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Investing 101

The Basics of Behavioral Finance: Tips and Tricks to Combat Your Cave Man Brain

Thousands of years ago one of your ancient ancestors was enjoying the spoils of a recent hunting trip when suddenly a saber toothed tiger jumped out of the bush.  Your cave man relative had a choice, fight off the tiger or drop the food and run.  They ran….and they ran fast.  The human brain is an amazing thing, it has evolved over the eons to help us survive.  Most of those eons involved surviving physical threats where flight over fight was often the smart choice.

The financial “threats” we face in the 21st century are diametrically opposed to the physical threats of ancient times.  Stock market crashes, unlike hungry saber toothed tigers, often present opportunities as opposed to imminent death.  My very simple example here downplays the complex neurobiology of the human brain that drives us to make poor financial decisions, but the end result is the same:  humans are hardwired to be poor investors.

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The Corrosive Nature of Investment Fees

Corrosion is the slow decay of metallic materials that, over a long period of time, can lead to catastrophic failure of a structure.  Investment fees act in a similar nature, slowly and constantly eating away at your returns and severely damaging your potential to buy that house, put your kids through college or retire when you want.  The good news is that, like an engineer dealing with corrosion, you can avoid the damage if you make smart decisions to protect yourself.

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”  -Warren Buffett

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Modern Portfolio Theory and the Efficient Frontier

In 1952 a guy named Harry Markowitz introduced something known as Modern Portfolio Theory (MPT).  Harry won a Nobel prize for his work which mathematically showed how and why risk and return for an individual asset should not be viewed on its own, but on how that asset impacts the overall risk and return of a portfolio of assets.  My prior blog post on asset allocation explains the basic mechanics of how different asset classes can impact the risk and return of a portfolio.  In this post we will dive a little deeper to show how the efficient frontier is constructed.

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Historical Risk versus Return of Stocks and Bonds

Stocks are risky but they generate high returns.  Bonds are safer but they offer proportionally less returns.  Investors may think that combining these asset classes in a portfolio linearly scales risk versus return.  For the most part this is true; but due to a lack of correlation between these assets, combining them in a portfolio can actually increase returns without increasing risk.

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Basics of Asset Allocation and the Efficient Frontier

With investing, we all know that if you want to play it safe you buy bonds and that if you want more return and can stomach the risk you buy stocks.  But what if I told you that there is a way to have your cake and eat it to, to have less risk AND more return.  Normally if you hear this kind of claim from someone I would advise you to run from them and run fast.  But in this case I think you should hear me out because engineering a portfolio comprised of the right mix of different asset classes can help you travel on the efficient frontier all the way to the bank.

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