Are you doing your own investing and wealth planning without the help and guidance of a wealth advisor? In this episode, Valerie Escobar, senior wealth advisor, and Mike MacKelvie, wealth advisor, share 5 of the most common financial pitfalls of a DIY investor, like overconfidence, lack of diversification and staying up-to-date on tax laws. They also cover the risk associated with these pitfalls and the benefits of using a team to help you reach your financial goals.

Transcript

Mike MacKelvie: There’s this massive misunderstanding that seems to exist. And I think it really kind of plagues a lot of people, but also investors. And I think it has to do with the confusion of what’s simple with what’s easy. Just because something is simple doesn’t mean that it’s easy. Just because something doesn’t mean that you’re doing it. Easy is not the byproduct each and every time of simple. It’s quite simple to understand what you need to do to be in shape: eat well and work out. But a lot of people are out of shape. It must not be that easy. And again, this line of thinking I think is detrimental both in our daily lives, but also just for investors. We were kind of told that this information, this abundance of knowledge, would help curb decision-making so that people would make better decisions about money. And we were wrong about that.

As far as I’m concerned, there’s really two types of individuals. There seems to be one who maybe has an abundance of overconfidence; it’s amplified because they can search the coffers of the internet and find the bias that maybe supports their point. And maybe the second individual is somebody who struggles with the paradox of choice; there’s just so many different options that they’re paralyzed. They don’t know where to start. Obviously, nobody strives to be either of those individuals. So what do you do about it? I think the answer lies in the unknown. And I think that’s a form of intellectual vulnerability, and that is what I don’t know is more important to me than what I do. That’s understanding. That’s the difference between knowledge and understanding. So that’s why I’m so excited for this ongoing series because it’s not going to be just industry professionals spewing knowledge and facts and different strategies each week but rather practicing professionals sharing insights to help provide understanding.

That’s what “Your Life Simplified,” this show, is going to be about. And I’m joined today by Valerie Escobar, who’s another CFP. My name’s Michael MacKelvie, some of you probably don’t know who I am. I would imagine most of you probably don’t know who I am, but I’m a Certified Financial Planner with Mariner. And we’re a full-service firm, which is going to be huge for this ongoing series because we have a reservoir of professionals, CPAs, CFPs, attorneys, that all work here. We’re a national firm, so we can bring in, again, a breadth of professionals to help provide a better experience for you from individuals who have experience practicing this. So I talked with Valerie and today we felt like a good topic would be to start with five of the biggest financial pitfalls that investors struggle with.

Valerie Escobar: Thanks, Michael. I’m excited to get into this subject, too, because there’s just, like you said, there’s so much misunderstanding and a lot of it comes from the abundance of information, which sort of has the opposite effect. And like you said, overconfidence can be something that’s a real killer.

Sometimes I have clients that have come in, and this is usually the case when there’s a big inflow of cash that they didn’t have before. So all of a sudden they had a half a million, a million dollars, and they think this is a huge amount of money, it’ll last forever, and I don’t have to really do much about it. Having that overconfidence leads to overspending, it leads to not making good decisions regarding investing, and then just that carelessness makes it so that million dollars or whatever bucket of money you had just absolutely goes away. And so that overconfidence with thinking that any dollar amount is sufficient, there are clients that will struggle with having $10 million, whereas there’s some clients who have half a million and they do absolutely fantastic.

Mike: Right.

Valerie: So I think that’s one of the biggest ones. I’m not sure if you have any experience with clients that have been in that situation.

Mike: Yeah, and what comes to mind is… So Daniel Kahneman, one of my favorite authors, if you ask him, “What’s one thing you could fix to help investors make better decisions?” This is perhaps the most well-known behavioral psychologist there is, he won a Nobel Peace Prize for prospect theory. He says that the number one thing he would fix would be overconfidence. So this comes from a variety of different places. But hindsight bias, we have a tendency to look back and say, “Well, yeah, I knew that that was going to happen. I knew it was going to play out like that.” But also, again, we all are probably somewhat aware of confirmation bias, we like to seek out supporting evidence that helps support whatever point that we’re trying to make. And in an information-abundant age, it’s not difficult to find that.

So second pitfall that I would see, I think it’s great starting with overconfidence, as I mentioned that’s a huge one, is fear of risk. And again, this is something I’ve thought about quite a bit. And it’s interesting because when you’re sitting down with a client, right now there’s obviously some issues going on globally. There’s inflation that we’re dealing with here just personally in this country. And there’s this fear of, “Okay, well, I don’t know necessarily what I should do. I know that if I just have my money in cash, I’m lighting a percentage of it on fire to inflation. But at the same time, I’m maybe worried about taking risk in the market.” And you can’t avoid risk, because not taking a risk also constitutes risk. And we talked about paralysis, there’s risk in paralysis. So I think a lot of times is investors are maybe managing their money and they’re worried about taking risk, or they’re maybe taking too much risk. That’s something that also happens, certainly for DIY investors, retail investors, anybody doing it on their own.

