding home exercise DVD programs, I get it. Maybe it’s driven by the infomercials or the way they seem to gather cult-like followings. Either way, I’m willing to admit that I’ve become a Tony Horton disciple over the last few years. Every morning I pop in a P90x DVD and get my […]

There’s a stigma surrounding home exercise DVD programs, I get it. Maybe it’s driven by the infomercials or the way they seem to gather cult-like followings. Either way, I’m willing to admit that I’ve become a Tony Horton disciple over the last few years. Every morning I pop in a P90x DVD and get my daily workout in. I’m confident that Horton’s program has improved my health.

Muscle confusion is P90x’s foundation. It helps fight the plateau effect by continually mixing up workouts. On any given day you could be in for cardio, resistance training, mixed martial arts, yoga, Pilates, or intervals. There’s no way for your body to get used to it, and that’s the beauty of the program. You’ll eventually adapt to any one of those exercises on their own, but when they’re constantly rotated within a program, your body is left guessing. It also helps you avoid boredom from too much of one exercise type. Boredom often leads to slacking off or quitting entirely.

This isn’t all too different from the idea of factor diversification. Different investment factors are cyclical in nature, and diversifying them can help smooth the ride.

A classic example of factor diversification is combining value and price momentum (or relative strength). Value investing works, but it has the tendency to be early. Momentum investing works, but it’s sometimes volatile. Both factors have outperformed the market over time, but neither of them works all the time.

Jack Vogel of Alpha Architect did an excellent two part series of combining value and momentum strategies. The premise is that pure versions of these strategies held in conjunction can generate higher returns, higher Sharpe Ratios, and lower standard deviations than either can on their own.

Back in January, Patrick O’Shaughnessy was interviewed by Barry Ritholtz on his Masters in Business series. The two spoke about several topics, but one that applies to factor diversification is Patrick’s checklist for active investors. In order to identify stocks worthy of investment, Patrick urges investors to look for stocks with high shareholder yield, high return on invested capital, operating cash flows greater than reported profits, enterprise value to free cash flow less than 10x, and 6 month price momentum in the top three quarters of the market. This is another excellent example of factor diversification. Rather than rely on any one of the five factors alone, the combination of many is what provides optimal results.

Patrick’s father, Jim O’Shaughnessy, is also an advocate of multifactor strategies. In his classic book, What Works on Wall Street, Jim discusses many investment factors including value and relative strength, as well as various accounting principles. One of the main themes I took away from reading What Works on Wall Street is that factors are better together. The best performing strategies from the book were all combinations of ...

“I can only afford to save $50 a month, that won’t be enough to make a difference. Why bother?” I can’t tell you how many times I’ve heard this or a variation of it. It comes up when discussing things like creating an emergency fund, saving for a down payment, investing for a child’s college […]

“I can only afford to save $50 a month, that won’t be enough to make a difference. Why bother?”

I can’t tell you how many times I’ve heard this or a variation of it. It comes up when discussing things like creating an emergency fund, saving for a down payment, investing for a child’s college education, and (the big one) retirement. No matter what the situation is, the mindset that your contribution toward it will be insignificant is wrong. Somehow this feeling has crept its way into people’s minds, and I believe a big reason for it is framing.

Framing relates to how we contextualize things in our life. We often make different decisions about the same thing when in a different mental state. A great post over on The Psy-Fi Blog shares an example of framing, explaining that:

“If you tell a nicotine fiend that if they smoke for the next forty years their chances of getting terminal lung cancer will increase from 1% to 1.3% they’re likely to carry on inhaling. If you frame the argument by telling them that they’ll increase their chances of dying by 30% they’re likely to choke on their next fix. Same argument, same numbers, different frame.”

We get caught up thinking of our contribution in terms of how much we’ll need to reach our target. That can become pretty daunting as we’re discussing some big ticket items and goals. Emergency funds, college educations, houses, and cars are expensive goals whose cost we can determine with a fair amount of accuracy. However, the amount needed for retirement is often an unknown (especially early on). It’s easy to allow these big numbers to disarm you. This is where the mindset of “why bother saving $50 today” comes from.

Think about the situation differently. That $50 is 100% of what you can afford to save right now. You should make that contribution and be proud of it. $50 saved today has a pretty solid chance of helping you in some future capacity. Plenty of people reach their goals by making small, repeated contributions toward them. An easy way to make sure you do this is by automating the process. Once you automate, compound interest can go to work for you. Anthony Isola detailed just how awesome compounding can be in this post.

