In our last installment, we recognized the value of money as a means of allotting your time in accordance with your values; identified financial independence for physicians as a goal worth pursuing from the earliest stages of your medical training; and discussed poor decisions that physicians commonly make, with the hope that we might tame the impulse to buy a new car or an irrationally expensive home fresh out of med school or residency.
In this installment, I’ll debunk common myths that prevent physicians from managing their own finances and provide a glossary to explain terms you’ll need to understand for investing purposes. Finally, I’ll provide you a newbie reading list to start you on the path toward financial literacy.
The intelligent investor (yes, I’m talking about you!) chooses an asset allocation based on risk tolerance and income objectives; develops a reasonably diversified portfolio; rebalances periodically to buy low and sell high; ruthlessly eliminates or minimizes transactional costs; and maintains discipline to stay the course during bear markets. None of this mandates the use of a financial advisor. For the person who doesn’t want hassle, single funds now exist that meet all of these objectives at costs that are an order of magnitude lower than traditional advisor fees. My intent is to empower you, as a new physician, to keep as much of your hard-earned money as possible by following the principles outlined above.
Is that more money in your pocket, or are you just happy to see me?
Financial advisors are not an inherent evil to be avoided. They can certainly add value by helping you design and execute long-term investment strategies and stay the course in volatile markets. Unfortunately, advisors also add cost that significantly erodes your earnings in the long run. Whether advisors add more value than they extract is a matter of debate. Let my bias be clear: learning to manage your own finances keeps more money in your pocket, and out of the pocket of a would-be financial advisor.
If you are tenacious enough to have made it into medical school, you certainly possess the work ethic to manage your own portfolio. Unfortunately, the “bad eggs” of finance often employ intimidation in an attempt to make you reliant on their services. The aim of this article is to help you become an intelligent do-it-yourself (DIY) investor, and to arm you with the knowledge you’ll need to understand and rebut the following common myths perpetuated by the financial services industry:
1. Managing investments solo is akin to a DIY appendectomy – get a specialist.
The alphabet soup of letters that trail after a given “specialist” advisor’s name can be much harder to decipher than the mark of quality implicit in obtaining an M.D. or D.O. degree. The more rigorous certifications, such as Certified Financial Planner (CFP), require a bachelor’s degree in addition to at least a year of study and testing to achieve. The Registered Investment Advisor (RIA), in contrast, may spend as little as a week or two cramming to pass a single test. Regrettably, both can lay claim to the designation “financial advisor.” This is not an appendectomy, and financial advisors are a far cry from medical specialists. In the words of Jack Bogle, “Successful investing involves doing just a few things right and avoiding serious mistakes.” You can absolutely do this on your own if you learn what pitfalls to avoid.
2. All your peers use an advisor – why shouldn’t you?
Replicating what others do can feel reassuring. Unfortunately, behavioral economists have demonstrated that peers can strongly influence financial behavior in a detrimental manner. Look to Bernie Madoff or the high percentage of American investors who owned worthless investments in subprime mortgages just prior to the great recession of 2009 to understand that blindly following our peers is unwise for lemmings and investors alike.
3. Wouldn’t you rather remain oblivious and let an advisor get the ulcers?
There is a definite benefit to being an oblivious investor, since it allows you to insulate yourself from the ample noise of the financial media. Five minutes of Jim Cramer screaming on TV is enough to raise my sphincter tone to diamond-producing pressures. I’ll be the first to suggest you change the channel (or better yet, pick up one of the books recommended at the end of this article!).
Ideal oblivious investors are ones who develop asset allocations appropriate to their risk tolerance; choose diversified, passively-managed index funds; and then proceed to ignore their portfolios. Other than periodically rebalancing the allocation annually (a strategy that ensures buying low and selling high), these investors avoid worrying about their investments for decades until they tap them in retirement.
The problem arises when you become an oblivious victim, unaware that the hand you’d trusted to guide you has instead picked your pocket. During the recent Great Recession of 2009, many large financial institutions offloaded worthless investments in subprime mortgages (a.k.a. collateralized debt obligations) onto unwitting individual investors who were steered toward them by financial advisors beholden to firms.
