Simple but not easy: Reflections on Personal Finance

Almost everyone has heard the recommendation to buy index funds, but few truly internalize what that means. I reflect on how I learnt the value of indexing and simplicity. 

Darkness

I started my career in the USA in mid 2010s. Once I had paid off my education loans I was left with the question of how to invest my money for the future. I remembered that for my parents' generation investing in land and gold was the way to go. They considered stock markets dangerous and equated it to gambling. But I knew I was in a different place and time. Searching the web some articles suggested that I should invest the money in index funds. I found a global equities index fund, but I wasn't sure if that was the right one. I invested in it for a year and it barely moved, rising by a few percentage points. Then I looked at big tech stocks and they were soaring. I also held a large chunk of employer stocks that was part of my compensation and that was rising by more than 30% per year. Since I was a tech enthusiast, I was pretty sure I could predict and make more money by investing in tech stocks rather than index funds. So I sold off all of my index funds and purchased a variety of tech stocks. Then I read a bunch of news articles about stock markets being at an all time high and it might crash. So I got scared and moved to cash for a year. This led to me missing a year's worth of appreciation of equities. I was haphazardly buying individual stocks and selling based on vibes..

Knowledge is not wisdom

Luckily in a few years I chanced upon this book "A simple path to wealth" by JL Collins. This finally gave me a guide on what I should be doing with my money. I realized some of the mistakes I had made. I wished someone would have given me this book when I started my career. I started moving my portfolio towards US equities index fund over time, but I still held a considerable chunk of individual stocks. I was soon to learn that knowing is only half of the battle, sticking to it is the other half. Then Covid hit and the market started going down. When the market fell 10% - back to my purchase price, I sold most of my stocks and moved into cash. I reasoned that since I'm not losing or gaining anything, it is OK to sell and I predicted stocks would go way more down. I truly felt that this time it was different due to the global pandemic. Stocks did go further down, but then they started rising. Eventually I did get in but I missed half of the rise. I learned through experience how hard it is to time the market.

Progress over the years

When I joined my second company after a few more years I read books by William Bernstein. I learnt that it was a mistake to hold employer stocks so I started selling my employer RSUs as soon as I got them. I learnt to start optimizing on taxes (backdoor Roth, mega backdoor Roth, tax efficient placement). I started holding 10% in bonds. I got attracted by the high historical returns of small cap value after reading Paul Merriman so I tilted heavily into small cap value. Then I learned why owning individual stocks is a bad idea. Understanding mathematically that most long-term market returns come from a tiny fraction of companies finally pushed me from knowing to being convinced. I paid taxes and sold all of my individual stocks by in a few years and sector specific ETFs in a few more years. I understood the value of using an Investment Policy Statement and not reacting arbitrarily to current events.

Random Walk and the Unknowability Problem

I think the hardest thing to grasp was the random walk nature of stocks. As an ex-signal-processing engineer I have a special appreciation for noise and signals. We are wired to see patterns where it does not exist. Stocks are even worse as they are not just noisy, but also adapt to our actions. Because of the random walk nature, there is no way to learn if our actions were good or bad. The only way to know is to hold a fund till retirement and then judge. But by then it is too late to do anything about it. This necessitates an extremely strong conviction to hold a fund for life. This in turn requires simplicity. Now whenever I think of a new investment I ask myself, am I convinced enough to hold this for the rest of my life? If the answer is no then I ignore it. I'm planning to gradually reduce my small cap value tilt. The most shocking thing I learnt is how little information is obtained by looking at the past returns and how most people (including past me) used it as a guide.

Thus personal finance is an interesting area where the prescription is very simple. But the hard part is sticking to it. This is one strange area where the more effort one puts in prediction, the worse is the outcome. In fact the main effort I have to put is to stop myself from fiddling with my portfolio.