Sir Isaac Newton and the Madness of the Stock Market

Larry Schnaid, SVP and Senior Portfolio Manager of UBS Financial Services Inc., breaks down investor's behaviors and what they are focused on.

After Sir Isaac Newton lost his fortune speculating in shares of the South Sea Company, he muttered, “I can calculate the motions of the heavenly bodies, but not that madness of the people.”

Sir Newton pocketed a 100% profit in South Sea shares, but he succumbed to excitement or the fear of missing out and jumped back in at a higher price. Sir Newton bought back in at the top of the South Sea bubble, resulting in a loss of $3M in today’s dollars. He gave in to the exuberance of the market or, in his words, the madness of the people, and lost.  

If even the father of calculus and one of the smartest people to ever live fell prey to speculative frenzy, what hope is there for everyone else? 

[To read more of Larry Schnaid’s thought leadership click here]

According to research, investors still fail to maximize their returns or even invest in a manner that allows them to reach their goals. According to Dalbar’s 22nd Annual Quantitative Analysis of Investor Behavior for 2015, investors’ own behavior was the leading cause for diminished returns. In 2015, Dalbar’s research indicated that over a 20-year time period, the S&P 500 outperformed the average investor by 3.52%. The study further stated it did not find any evidence that poor investment recommendations materially impacted poor returns; rather, underperformance can be attributed to voluntary investor behavior. Buying high, attempted market timing, and panic selling usually hallmark voluntary investor behavior.

To mitigate the failings inherent in investor behavior, our team advocates a purpose-driven approach to wealth management. We believe the purpose of wealth is three-fold: to meet an investor’s needs 1) now, 2) in the future, and 3) with regard to inheritance and the needs of their heirs.

Using a purpose-driven approach changes the framework of investing from return-chasing to liability-driven investing. Or in other words, the investor now invests to meet future liabilities, obligations, and needs, such as college tuition in 18 years, financial independence in 5 years, or to pass on an inheritance to children.    

To transition from market-chasing to a more personalized, purpose-driven approach, an investor should consider segmenting their assets.  Our team recommends a bucketing approach to broadly segment assets and implement the purpose-driven approach. We use three buckets; each bucket aligns with the three-fold purpose of wealth.  First, we design a liquidity bucket to meet the investor’s needs now and maintain their current lifestyle. We call the second bucket the longevity bucket, which is used to improve an investor’s lifestyle and meet future needs. Finally, we use the legacy bucket to improve the lives of those closest to the investor or fulfill their charitable desires.

Using a purpose-driven approach changes the framework of investing from return-chasing to liability-driven investing. Or in other words, the investor now invests to meet future liabilities, obligations, and needs, such as college tuition in 18 years, financial independence in 5 years, or to pass on an inheritance to children.

The liquidity bucket holds two to five years of cash flow, with a very conservative allocation. The focus on safety as well as easy access to the funds allows the financially independent to avoid selling equities and potentially realizing losses in down market years to meet current expenses. If Sir Newton had a liquidity bucket, maybe he could have taken comfort in knowing he could meet his immediate needs  and wait to see if the South Sea Company recovered (it never did). The investor with money safely stored to meet immediate needs can more easily maintain a long-term focus and avoid reacting in a bear market.

The longevity bucket holds assets for expected spending from year 4 until the estimated end of the investor’s life. Therefore, it can be as short as five years or as long as 60-70 years. The structure of the longevity bucket depends on the investor’s time horizon. For the investor with the shorter time horizon, the longevity bucket takes a balanced approach. It weighs the need for growth against risk in order to provide asset growth and appropriate risk hedging to meet goals. The funds in the longevity bucket gradually move into the liquidity bucket. For the investor with a long-time horizon, such as a millennial, the longevity bucket may be divided in two; a balanced bucket with lower volatility and a growth orientated bucket with higher volatility. The money would flow from the growth bucket to the balanced bucket before leaving the longevity bucket completely and moving to the liquidity bucket.

The legacy bucket’s sole purpose is to grow over the lifetime of the investor and pass on to their heirs. An investor’s excess assets fill this bucket. It holds the most growth orientated and volatile assets because its time span lasts longer than an individual’s lifetime. Many of our clients place the legacy bucket outside of their taxable estate, working closely with us and their attorney to use complex estate planning tools in order to pass wealth unencumbered to heirs.

The size and composition of each bucket will fluctuate over the lifetime of the investor. Purpose-driven asset segmentation requires diligence and discipline. The longevity bucket composition dynamically changes as an investor ages and requires reshaping as its funds refill the liquidity bucket. The legacy bucket should be monitored for its performance falling below expectations or for goal changes, but otherwise grow unfettered.

While we cannot completely eradicate behavior biases, we may be able to avoid Sir Isaac Newton’s mistakes and stay above “the madness of the people” by using a purpose-driven investment model.   With purpose driven wealth management investors can measure their success relative to what really matters—their own goals.

[For more on UBS’ approach to Wealth Management click here]

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