It's Not Rocket Science

I read an article written by my associate, Bob Rall -- another fee-only financial planner -- and I thought it was worth passing along:

Living on Florida’s Space Coast, I am surrounded by the rocket scientists, engineers and technicians who make up our country’s space program. They are very smart people. In fact, they do their jobs so well that those of us not directly involved in the space industry often take the success of a particular mission for granted.

As a layperson, it’s hard to fathom the knowledge and skill sets that are necessary to carry out a successful mission. First you have the complexities and dangers of the launch itself. Then you have the many teams that are involved in deploying satellites, building a space station, or carrying out a variety of scientific experiments and exploration of our solar system. Pretty heady stuff.

I started thinking about this recently, when I began to read the latest book by William J. Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between. Having previously written two books suggesting that anyone, given the right tools, can successfully manage their own investments, he now admits to being wrong. In fact, he says that he has come to the sad conclusion that only a tiny minority of people will succeed in managing their money “even tolerably well.”

As an investment manager, you can imagine that I was pleased with his new conclusions. I make my living by helping my clients execute a successful investment plan. Granted, investment management is not rocket science or brain surgery, but it’s not something that should be left to amateurs either…especially amateurs trying to manage their own portfolios.

In the foreword of his book, Mr. Bernstein says that successful investing requires a skill set that very few people possess. He concludes that successful investors need four abilities.

First, they must have an interest in the process of investing. If a person does not have an interest, or I would say a passion, for investing, they will not do well. Just like carpentry, playing a musical instrument or parenting, if managing investments is not enjoyable, your results will suffer. And most people don’t enjoy finance.

Second, successful investors must have a good bit of what he calls “math horsepower.” Mastering the laws of investment theory goes way beyond basic arithmetic or knowing how to work a spreadsheet. A successful investor must understand the laws of probability and have a working knowledge of statistics. Unfortunately, with the exception of our aforementioned rocket scientists, just dealing with fractions is a challenge for a large part of our population.

Next, Mr. Bernstein suggests that investors need a firm grasp of financial history. The Dutch tulip bubble of 1637, the great stock market crash in 1929, and the more recent dot com and real estate busts all provide valuable lessons for the learned investor. But even many investment pros have trouble with this ability.

Finally, he says that even if an investor has all three of these abilities, they aren’t enough unless they have the last ability…the emotional discipline to execute their strategy…no matter what. It’s easy to stick with your strategy when things are going well. But when the financial world goes into turmoil, as it often does, it takes real discipline to stick with your plan. The events of the last 18 months in our markets drive this point home very well.

Mr. Bernstein estimates that only 10% of the population passes muster on each of the four skills, which means that only 1 in 10,000 (10% to the 4^th power) has the skill set to successfully manage a portfolio. But even a more optimistic estimate suggests that only a small percentage of people are qualified to manage their own money.

But that is exactly what is happening. Not that long ago, individuals didn’t have to worry about managing a portfolio. In many cases, they didn’t have enough money to invest, and in others, they had a company pension plan, which was professionally managed for them. The old pension plans are mostly gone and now most of us have a 401(k), 403(b), or a similar plan which puts us in the position of portfolio manager.

Unless you are trained to do so, you wouldn’t try to fly your own jet, or perform surgery on yourself or a loved one. So, why would you manage your own portfolio? Many people say it’s because it’s too expensive to hire a professional. That always brings up one of my favorite expressions…”If you think it’s expensive to hire a professional, wait until you hire an amateur."