You don’t have to be content with the amount you’re currently capable of saving, but don’t let your dissatisfaction paralyze you. Recognize that you would like to save more, and create a plan to do so. For the time being, contribute what you can and be proud of the steps you’ve taken, but realize that improvements need to be made. It’s possible to be proud without being content.

You cannot realistically expect to go from saving nothing to suddenly being able to save a sizable amount. That’s like thinking you can run a marathon without any training. You have to be capable of running a 5k first! Ben Carlson of A Wealth of Common Sense provided good guidance, writing:

“If you haven’t started saving yet or aren’t saving enough, set a reasonable monthly goal. Don’t try to do it all at once. You’ll never stick with it if you try to go from saving nothing at all...

We fear change. It’s a fact. Think about the last time Twitter or Facebook updated its app. How many people initially complained about it? I’m guilty of eating the same thing for breakfast every day, scrambled egg whites with assorted vegetables. Don’t even think about recommending cereal to me. We are creatures of habit, and […]

We fear change. It’s a fact. Think about the last time Twitter or Facebook updated its app. How many people initially complained about it? I’m guilty of eating the same thing for breakfast every day, scrambled egg whites with assorted vegetables. Don’t even think about recommending cereal to me. We are creatures of habit, and there’s a name for this behavior: the status quo bias.

The status quo bias says that people tend to prefer doing nothing over taking action. We almost always choose to maintain our current or previous decisions when given a choice. Rather than deal with the possibility of making a poor decision, we remain inactive, even if we know that inactivity is to our detriment. This is another cognitive bias that’s based on loss aversion.

The status quo bias has notable effects on savings rates. If you ask somebody to save more today, what you’re really asking them to do is sacrifice the present. In order to save, they’ll probably need to cut back on spending. Not spending when you’re used to doing so feels like losing. We all know saving money for the future is good, but that doesn’t make it any easier to part with our money in the present. When faced with the choice of increasing our savings rate or continuing with the status quo, the latter usually seems preferable.

It’s very easy to become accustomed to a certain lifestyle and whatever spending habits it entails. This reminds me of Parkinson’s Law, “Work expands to fill the time available for its completion”. I believe this applies to saving and spending too. Our lifestyle has a knack for expanding to consume the money available to it. However, that’s largely because we let it!

If we learn to recognize the status quo bias, we can stop it from victimizing our savings rates, and potentially use it to our advantage.

Richard Thaler and Shlomo Benartzi developed a plan they call Save More Tomorrow. They recognized that a combination of the status quo bias and present bias keep retirement savings rates lower than they should be. Their proposed solution actually uses the same biases to help savings rates grow. Since we overweight the present, it’s difficult to see the value of saving money for the future. However, it also makes a commitment to save more money in the future preferable to a commitment to save more money today. The Save More Tomorrow plan works like this:

“First, employees are approached about increasing their contribution rates approximately three months before their scheduled pay increase. Second, once they join, their contribution to the plan is increased beginning with the first paycheck after a raise. Third, their contribution rate continues to increase on each scheduled raise until the contribution rate reaches a preset maximum. Fourth, the employee can opt out of the plan at any time.”

This is a great way to get individuals to agree to save more. The beauty of it is that the status quo bias will likely keep individuals enrolled in such a program once it’s established. It’s way easier to commit future dollars towards retirement than it is to commit present dollars. This is accomplished by not asking individuals to spend less in order to save more, but just to save more when they make more. In Benartzi and Thaler’s first Save More Tomorrow case study, savings rates soared from 3.5% to 11.6% over a 28 month time period.

Michael Kitces also proposed a strategy where individu...

Imagine that you and your family are about to take a cruise to the Caribbean. You’ll be stopping in St. Lucia, Grenada, and St. Vincent and the Grenadines. You’re excited for what should be an excellent trip, but upon boarding you find out that the ship is taking on water. Are you still going to the […]

If you’ve ever eaten at a buffet, you probably know what the naive diversification heuristic is without even realizing it. Let me explain. When I visit a buffet, I end up taking a little bit of everything so I don’t miss out on the restaurant’s best dish. It always seems like a reasonable way to […]

“It’s okay to be wrong, it’s not okay to stay wrong”. Maybe you’ve heard some variation of this saying before? It’s one of my favorites, as it applies nicely to all facets of life, especially investing. A common reason many of us decide to “stay wrong”, rather than change, is the sunk cost fallacy. The […]

As humans, we’re all affected by different behavioral biases. We often let emotions dictate our actions, which can lead to unfavorable outcomes. These inherent biases make rational investing a difficult task. The endowment effect is one such bias that works against us as investors. Professor of Behavioral Science and Economics at the University of Chicago Booth […]