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Do you have a money mind?

Photo of Todd Wenning

During this year’s Berkshire Hathaway annual meeting, Warren Buffett discussed the importance of his eventual successor as CEO having ‘a money mind’:

“People have to have a money mind. They can be very smart but make very unintelligent money decisions; their wiring works that way…

A money mind will know what needs to be done.”

Though I was in attendance, the importance of this commentary didn’t register right away. The more I thought about it, however, the more I realised it’s a great mental model for evaluating your financial skill set, as well as those of others such as fund managers and financial advisors.

We all know otherwise well-educated people who make dumb money decisions. That person might even be you from time to time, and I’m certainly in that camp.

Indeed, in a moment I’ll share why even financially-savvy people may not always be in the right ‘money mind’ state.

Putting your mind under the microscope

So, what is a money mind and why should it matter to you?

A money mind should:

1. Understand opportunity costs

Put simply, opportunity costs measure the gains you’ve forgone to make another choice.

Let’s say you choose to attend one university over another. Since you can’t attend both simultaneously, your opportunity cost is what you would have benefited by attending the other school.

As investors, we face opportunity cost decisions all the time, whether we recognize them or not. Cash or shares? Bonds or property? Company XYZ or the FTSE 100?

A money mind will acknowledge his or her objectives and time horizon, and balance those with current market opportunities.

For an investor with a 30-year time horizon, for example, the potential opportunity cost of holding cash is rather high when considering that the stock market’s returns over rolling 30-year periods have been consistently positive.

2. Have high emotional intelligence

Warren Buffett also famously quipped that:

“Success in investing doesn’t correlate with I.Q… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

There are four critical aspects of emotional intelligence, according to Travis Bradberry and Jean Graves in their book Emotional Intelligence 2.0.

These four aspects are: Self-awareness, self-management, social awareness, and relationship management.

As investors of our money or someone else’s capital, we must be able to recognize our biases (self-awareness), be able to act at times against those biases (self-management), understand the emotions of other investors (social awareness), and balance our emotional state with theirs (relationship management).

These requirements are a tall order, especially when we’re facing outside stressors in our personal lives.

A few years ago, for instance, my wife and I bought a car immediately after moving to a new city and buying a new house – both major life events. By the time we walked into the car dealership, I had decision fatigue and didn’t spend enough time preparing for the purchase the way I normally would have. I ended up overpaying.

An ideal money mind would have Spock-like reason and be immune to outside stressors, though this is more science fiction than reality.

Instead, seeking a state of controlled emotion seems the best strategy for most. A money mind will more frequently strike the right balance.

3. Be able to think and act long-term

Rarely will you find a capital allocator or company executive who admits to being short-term focused, but the numbers tell a different story. Capital allocators such as fund managers frequently feel the pressure of monthly, quarterly, or yearly results. Portfolio turnover is much higher than it otherwise might be.

For an investor to truly think and act long-term, they must have the personal capacity, the right clients, and the right investment vehicle to do so.

If you manage money for someone demanding quarterly performance, for instance, you will have a hard time executing a long-term objective. This could be a reason why Buffett operates a corporation with steady insurance float to invest, rather than managing an open-ended mutual fund.

We individual investors have a tremendous advantage in our ability to be patient, since we have no outside capital ready to flee following a year of market underperformance. Sadly, few investors fully capitalize on this valuable advantage.

Money minds will seek out environments that will enable them to execute their objectives.

4. Judge investments on value and not on price

One of the bigger mistakes that investors make is buying things that look cheap based on price alone, without consideration to quality.

It’s an issue we often face as consumers. Let’s say you need a new coffee maker. Prices might range from £10 to £200 for a top-of-the-line brewer. The ‘cheap’ shopper will simply grab the one with the lowest price but runs the risk of coming back to buy another when it breaks due to poor assembly. The ‘value’ shopper, on the other hand, will find the highest quality coffee maker for what she needs at the best possible price.

At this year’s Berkshire meeting, both Buffett and his business partner Charlie Munger discussed how important the purchase of the See’s Candy confectionery chain was to their development as investors. Leading up to that investment, Buffett in particular was more attracted to so-called deep value shares. But he came to understand the attractiveness of buying a quality franchise at a good price and holding it patiently.

A money mind will recognize the folly of being penny-wise and pound foolish.

5. Be insatiably curious and contemplative

When I interview company executives, my last question is typically a request for book recommendations. More times than not, the manager will look at me like I have two heads.

“A book recommendation?” they’ll reply. This isn’t the response I want to hear.

While most analysts ask about quarterly trends or expected capital expenditures for the year, I’m more interested in finding out if the executive is a learner and thinker. Some CEOs and CFOs have told me they don’t have time to read, which could be a sign they can’t manage priorities or don’t consider reading a priority. Neither is a positive sign.

Every so often, an executive will light up upon my request and talk about a book they read on history, business, or science. This is more like it. Money minds will be fascinated by new ideas and figuring out ways to glean lessons applicable to their operations.

