Financial behavior on a napkin: The rear-view mirror

Carl Richards' "circle sketch" on the rear view mirror.

Tess Vigeland: Every now and then we check in with Carl Richards, founder of Prasada Capital Management in Park City, Utah. You might be familiar with his drawings in the New York Times Bucks column, where he takes an economic term or idea, gets out a Sharpie, and illustrates it on a napkin.

Well, Carl is back with another rendering for us. Hi there!

Carl Richards: Hi Tess.

Vigeland: Tell us about the napkin that we're looking at today.

Richards: I'd call it a Venn diagram, but the Venn diagram police got mad at me. So it's a circle sketch, which I realize I'm going to have to explain that. I call them circle sketches. It's two circles and one circle says, "Investing based on past performance." The other circle says, "Driving while looking in the rear-view mirror." And where they overlap is labelled "Causes a lot of accidents."

Vigeland: AlL right, what are we talking about here?

Richards: Well, this is the sort of standard story in the industry where we all say that investing on past performance is no guarantee of future results.

Vigeland: So basically, ignore everything that has happened already, because it says nothing about the future.

Richards: Yeah, but imagine sort of like we all seem to know that or at least we, on an academic level, we've at least read the disclosure. But then the very first thing you do is look at what's been successful in the past and that makes sense in every area but investing it. You know, if we're going to hire a new basketball coach...

Vigeland: We're going to look at his record.

Richards: Yeah. If you're going to hire a contractor, wouldn't you want to look at work he's done on other kitchens. So logically, rationally, it makes sense. I mean, what are you going to do? Invest in something that's been terrible? That doesn't necessarily jive with our experience. I'm going to hire a basketball coach that has the worst record and see how that goes. But the reality is investing based on past performance leads us to buy things that historically are going to do poorly in the future, a la the accidents.

Vigeland: Right. But then what are you supposed to look at?

Richards: I think this gets to a bigger issue, which is we may be asking the wrong question, right? I mean, the question we're asking is "how do I identify the best investment?" And we're asking that almost in a generic sense. Maybe the right question is to start with saying, "Look, what are my financial goals?" Then starting from goals, building a sort of -- and I use this term very lightly -- but building sort of a plan to get there, to those goals. And then picking the investments to populate that plan, because if the investments are based off of our goals, we have a better chance of sticking with them when things go bad. What's really interesting -- again, this took me, like eight years to figure out... One time we did, what we call in the industry a "manager search and selection." I look at what manager's available in this investment program, I search and what's the first screen? Part of it's past performance. We pick the manager. A couple years later, they underperform. We fire and switch to another manager. A couple years later, we're reviewing again, and guess what? It's the same manager originally that shows up in our search? And you're like, "Wait a second. What if I just held onto that manager from the very first time we chose them?" And the message to me ended up being, "Look, you can own a mediocre investment and as long as you behave correctly, you're going to outperform 99 percent of your neighbors."

Vigeland: Sounds also like an argument for sticking with really really basic index funds.

Richards: Yeah, you can make that argument. I try to stay away from the passive-versus-active debate to some degree, 'cause I don't want people to miss the point. If having an active manager encourages you to stick with it longer, then you should have an active manager.

Vigeland: Hm. So it's all about our personal behavior.

Richards: Right. Matching our plan. Start with the right question -- what investments will help me get to my financial goal? Beating a benchmark, picking a great investment is not a financial goal; retirement is a financial goal, sending my kinds to college. So what investments will help me meet those goals? And then stick with them, 'cause realize that no matter how good a job you do picking it, you're going to go through times where it doesn't do well.

Vigeland: All right, Carl, thanks so much.

Richards: Thank you Tess.

Vigeland: You can find those Sharpie drawings and a link to Carl's blog at Behavior Gap.

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