It’s a question much more of how do you measure risk? Because if you can measure risk, then you can manage it. And if you ask really any investor about their portfolio, “Help me understand what amount of risk are you taking on.” You’ll find that’s a fairly difficult question to answer. I doubt that many people are reciting a Sharpe ratio for their entire portfolio right off the top of their head. So I think fear of risk is part of it but also just a misunderstanding of risk. Really a risk literacy of sorts.

As far as how to combat this, because I always think it’s good just to talk about just different ways to maybe deal with it, the industry kind of looks to these risk tolerance questionnaires. Those aren’t always perfect either. I’ve read a few different white papers on it and part of the challenge with just risk tolerance questionnaires is it can depend on even who’s asking the questions, where you’re filling it out, what type of day you’re having. If you think that it’s just a risk tolerance questionnaire about that account versus your whole life. I mean there’s so many variables and when you’re just reading something in that isolated moment, again, it can be misleading.

Plus, again, we mentioned risk literacy. People might not fully comprehend risk as they’re filling these things out, and they wind up in maybe a more conservative portfolio than they want. And so I think really the best combatant for this is to actually spend some time really getting to understand what risk is from my just experience working with clients. Gain a little bit of just experience working through, “Okay, how do I measure it?” And then turning back to, “Okay, now how am I going to manage this within the grand scheme of my entire plan?”

Valerie: Yeah. And I would certainly say that the best time to understand the risk tolerance of your clients is when things get scary. And so we certainly try to, especially when we’re first getting to know someone, is keep things a little bit less risky than maybe that they claim to be able to handle. And really, asset allocation, which is the next piece that I wanted to talk about, is something that helps manage that risk. And asset allocation, by that I mean is where are we putting our investments? One of the biggest pitfalls I see is that clients think, “Well, all I need to do is pick the next Tesla and then all of my financial goals will be met.” In theory, sure. But in reality, that very, very rarely happens. And so being able to help a client understand that diversification and putting assets in different asset categories is much more the key to achieving financial goals.

And in that same vein, feeling that X asset class did poorly, then I need to just always avoid it. And bonds are absolutely right there, they’re performing awful. And we can’t just go and say, “Well, that did terrible. We’re just never going to touch that.” There is a quilt out there. I’m going to one day make you a quilt, Michael, that has all the performance of all the different asset categories.

Mike: Yeah.

Valerie: And it’s just crazy.

Mike: Yeah.

Valerie: Like real estate, what did it do? Like, 40% last year?

Mike: Yeah. Shot up.

Valerie: I mean, I certainly didn’t call that.

Mike: Right. Commodities right now, I mean if you look the last few years, they’ve done phenomenal, but their 10-year rolling was negative from I think it was 2011 to 2021. JP Morgan put out that piece. So it’s, again, these correlations that we love can quickly turn. They’re not necessarily a physics law.

Valerie: Yeah, absolutely. And so, we don’t pick the best horse, we just pick all the horses and bet on them. And I think that we focus on that financial plan, and certainly something that DIY would serve themselves well to try and keep diversification top of mind.

Mike: Yeah. And you mentioned Tesla, too, is something that seeks out. What’s funny is everybody seems to view themselves as the exception.

Valerie: Absolutely.

Mike: And we talked about what’s simple and what’s easy. And again, it’s not like we wouldn’t struggle with these pieces, too, just personally. I certainly have my own flaws, I certainly have my own misunderstandings with things. But when you’re in the stance of constantly seeing all of these different experiences that people are bringing into, you can see where these emotions get in the way and you can start to see where, again, there’s a theme of everybody kind of viewing themselves as this exception to traditional fundamentals. “Yeah, of course I know I shouldn’t get emotional. I shouldn’t try and pick and choose stocks.” And then you look back at their trading history and that’s exactly what they’re doing a lot of times, so it’s interesting.

But another risk for DIY investors, this is one that kind of goes under the radar for whatever reason. It’s just not talked about as much. It has to do with sequence of returns. So we refer to this as just sequence risk. And it’s a lot of times just unnoticed, it’s one of those ones that a lot of people probably just live their life without even knowing that it was there the whole time. But it has to do with the timing of returns, the order of returns. There’s danger in having poor returns early on as you get into the distribution phase. So as you start to take income from your portfolio, having those negative returns earlier on, you don’t necessarily want that. It can drastically affect the portfolio.


So I wanted to just walk through an example to give people an idea how big of an impact this is. So we’re going to use 15 years, and we’re going to say from 1995 to 2009 we started with $2 million. So you retired in 1995 and we’re going to use historical S&P data. Just what the S&P 500 did for 15 years. You started with $2 million in 1995. And let’s say you’re taking a distribution from that of $150,000 each year for 15 years. So at the end of that period of time, if you’ve retired in 1995, taken $150,000 from $2 million each year. Let’s just say your portfolio was invested in the S&P 500. You would still have $3.3 roughly million dollars left. It’s $3,316,199 in addition to getting to take that income each year. You’re feeling probably pretty good about that. That’s a pretty good sum that you’re left with.

