GameStop. Bitcoin. AMC. Special purpose acquisition companies. NFTs. These aren’t just the hottest topics on Wall Street. As Creative Planning’s Peter Mallouk and Jonathan Clements discuss, they’re also great examples of key behavioral finance phenomena.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Jonathan Clements: This is Jonathan Clements, Director of Financial Education for Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, President of the firm, and we are Down the Middle. So Peter, the first quarter is in the books and, as always with the markets, it’s been a fascinating one. We’ve seen the yield on the 10-year treasury note almost double so far this year, we’ve seen this rotation from growth stocks to value stocks, and from large companies to small. We also saw a surge in foreign stocks earlier this year, but we’ve given back some of those gains as the dollar has renewed its strength in the foreign exchange market. And overall, the markets are looking not terribly overvalued, despite what people are saying. We’re currently trading, in terms of the S&P 500, about 25 times this year’s expected earnings. But, when it comes to market buzz, it hasn’t really been about these broad market trends, a lot of it has been about what we might call pockets of craziness, Peter. So, pop quiz. If I said to you topics like extrapolating recent returns, or recency bias, or following the crowd, we’re talking here about behavioral finance concepts. If I mentioned those concepts to you Peter, what would come to mind?
Peter Mallouk: Well, what we have right now is we have a bunch of money flooding the system. We’ve got low interest rates, we’ve got businesses with private loans, corporations with bailouts, individuals with stimulus checks, tons and tons of money coming into the system. And, that money tends to go to two areas. One is investing, so you see real estate stocks, private equity, all doing really well as people go buy assets that are expected to bring money to them. And then, we see a lot of money going into speculation, as we always see when there’s a lot of money sloshing around in the system. So we start to think about things like specs, or NFTs, and stocks like GameStop and AMC that have been trading. Everyone’s familiar with the investing side. I think valuations, to your point, are pretty reasonable on the US stock, international stock, those types of markets. I think the bond market is a different story, with yields very low. But, we’re seeing a bunch of speculative bubbles. I think the most popular ones are specs in non-fungible tokens. We’re seeing a lot of speculation in those markets.
Jonathan: Okay. So Peter, I started to feel, when I think about non-fungible tokens, I start to feel like an old fart, like I don’t get it. Is there something here that I should be getting about non-fungible tokens?
Peter: Well, an NFT, it’s amazing how this just came out of nowhere and has just turned into its own little speculative hotbed, and a lot of people think a real emerging asset class. Basically, non-fungible just means unique and original. A non-fungible token’s basically just something that’s documented digitally on the blockchain. If you go buy it online, you know that you’re the person that owns the original. As an example, LeBron James sold a short video of him slam dunking the ball in a game, which he’s done thousands and thousands of times. He sold one of those for around $200,000. So somebody knows they own that original video image of him doing that. There’s a rock band that sold the original of their new album for $2 million, so somebody knows they own the original. Now, the reality is anyone else can go online and listen to that album or watch that slam dunk video, but somebody owns the original. So, there’s a big group of people that thinks, “Hey, this is a fad, and a speculative bubble.” We’ve got Patrick Mahomes selling images of him doing things, Time Magazine is selling covers. Somebody sold a single red pixel as a video. Someone sold a non-fungible token of them farting. This is real stuff that’s happening in the world, and this is selling for real money. I think what we’re going to see is most of this stuff is going to be worth zero, but some of this is going to be real. I would liken it to the art world. There’s millions of pieces of art, 99% of it is worth far less than whoever paid for it, 1% of its worth a fortune. I kt when we look at the NFT space, we’re going to see something emerge to there are going to be things that retain their value and grow in value, but most of this stuff, whether it takes months or years, a lot of people are going to lose a lot of money.
Jonathan: That brings me to a second behavioral finance concept. One of the most crucial concepts in behavioral finance is this notion of self-confidence, of over confidence, and we’ve seen a lot of that over the past year. We’ve seen this increase in day trading, the amount of margin debt outstanding is up almost 50% over the past 12 months. We’ve seen people making these big, undiversified bets on things Tesla, on GameStop. Do you see a lot of over confidence among the people you talk to, Peter?
Peter: We’re talking a lot to our clients, and I don’t see that really at all among our client base, which obviously tends to be wealthier than normal and more long-term focused, and just has been through a bunch of series of fads, and bubbles and waves. But, I will say that when we’re meeting someone new, the questions are around these sorts of assets. I’ll use specs as a great example, which specs have been around a long time. It’s basically just someone sets up a company that does nothing, owns nothing, raises money and then goes and buys companies with it and goes public. Well, there’s nothing wrong with that in and of itself, but what’s happened lately is there are many, many of them coming out and many of them are celebrity driven. An online personality or an athlete will basically say, “Okay, I’m going to form this company and we’re going to go buy other companies so just give me your money to do that. And by the way, I’m going to take a 20% haircut, I’m going to make 20% of the money on this just for raising the money.” Well, very little downside to the celebrity and a lot of money coming at them, but some investors, usually people that are newer and starting out, they feel like they’re getting in on something on the ground floor that’s special. So you’re seeing that over confidence, that greed over fear. It’s that race to get wealthy the easy way, trying to find that shortcut. Some of these things are going to hit. It’s a little bit like a casino, some of these things are going to hit, but most of these things are going to underperform.