Bottom line

In a previous post, I suggested that assuming a normal distribution of capital allocation skill among company leaders, perhaps 3-5% can be considered exceptional. A true money mind is rare and isn’t always consistently so over time.

Nevertheless, whether we aim to wisely allocate our own capital or someone else’s, possessing a money mind is a goal worth pursuing.

What other money management skills might you add to my list above? Let us know in the comments below!

Todd Wenning, CFA is an equity analyst based in the United States. Opinions shared here are his own and not those of his employer. A full disclaimer can be found here. For compliance purposes, Todd cannot reply to comments below, though he welcomes any correspondence sent by email. You can read Todd’s expanding collection of dividend articles here on Monevator or check out his book, Keeping Your Dividend Edge.

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Five reasons why you’ll love index investing

When I first looked into investing, it was like staring across the Atlantic Ocean. All I could see was a vast, churning deep, full of danger that could swallow my wealth whole.

I needed help to sail these seas, and among the competing offers I found a trusty vessel named index investing.

The animal spirit of investing

While you can make the journey in expensive luxury liners like actively managed funds or in a one-man skiff tossed hither and thither by your own stock picking, here are five reasons why a more modest seeming vehicle – a portfolio of index funds – makes the most sense:

1. Index investing is simple

Never invest in anything you don’t understand is a mantra repeated time and again in personal finance. Like never crossing the road between parked cars, it’s excellent advice that’s all too easy to ignore.

Happily, index investing is easy to understand, even for those with little investment experience.

  • You make regular contributions to your funds and rebalance your portfolio as little as once a year (some prefer never).
  • Holiest of holies: You don’t try to time the market or pick hot stocks.

2. Index investing works

Index investors will beat the average active investor after costs and taxes, according to Nobel Prize winners like William Sharpe and legendary investors like Warren Buffett.

Study after study shows that most actively managed funds are trumped by index funds over the long-term. Why? Because index trackers are dirt cheap. Their low costs nibble away less of your pie than pricier active funds, which rarely put in the consistently stellar performance required to justify their high fees.

Index investing is not a ticket to instant riches. It doesn’t aim to beat the market, but rather to capture the returns of the market. We’re putting our money on the tortoise, not the hare.

3. Index investing is affordable

Cheap index trackers can be bought from online brokers like Hargreaves Lansdown. You can buy in small, regular chunks (as little as £50 per month) and build up your portfolio slowly over time.

With a bit of confidence and self-education you can manage it all yourself. This means you avoid paying commission or fees to a financial advisor.

4. Index investing doesn’t waste your life

Stock-picking hoovers up vast amounts of time. Index investing leaves you free to sniff the roses. There’s no need to grapple with complex methodologies, pour over company accounts or entangle yourself in charts.

5. Index investing puts you in control

Ever hire a dodgy financial advisor only to discover later you’re paying sky-high fees for mediocre funds that didn’t suit your needs? (Or was that just me?)

Knowledge of index investing strategies can help you avoid a similar fate by revealing:

  • The risks you’re taking and how to dilute those risks to a level you’re comfortable with.
  • How much you need to invest to achieve your financial goals.
  • A DIY approach that avoids rip-off merchants and saves you a bundle in the long term.
  • Good questions to ask an advisor should you still want to hire one, which will help you find one of the good guys to work with.

To get you started we’ve a huge library of passive investing articles here on Monevator.

Dive in, and happy investing!

The Accumulator

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Weekend reading: Caveat emptor needs to make a comeback post image

What caught my eye this week.

I mentioned the other day that I’m getting increasingly grumpy about the supposed victims of financial misdeeds seeking redress for shooting themselves in the foot.

Not a popular stance for a personal finance blogger to take, but the truth.

Paul Lewis for instance on Radio 4’s MoneyBox reliably turns me to the Dark Side like a neophyte Sith Lord as he rails against – oh, I don’t know – Tesco having the temerity to sell apples at ‘rip-off’ prices of more than what it paid for them.

A more serious example came this week in the Financial Times [Search result] in an article about interest-only mortgages.

The FT is not the first publication to warn of a looming crisis from interest-only mortgages. The charge is that borrowers have not saved up enough money to repay the capital at the end of the term.

And to be fair, the FT didn’t quite headline the mis-selling angle in this piece, though it did raise the juicy prospect.

But a victim narrative was certainly foreshadowed in the angle it took and the quotes it used.

The article led by painting a picture of a son being denied the inheritance of the family home because of his mother’s decision to take out an interest-only mortgage:

Linda needs to have a difficult conversation with her son. The expectation was that one day, he would inherit the family home in London where she still lives. But her decision to take out an interest-only mortgage of £182,000 nearly a decade ago has effectively cost him his inheritance.

Well, no.

I don’t know Linda’s circumstances, obviously, but from as much as we can tell here it was her decision not to save up to repay “a penny of the underlying debt” that has cost him his inheritance.

Alternatively, if she would never have been able to find the money to pay for what she bought, then she shouldn’t expect to own it.

That’s not a scandal. That’s shopping.

