Financial Confidence From Knowledge: What You Don't Know Can Hurt Your Returns

Why those who know the least about money are most likely to go it alone.

ByABC News

March 19, 2015, 6:22 AM

Why those who have the least amount of knowledge about investing are most likely to go it alone.
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 -- "It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so." —Mark Twain

Managing your assets is a complex undertaking involving difficulties that many people vastly underestimate. Doing this effectively requires true confidence, which can only stem from overall financial awareness, perspective and extensive knowledge.

Yet confidence as an investor involves a paradox. Without it, you can’t be a successful investor because you’re too afraid of making the wrong moves. But too much confidence — often stemming from too little knowledge or awareness — may doom you to failure.

Though studies show that women tend to lack financial confidence, they tend to make fewer investing mistakes than men. That’s because men are generally more inclined to make mistakes stemming from overconfidence.

All investing involves risk, and lack of confidence can inhibit women from taking the reasonable risks necessary to succeed. So the challenge for women is to develop realistic confidence by increasing their financial knowledge as a key step toward financial empowerment.

For both men and women, financial education reveals the complexity of financial markets and the difficulties of making the right decisions concerning investments. Real financial education, then, is a humbling experience, and those who have it are more apt to approach the markets with great caution. By contrast, some who lack financial knowledge aren’t humble. Instead, they have hubris that causes them to make serious errors. Not only do they not know what they don’t know, but they may be dead wrong about things they think they do know.

Understanding financial markets and how best to approach them — for your particular goals and risk tolerance — is only part of the battle for financial success. Succeeding financially also involves managing your assets correctly to jibe with your tax scenario at different points in your life, your evolving cash-flow needs and your estate-planning goals. Thus, the weighty education burden grows even heavier for those seeking to comprehensively manage their assets as part of their overall financial lives.

As far as investment management is concerned, there are myriad concepts you must understand to do this without irretrievably damaging your portfolio. These include:

True asset allocation. There is much talk of asset allocation — the distribution of your total investment dollars among different types of investments, a practice known as portfolio diversification. But there’s not nearly enough discussion of the reason this is a critically important move: so that your portfolio can retain value when one type of investment tanks. This means that to be truly diversified, the asset classes you choose for your portfolio (stocks, bonds, etc.) should be unlikely to rise and fall in value together. This is true asset allocation.

The damage that can be caused by failing to manage your portfolio’s exposure to market ups and downs, known as volatility. Your asset allocation should be designed to reduce the impact of volatility. Superficial comparisons of the average returns of portfolios belie the severe damage to actual returns that volatility can cause. People focus on the average annual return of their portfolios, but this doesn’t tell the whole story. Two portfolios valued at the same amount initially can have the same average annual returns over a set period, but the portfolio that leaves its owner with the most money is the one that is structured to withstand volatility. This is because of the impact of compounded returns — the returns on your returns. When an investment dips severely in value, this reduces not only its returns, but those of its compounded returns. So even if the investment rebounds in value, bringing up its average for a given period, compounded returns are affected. But if the holder of this portfolio has counterbalanced the investment that dips with those that don’t do so at the same time, this buoys overall compounded returns. Thus, this investor can get better net overall returns.

Why feeling good about market returns in a “great year” like 2014 can be foolish. Large- and mid-cap stocks did great in 2014, returning more than 14 percent, as measured by commonly referenced indexes. However, other stock categories, including small-cap stocks, didn’t do nearly as well, and some asset categories — including international stocks and bonds, and emerging markets — delivered negative returns. Natural resource commodities posted a return of minus 17 percent. So if you had a widely diversified portfolio that included all of these asset classes, your overall returns probably weren’t stellar. Yet, you would have been controlling for risk, unlike those who got great returns by overinvesting in U.S. large- and mid-cap stocks. If you had a portfolio heavy in these winners, you would have done well, but you took substantial risk. The idea of diversification is to accept moderate overall returns to protect against the abysmal returns that can result from under-diversifying your portfolio.

Why listening to mass media financial gurus and pundits is a bad idea. These “experts” encourage their followers to stray from their asset allocations to pursue hot stocks. But this hype and noise is nothing more than financial pornography. If you’re not disciplined, it can lead you to expose yourself to substantial risk. Instead, you should establish an asset allocation that works for you — your goals and risk tolerance — and stick to it. Thus, you can invest for the long term, rather than letting your plan be derailed. Even one wrong move — if it’s a severe enough error — can ruin you, while many smaller blunders can chip away at your nest egg, causing a lot of cumulative damage.

These points illustrate just a few ways that you can go wrong. There are many others, prompting many financially knowledgeable people to hire advisors. Studies show that people who hire advisors tend to have far more financial knowledge and thus are aware of the potential benefits.

If you decide to hire a financial advisor, it’s critical to determine whose interests the advisor is planning to serve, their own or yours. The best way to do this is to be sure that the advisor you’re considering is a fiduciary — a legal term meaning that they must always put your interests first. True fiduciaries don’t sell financial products, because this is a conflict with their advisory role; their only compensation is for their advice. Most advisors aren’t fiduciaries.