Medicine has legal anti-kickback statutes that preclude a physician from referring her patients to an imaging center in which she has a financial interest, but no such laws prevent advisors from receiving similarly shady payments from brokerages whose products they peddle. The unfortunate reality is that fee structures at large financial institutions incentivize advisors to sell their clients more expensive funds, resulting in higher fees paid to the firms and greater commissions paid to the advisors. Worse yet, many advisors are not held to a fiduciary standard, which would require them to place your interests before their own.
4. You aren’t smart enough to pull this one off.
Great news: you don’t have to be smart. Advisors add value by preventing investors from making human errors like selecting an overly risky asset allocation, failing to diversify, and failing to rebalance. Single funds, such as Vanguard’s LifeStrategy, offer various fixed asset allocations using low cost index funds with rock-bottom expenses, broad diversification, and automatic rebalancing. Best of all, since the strategy does not require any hands-on management, it removes the risk of making human error, which is one of the biggest threats to your financial success. Are there a handful of more complex portfolios that will outperform this type of simple, passive, balanced and diversified portfolio? Absolutely, but as Jack Bogle has memorably put it, “the number of alternatives that will prove to be worse is infinite.”
5. You can’t replicate an advisor’s complex, proprietary strategy to beat the market.
We all have one friend who drives us crazy: He insists “his guy” has beat the market by an obscene amount over the past five years by handpicking stocks or using genius active fund managers and implies our indexing strategy cannot reproduce his advisor’s. Ironically, he’s right: over time, our strategy is unlikely to reproduce, it’s more likely to outperform.
Burton Malkiel, Princeton Professor of Economics Emeritus, famously concluded that a passive indexing strategy will beat the vast majority of active managers over a long time horizon. In his picturesque words (supported by hard data), “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” Those active managers who beat the market mostly do so by chance. With rare exception (Warren Buffett), there is no persistence of performance over long time periods among actively-managed mutual funds. The high fees, high turnover, and transaction costs incurred by active managers put them at such a tremendous disadvantage that most underperform the market after expenses.
Worse yet, data demonstrate the tendency of reversion toward the mean: This year’s darling, who outperformed in the past few years, is very likely to become next year’s stinker by the time its reputation has grown sufficiently to attract performance-chasing investors. Long Term Capital Management is a classic example where a fund with a stellar record (43% returns after fees in its second year of existence!) drew praise and investors by the truckload, only to go bankrupt shortly thereafter.
6. You’ll lack the intestinal fortitude to stay the course during a bear market.
Another temptation for using an advisor is the desire for plausible deniability: When your portfolio loses value (as any investment invariably will during periods of market volatility, a natural part of market cycles), you can claim it was not your fault. This is again rooted in human psychology: Behavioral economists have demonstrated that loss aversion is a driving force in investor decision-making. We’re wired so that it hurts far more to lose a buck than it pleases us to earn one, and we’ll behave irrationally to avoid that pain.
A classic example is selling stocks during a bear market (We’re losing money hand over fist!) instead of buying them as part of a rebalancing strategy (Woohoo, stocks on clearance sale!). I have relatives who sold all their stocks at the bottom of the market in 2009, which not only locked in those losses, but caused them to miss out on the second longest bull market in history.
If you are skittish, this is one example where a competent financial advisor can prove critical in deterring you from making a colossal mistake. Whether having an advisor on hand is worth the thousands of dollars you’ll pay in fees is a highly individual decision. The key to determining whether you might avoid a financial advisor and the concomitant fees is to ensure that 1) your portfolio appropriately reflects your risk tolerance and 2) you possess the discipline to stay the course.
Investing Anatomy
Now that you feel empowered to manage your finances, let’s define some basic investing terms to demystify some of the complexity:
Stock (a.k.a., equity): An ownership share in a business. Valued based on growth of the business (causing share value to increase) and dividends (money paid at regular intervals to stockholders). More volatile than bonds; greater risk allows greater potential reward (or loss).
Bond (a.k.a., fixed income): A loan to a company or government to be repaid by a certain date and with a specific rate of interest. Less volatile than stocks; less risk means greater safety but also less earning potential.
Alternative asset class: A broad category for assets other than stocks, bonds or cash, which can include real estate, precious metals, collectibles, etc. Often less liquid (easy to sell) than stocks and bonds.