Jonathan: So Peter, just for completeness purposes, when I think about behavioral finance concepts, the big three when it comes to investors, I believe, is one this notion of extrapolation that we’ve talked about. Two, over confidence which you just talked about. And third, the other big concept is lost aversion, this fact that we just hate losing money. And you might say, “Well, whose lost money over the past 12 months?” Well, there is a group of investors who, this year, are hurting and it’s those people who owned long-term bonds. I’m starting to get emails from people who owned long treasuries and thought that was the way to protect themselves because of all the craziness they saw last year, particularly during the early stages of the Coronavirus. And now, these people are looking at significant double digit losses this year and they’re hurting. They’re like, “I don’t really want to sell at a loss!” And, it’s a painful point to be at, people hate losing money. Because it’s not just that they say goodbye to a significant amount of their wealth, but also they kick themselves. There’s this aversion to regret, we hate feeling foolish. So wrapped up with all of this, Peter, is this notion of risk tolerance, and we’ve clearly seen over the past 12 months, this growing enthusiasm for stocks among investors, especially newbie investors, the whole Robin Hood phenomenon. One of the things that I worry about, and I’m sure you worry about, is what’s going to happen when the market next turns down. Are these people going to find that they have taken more risk than they should have, more risk than they’re comfortable with? And that raises the question of, how do you figure out what your risk tolerance is? This must be an issue you deal with every day with clients, trying to help them figure out what mix of stocks and bonds they’re truly going to comfortable with for the long-term.
Peter: Yeah. You know, I’ve always thought it’s a problem when people make their investments based on their age, or based on their risk tolerance. At Creative Planning, we’re really focused on what are the goals. What is somebody trying to do and where are we starting from? And, what’s a reasonable way to make these goals happen? We can’t tell somebody you have to earn 100,000 more a year if it’s impossible. So we have to say, “With the parameters that we have, how can we get this portfolio to do what we need to do to get you where you want to go?” That should really drive the allocation. But, we do still ask questions about risk tolerance because we can be on the right plan, but if you can’t handle the down market and you jump off the ship at the wrong time, then you’re definitely not going to hit your goals. So risk tolerance, to me, is important but secondary. So we’re really looking and saying, “How do we get somebody from here to there? And, within the risk framework that they can handle.” And when you look at the markets today, it used to be well, if you can’t handle a lot of volatility we’re just going to add a bunch of bonds and it’ll lower the path to getting where you want to be just a little bit. But with bond yields really, really low, 80% of bonds paying less than 2% for the first time in history, it’s really caused a revisiting of hey, we’ve been through a big bear market now. How did you behave? Could you handle it? Did you get through it okay? If you got through it, fine. If you let us buy stocks in the middle of the weakness, if you let us do those things, and you came out on the other side in great shape, that gives us a good real world test, not just a questionnaire, of what you can really handle and allows us to make adjustments that the client can live with.
Jonathan: Yeah, I think that’s absolutely right. That the best guide to your future behavior is through past behavior. If you got through the last bear market in one piece, you didn’t panic and sell, and indeed you stepped of the plate and bought more, that’s a great sign that you do have a reasonably high risk tolerance. But, if you sold last time around, I wouldn’t count in behaving any differently next time around and you should probably have a portfolio that reflects. Or, have somebody that you can turn to, who can keep you on the ship when we next have rough waters. So that’s the end of this podcast, Peter, except for the usual, our tip of the month. So what have you got for me this month?
Peter: It’s tax time, people are looking at contributing if they haven’t already, to their 2020 IRA while you’re at it. Go ahead and fund if you’re able to, go ahead and fund your IRA for 2021, it gives you the whole year to get that money compounding for you. Try to do these things early in the year, instead of at tax time.
Jonathan: So for me, Peter, my tip of the month is find out the duration of the bond funds you own. So duration is a funny, complicated thing, but basically if you know the duration of your bond funds, it’ll be a number expressed in number of years, it’ll tell you how much you stand to gain or lose if interest rates rise or fall by one percentage point. If you have a bond fund that has a duration of seven years and interest rates go up one percentage point, you stand to lose 7%. And, the reason you want to know this number is one, to manage your own expectations so you know what sort of hit you might face, and therefore you’re less likely to panic if it should come to pass. But second, it’s chance to say, “Hey, am I really comfortable taking this much risk with my bond portfolio as I am?” And if you aren’t, then maybe you want to shorten up your bond portfolio and take a little bit less risk and shorten the duration on your portfolio. So that’s it for us, Peter, that’s the end of our podcast for this month.
This is Jonathan Clements, director of financial education for Creative Planning. With me is Peter Mallouk, president of the firm, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.