How much time does it take to be Cognitive Investor? (part two)

In part one, we answered the question of how much time it takes, assuming you already have a cognitive investing portfolio.  In part two we will discuss how much time it can take to learn the process of becoming a cognitive investor and converting an existing portfolio to one that adheres to the cognitive investing methodology.

The short and simple answer is, “it depends.”  A more complex answer is that it can depend on how different your existing portfolio management process is from a cognitive investing process, how different your portfolio is from a cognitive investor’s portfolio, and how much needs to be learned and unlearned to make a successful transition.  Examining some hypothetical scenarios will illuminate the issues encountered by different types of investors as they make the transition.

Let’s take a look at five investors: Gambling Gordon, Fearful Frieda, Oblivious Oscar, Analytical Annie, and Delegating Dan.

Gambling Gordon is a highly confident stock picker.  He has been investing in stocks for many years and had a variety of big winners, big losers, and everything in between.  He follows the market closely, keeping track of his portfolio on a daily basis.  He watches CNBC and reads the Wall St. Journal.  He considers himself to be an above-average investor.  He does not bother to measure his results and compare them to market benchmarks because he can easily recall his most profitable investments and knows he is smarter than most other investors.  He assumes that he outperforms on a regular basis.  His portfolio is made up almost entirely of stocks and commodities, since bonds and cash are for wimps.

Fearful Frieda is on the opposite end of the spectrum from Gambling Gordon.  She has lived through too many painful stock market declines to invest very much in the stock market.  She keeps most of her assets in savings accounts and CDs.  She owns a few shares of three very large stable companies, but frets when those prices decline.  Her bond investments are all at the short, high-quality end of the spectrum, since she does not ever want to lose money if interest rates rise.

Oblivious Oscar also has most of his assets in CDs, but it is not because of fear about gyrating stock prices.  He simply doesn’t care and is not concerned about how much wealth he has or whether it is adequate for his long-term needs.  Financial markets have no interest for him and he does not want to spend any time or attention even thinking about anything having to do with money.

Analytical Annie does not consider herself a financial expert, but spends a fair amount of time researching the mutual fund selections in her company’s 401(k) plan.  She is frustrated by the fact that she never seems to own the best performing funds, in spite of choosing what appears to be the best performing funds and avoiding the worst performers.  She gets confused by the conflicting viewpoints about how to best invest her money and tries to combat this by continually seeking out more information.

Delegating Dan has outsourced his decision-making to an adviser.  He pays little attention to what his adviser is doing with his money since he trusts his adviser completely.  He does not realize that his adviser is really Gambling Gordon, who is taking unwarranted risks with someone else’s money.  The relationship is great (financially) for Gordon, who benefits from any upside, but insulates himself from any downside losses.  As long as Delegating Dan is satisfied with the arrangement, Gordon benefits.

None of these prototypical investors manage their portfolios according to the principles of cognitive investing.  Now let’s pretend that they all read Cognitive Investing.  Some will take more convincing than others that the cognitive investing approach is superior to what they are currently doing.

Delegating Dan will need to come to the realization that his adviser has an incentive to keep him uneducated so that he cannot manage his money on his own.  Dan’s adviser’s interests and his own conflict, and the sooner and more thoroughly Dan understands that fact, the sooner he will realize that he needs to manage his own money.  Once he makes this fundamental change, then the change in his portfolio is minor.  He will need to figure out which investments that his advisor purchased are no longer appropriate and what they should be replaced with.  If he follows any of the template portfolios described in Cognitive Investing or the demonstration portfolio on this web site, he should be in good shape.  The time involved in making the necessary changes to his portfolio will depend on how far his adviser strayed from that of a cognitive investor.

Analytical Annie must learn that past performance is an extremely poor indicator of future results.  Mutual funds that have most recently performed well are not inherently “better” than those that have recently underperformed.  Switching from the recent underperformers into the best performers is just another way of selling low and buying high.  Her portfolio and process can be adapted to a cognitive investor’s portfolio relatively easily, since she already has access to numerous choices of diversified index funds.  She will need to implement a new process focused on keeping her asset allocation fixed, rather than focusing on security selection and market timing, which more often subtracts from her performance instead of adding to it.

Oblivious Oscar will have to change his attitude about managing his wealth.  The amount of time it takes is almost beside the point, since changing his attitude does not need to take much time.  It will require conscious effort on his part and a commitment from him to do things differently in the future than he had always done them in the past.  Once he decides to change his process, the actual transition process might take a while depending on how quickly he wants to implement his new portfolio.  For example, let’s say that he realizes that having all of his money in CDs and savings accounts will not earn him enough money to help him reach his financial goals.  After some analysis, he determines that he should have 40% of his money invested in stocks, 40% in bonds, and 20% in cash.  If he were to implement this new allocation immediately, he would be making a huge market timing bet that the present moment is a great time to move money from cash to stocks and bonds.  If this turns out not to be true, he could suffer, both financially and emotionally.  If he invested a big chunk in stocks only to watch the prices decline, he could easily get disillusioned with the entire idea of investing in anything other than CDs.  This would be counterproductive.  A better alternative approach is to spread out the transition from his existing portfolio to his target portfolio over a longer period of time, such as three years.   He could invest 10% each in stocks and bonds now, another 10% in a year, 10% in two years, and the final 10% in three years.  Spreading the transition out over a longer period will insure that all of his money is not invested at the most inopportune time.  It will also not be invested at the most opportune time, but the chance of that happening on its own is very small to begin with, and attempts to figure out the perfect time for any investment are likely to be more counterproductive than not.

So, if there is a large difference between the investor’s existing portfolio and the target cognitive investing portfolio, it probably makes sense to spread this transition out over time.  Although this takes calendar time, it does not require that much attention along the way.  The process is only a bit more complicated than the ongoing portfolio maintenance process of the investor who has already implemented a cognitive investing portfolio.

As was the case of Oblivious Oscar, Fearful Frieda will find that changing her attitude about money management will be much more of a challenge than the time commitment to make such a change.  The change to her portfolio and the process to manage it will be similar to Oscar’s, even though her attitudes and process are quite dissimilar.

Gambling Gordon will also need to change his philosophy about how his money should be managed.  Since he is already highly confident that he is producing above-average results, it will likely take some sort of crisis before he re-examines his fundamental assumptions and considers a vastly different approach to managing his portfolio.  As in the previous cases, the time to make the transition is not nearly as significant as the changes required in his attitudes and assumptions about the best ways to manage money.  How long will it take for him to learn that he cannot accurately predict the future?  Making such an admission will be disruptive, because afterwards it will require him to think through various implications and force him to recognize the fallacies in much of his existing portfolio management process.  He will then need to be convinced that the cognitive investing methodology will lead to a higher probability of long-term success.

Once he decides to make the change, the details are straightforward and not very time consuming.  He would need to prioritize asset allocation ahead of security selection and market timing, and intelligently convert his portfolio to one of the models described for Delegating Dan.

In each case, the big obstacle to making a transition is not time, but the difficulties in changing attitudes and philosophy.  Attitudes must be changed first before the mechanics of the portfolio transition process take place, if the changes are to endure.  This does bring up another question, though.  Let’s say that my attitude is changed and I am convinced that I should invest using the cognitive investing methodology.  How much expertise is needed?

Answering that question requires another essay.  Stay tuned.

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