Asset allocation: Ratio of equity to fixed income assets (stocks to bonds), often denoted as relative percentages (a 60/40 portfolio reflects an allocation of 60% stocks to 40% bonds).
Portfolio: Your specific assembly of investments, often broken down into percentages of stocks, bonds, cash, alternatives, etc.
Mutual Fund: A group of investors pool their capital (money) to buy stocks, bonds, etc. Overseen by a money manager who works for a fee. Costs vary, including but not limited to expense ratio (cost of running the fund) and load (cost of joining or leaving the fund).
Capital gains: Profit from the sale of an asset such as a stock or bond.
Dividend: Payment by a company to shareholders who own the stock. Usually paid quarterly, with funds coming from either profits or cash reserves.
Index: A collection of stocks used to measure the stock market’s performance, or its benchmark.
Index fund: A mutual fund that attempts to track the performance of a specific index. For example, the Vanguard 500 Index Fund tracks the Standard and Poor’s (S&P) 500 Index.
Active investing: Buying and selling shares of stocks and bonds in the short term to try to outperform market returns. Each trade incurs significant costs due to turnover and generates capital gains taxes for shareholders. Often relies on market timing (predicting when the market will go up or down in the future). Incurs higher fees and operating costs, as well as higher tax burden, than passive investing.
Passive investing: Buy and hold strategy, also known as “set it and forget it.” You buy assets and reinvest dividends, planning to hold a portfolio over decades.
Rebalancing: Restoring your portfolio to your desired asset allocation after the market causes it to deviate. If you have a desired 60/40 portfolio, but over the course of a year stocks lose value such that you are now holding a 50/50 portfolio, you’d sell bonds and buy stocks in order to return to your desired 60/40 allocation.
Bear market: Stock prices fall for a prolonged period. Envision a bear pawing downward at its prey.
Bull market: Stock prices rise for a prolonged period. Envision a bull using its horns to thrust stock prices high in the air.
Diversification: Choosing uncorrelated assets (ones that respond differently to market conditions) to smooth out volatility in a portfolio with the hope that in conditions where one loses value, the other will gain value and offset the loss. Your portfolio performance is less volatile if one asset zigs when the other zags.
Essential Newbie Reading List
With the glossary above and far less reading time than it took you to master acid-base disorders as a med student, you can become a competent DIY investor. Reading books on finance should be part of a lifelong strategy to continually add tools to your financial toolkit. My essential reading list for a newly minted physician-investor includes what I consider the holy trinity for physician investors:
The Bogleheads Guide to Investing by Mel Lindauer, Michael LeBoeuf & Taylor Larimore
The Bogleheads are an online collective who promote the investing wisdom of Jack Bogle, who founded the Vanguard group and ushered in the age of passive index fund investing. The authors hold your hand as they patiently teach you how to invest for the long run. A gentle introduction to a valuable life skill.
The Four Pillars of Investing by William J. Bernstein
Dr. Bernstein left neurology for a second career in finance, becoming a prolific author and a student of market history in the process. His books developed a cult following of readers for championing low-cost, passive index investing. While he enjoys demonstrating the math underpinning portfolio theory and asset allocation, his erudite prose and wry humor will appeal to physicists and poets alike.
The White Coat Investor by James Dahle
Dr. Dahle, a practicing emergency physician, has been the hardest working physician finance blogger in the business since 2011. He was a millionaire by age 37, and his authoritative, opinionated voice has authored a wealth of blog and forum posts, guest articles and most recently a podcast to “help doctors stop doing dumb things with their money.” He’s saved his pearls for this concise, eminently readable book that addresses situations specific to new physicians.
In part III of this article, we’ll continue our journey toward financial independence for physicians. We’ll apply what we’ve learned by demonstrating the stepwise construction of a basic investment portfolio. We’ll also discuss the virtue of frugal living, and its paradoxical compatibility with the pursuit of pleasure out of proportion.
CrispyDoc is a graduate of Stanford, UCSF and Harvard. He completed a residency in Emergency Medicine (EM) at UCLA and an International EM Fellowship at Harvard. A born-again personal finance geek, you can drink his Kool-aid at crispydoc.com.