Later on we have Gary, who claims “we didn’t have things explained to us”. This might point a way forward to the sort of compensation windfall enjoyed by the PPI-paying masses, except that Gary immediately adds “Anyway, our hands were kind of tied at the time — it was more or less our only option.”

I don’t mean to dismiss the issues faced by these people, or make fun of them; I’m sure they have their worries. But they are in the victim role as portrayed by the FT, and it’s a role that needs to be challenged.

Why not a piece saying that the rest of the banks’ customers or shareholders – or the State – will need to bail out these kinds of individuals if they’re not to be turfed from their homes entirely because of their own decisions? Somebody always pays.

As for mis-selling, happily this kind of mortgage’s purpose is made pretty clear in the name itself.

We’re not talking about a Property Financing Multi-Year Upkeep and Retention Vehicle, or some other financial nonsense.

It is an Interest-Only mortgage. As in – slowly now – you only pay the interest.

[click to continue…]

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The FCA is avoiding the elephant in the room

The FCA is avoiding the elephant in the room post image

The Financial Conduct Authority’s recent report into the asset management industry didn’t go far enough for one frustrated fund manager. Requesting anonymity (but known to us at Monevator) they share their thoughts below…

The report by the Financial Conduct Authority (FCA) into the asset management industry is, in the view of this writer, a lost opportunity.

Nowhere in its 144 pages does it mention the words beta or alpha. Yet the heart of the problem with fund managers is not costs, as the report focusses on, but miss-selling.

Active managers claim to deliver better returns than the average – i.e. to offer alpha – but the reality is that in aggregate active management fails to even deliver beta – i.e. the market return – because of the higher risks and costs associated with trying to achieve alpha.

As regular Monevator readers will know, the evidence is overwhelming. Over meaningful time periods, most active fund managers underperform.

Should not the fact that most private investors fail to understand or take this into account when buying funds be a key concern?

Cut out the middlemen

In its defence the FCA says it didn’t want to use the terms alpha and beta because they are too technical for investors to understand.

This is the second mistake the report makes. It consistently refers to ‘the investor’ yet the reality is that most funds are bought by intermediaries – that is, IFAs and wealth managers.

They are not the principals in the transaction but the agents. That gives then a very different incentive from the owners. As agents they are far less worried about the costs of ownership and returns, and more worried about the risk to their reputations and businesses.

As a consequence they would rather recommend a fund that appears safer than one that is cheaper. It is the old “no one ever got fired for buying IBM” argument.

There is a secondary element to this issue of who makes the purchasing decisions relative to who is the ultimate beneficiary, too. The agent has a vested interest in making his role look more complex and demanding to his customer than it really is.

If the end investor realised that it was not actually that difficult to buy beta then he would do it himself and cut out the middleman – and about 1% in charges.

After all, that is essentially what budget airlines have done by cutting out the travel agent and marketing direct to the consumer. It is the same with many products and services now sold over the Internet.

Massive cost savings are available by bypassing the distribution chain and going direct to the consumer. The consequences can be seen in high streets and shopping centres up and down the land as shops are closed and boarded up.

Truly disrupting the financial services industry

This brings us to the real failure of the report. It is still difficult for asset managers to present hard data, such as turnover rates, information ratio, beta or even compound interest directly to the public for fear of giving advice. Instead the FCA seems to prefer them to use intermediaries, who have a different agenda. This is what is preventing real competition from shaking up the industry, reducing costs and bringing in new ideas.

The FCA says fund management is too complex for the average investor to comprehend. In this writer’s opinion, that argument is fallacious. Mobile phones, computers, cars and TVs are far more complex than the average fund but that does not stop the population buying them and, by and large, making decisions in their best interests.

Why should that logic not apply to asset management?

The reason is of course that there are lot of well paid, and highly intelligent, people who have a vested interest in preventing the public from buying beta, the market return, very cheaply.

Instead, they want to sell alpha, the goal of outperforming everyone else, for a much higher price.

The illogicality of that argument is not lost on them but they respond by saying that while it might be true that, like the children of Lake Wobegon they all claim to be above average, they can always find some element of complexity – often related to tax wrappers – to persuade the investor he should be guided by an expert.

Expecting the public to effectively separate signal from very noisy data, and then factor in risk and costs is deemed far too onerous. Intermediaries get around that problem simply by using past performance, despite all its flaws.

A beta solution

As Upton Sinclair famously said: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

There will always be a need for intermediaries for more complex financial situations. However, the reality is that the average investor can satisfy much of his basic investment requirements by purchasing beta cheaply and simply through a passive fund without using an intermediary at all. The FCA report makes this no more likely now than before it was written.

If we really want transparency in this industry we need to use simple clear language to explain directly to investors what they are being sold. The FCA’s reluctance to use technical but clear labels like beta and alpha does not help the process.

Transparency is also aided when goods and services are sold directly by the provider to the consumer. Making it difficult to do this – and encouraging the use of intermediaries – makes transparency more difficult because the agenda of the agent is different from the principal.

Further reading

  • The issue of intermediaries is set to be explored in the FCA’s follow-up platform market study, which launched on July 17th.
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