Let’s say that we entered a wormhole and the order of operations was reversed. Year one is 2009. Year 15 is 1995. We just switch the order of returns. We would therefore have the same average return; we’re just changing the time period of when these returns happen. The average stays the same. Valerie, we end up with nothing. We run out of money in year nine. So that’s nearly, that’s over a $3.3 million difference just by way of switching the order of returns. We took the same $150,000 out in the second example, all we did was just flip the order of returns, and we had over a $3.3 million difference.

So again, this is why we get a little bit more conservative as we get closer to retirement. A big part of this is this sequence risk, because we’re going to be switching into this new phase of life being distribution. And so I think it’s always important to highlight this. That’s one of the examples I love to show people because, again, it’s utilizing real historical returns and just outlines this is why, again, we gradually get a little bit more conservative the closer that we get to retirement and then after we retire from there on out. And I always like to mention just a couple pieces: “Hey, I don’t know you, but some things to think about if you’re looking to manage this. If you have good returns early on, it might be a reason to maybe change what’s called your safe withdrawal rate.”

Again, that’s dependent on your situation. But safe withdrawal rates, usually around 4%, you hear the 4% rule. But I always think of this withdrawal strategy as almost a form of guardrails. And if we have good returns earlier on, and we’re running the Monte Carlo analysis out, which is basically just a bunch of different simulations simulating different market types, I like to see, “Okay, can we potentially adjust your income, and can you potentially take more home”? So sequence risk is one that I think flies way too much under the radar.

Valerie: Yeah, absolutely. I mean and with that, that could lead to overconfidence and then it’s just like the snowball effect that we constantly have.

Mike: Yeah.

Valerie: So certainly one of the biggest risks. The last one that we wanted to touch, number five, is… and this is really I think it’s something the same thing. That it’s more of a thing of ignorance. It’s not something that people do wrong. And so, this is not being up to date with changing tax laws. This is our full-time job, which means that this is all we do is just focus on financial planning. Given that we are both CFPs, we have to take continuing education. Which means that constantly learning and finding out what’s going on and what’s new. So I just recently took one of my recent courses, and it was about upcoming or potential laws, changes due to the Secure Act. And so I just learned this, this is today. So one of the rule changes is for RMDs, if you are a non-eligible designated person, which first of all, that is this new definition.

Mike: That in itself.

Valerie: Let’s just talk about dark matter while we’re at it. So basically like a non-spouse inherits an IRA after the original owners required beginning date, which is April 15th of the year after in which they would’ve died after they turned 72. So if you even understood me up to that point…

Mike: Right.

Valerie: … you are not only subject to the 10-year rule, but they’re thinking about applying a required minimum distribution requirement on top of that 10-year rule. So within that stretch, there’s also going to be a minimum amount that you are required to take. We don’t know if that’s going to happen, but if you screw up your RMD, what happens?

Mike: A big hole in it.

Valerie: It’s huge… 50% penalty. I have clients that have a $30,000 required minimum. They just are like, “Sorry, you didn’t know, so we’re going to charge $15,000. It’s gone.” It’s just huge.

Mike: Right.

Valerie: Another one that could potentially change that I just learned was interesting, too, powers of appointments can be exercised by 9/30 of the year after the year of death in favor of an identifiable beneficiary. Same thing. I don’t know. I have to read it many, many times, and this is what I do with my life, to understand it. But basically, it allows for our clients to potentially fix something that was messed up by the person who passed away. So that would be a huge advantage. But, I mean, what are the chances anyone actually knows about? It’s pretty slim.

Mike: Right. I mean because you’re living a life. You’re not waking up on Saturday and reading tax laws, at least if you’re leading maybe a more interesting life. Unless you’re us.

Valerie: People, go live a fun life. We’ll do the stuff that you might think sucks. For us, it’s kind fun to nerd out on tax law.

Mike: Yeah, exactly. I mean, I think those are obviously really good points. And it’s like there’s just so much at the end of the day to keep track of. And it’s not to say that anybody can’t if you’re doing this on your own, it’s not to say that’s impossible. And I think for a huge contingent of our country, you’re not maybe going to be in a spot where you can work individually for a little bit of time with an advisor. And so you kind of have this fundamental responsibility to at least get the basics down. But as you grow in scale, you grow in complexity. The older that you get, you get increasingly more complex. And what comes with that, unfortunately, is more margin for error. There’s just all of these different things that can impact you. There’s all of these different things you have to manage. It’s not to say it’s impossible. It’s just more challenging than maybe when you’re 22, 23 and you just got a job.

Valerie: Yes.

Mike: So again, I think those were obviously all great points. And if you’re listening to us on Apple Music, Spotify, if you’re listening to us on YouTube, make sure to hit that subscribe button if you’d like to follow along for more industry professional content, more insights from industry professionals with “Your Life Simplified.” Again, I’m Michael MacKelvie, I’m joined here today by Valerie Escobar. Thanks so much for listening.

Valerie: Thank you. We’ll see you next time.

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