Mauldin Warns "This Debt Train Will Crash"

We are approaching the end of the debt Train Wreck series. I've spent several weeks explaining why I think excessive debt is dragging the world economy toward an epic crash. The tracks ahead are clear for now but will not remain so. The end probably won't be pretty. But there's good news, too: we have time to get our portfolios, our businesses, and our families prepared.

Today, we'll look at some new numbers on just how big the problem is, then I'll recap the various angles we've discussed. This problem is so big that we easily overlook key points. I hope that listing them all in one place will help you grasp their enormity. Next week, and possibly a few after that, I'll describe some possible strategies to protect your assets and family.

Now on with the end of the train.

Off the Tracks

Talking about global debt requires that we consider almost incomprehensibly large numbers. Our minds can't process their enormity. How much is a trillion dollars, really? But understanding this peril forces us to try.

Earlier in this series, I shared a 2015 McKinsey chart that summed up global debt totals. They pegged it at $199 trillion as of Q2 2014. Note that the debt grew faster than global GDP. Everything I see suggests it will go higher at an ever-increasing rate.

Source: McKinsey Global Institute

Last month, McKinsey published a very useful online tool for visualizing global debt, based on Q2 2017 data. It shows a total of $169T, which is less than McKinsey said in 2014. Is debt shrinking? No. The new tool excludes the Financial debt category, which was $45T three years earlier. A separate Institute for International Finance report said financial debt was $59T at the end of 2017. These aren't quite comparable numbers, but in the (very big) ballpark range we can estimate total debt was somewhere between $225T (per McKinsey) and $238T (per IIF) in mid-2017. (IIF's latest update last week says it is now $247T).

Source: McKinsey Global Institute

That would mean world debt grew something like 13% in the three years ended 2017. If so, it would be a slowdown comparable to the 2007-2014 pace McKinsey showed in the chart above—but still faster than world GDP grew in those three years. McKinsey says global debt (ex-financial) grew from $97T in 2007 to $169T in mid-2017.

Importantly, households aren't driving this. Governments accounted for 43% of the increase McKinsey cites and nonfinancial corporate debt was 41%. That is where I think the coming train crash will originate. Governments have more debt than corporations, but also more tools (like taxing authority) to manage it.

On the other hand, governments also have massive "unfunded liabilities" that don't show in the numbers above. So, they aren't in a great position, either.

Bottom line: There's going to be a train wreck here. Which train will go off which track is unclear, but something will. And we're all going to feel it.

Woes to Come

We launched this journey in my May 11 Credit-Driven Train Crash letter. I described my friend Peter Boockvar's perceptive statement: "We no longer have business cycles, we have credit cycles."

His point is subtle yet critical. Post-crisis growth, mild as it's been, has been largely a function of debt, which central banks encouraged and enabled. The result was inflated asset prices without the kind of "recovery" seen in previous business cycles. Interest rates, i.e. the cost of debt, thus became critical.

With rates now moving up again, premium asset prices are losing their raison d'etre and will stabilize and eventually fall. Peter Boockvar says this, not the conventional business cycle, is what will set off recession. That's key. Lower asset prices won't be the result of the next recession; they will cause that recession.

I showed in that letter how companies will need to refinance about $4T of bonds in the next year, almost all of it at higher rates. This will hit debt-burdened companies that are already struggling and make it almost impossible for some to keep operating. Lenders, i.e. high-yield bond holders, will try to exit their positions all at once only to find a severe shortage of willing buyers.

The following week in Train Crash Preview, I listed the steps in which I think the crisis will unfold. They fall in four stages.

• The Beginning of Woes: Something, possibly high-yield bonds, will set off a liquidity scramble. It will spread through the already-unstable financial system and trigger a broader credit crisis.

• Lending Drought: Rising defaults will force banks to reduce lending, depriving previously stable businesses of working capital. This will reduce earnings and economic growth. The lower growth will turn into negative growth and we will enter recession.

• Political Backlash: Concurrent with the above, employers will be automating jobs as they grow desperate to cut costs. Suffering workers—who are also voters—will force higher "safety net" spending and government debt will skyrocket. A populist backlash could lead to tax increases that prolong the recession.

• The Great Reset: As this recession unfolds, the Fed and other central banks will abandon plans to reverse QE programs. I seriously think the Federal Reserve's balance sheet assets could approach $20 trillion later in the next decade. But it won't work because the world simply has too much debt. They will need to find some way to rationalize or "reset" the debt. Exactly how is hard to predict but it probably won't be good for lenders, or for the holders of government promises like pensions and healthcare.

Next in High Yield Train Wreck, we dove deeper into the dream-driven high-yield bond market exemplified by this year's nutty $702-million WeWork issue. I quoted Grant Williams, who wrote a masterful takedown of this craziness.

Ten years into the ongoing laboratory experiment being conducted by the world's central banks, everywhere you look there are multiple examples of the kind of lunacy those policies have fomented by reducing the cost of capital to virtually zero and forcing investors to take risks they would ordinarily avoid in order to find some kind of return.

WeWork is one example of a company for whom, in the face of rapid growth, massive negative cashflows aren't a problem, but there are plenty of others. Uber, AirBnB, SnapChat and, of course, Tesla have all captured the imagination of investors thanks to lofty dreams, articulated by charismatic CEOs—but the day things turn around and the economy begins to weaken or, God forbid, investors seek a return on their investment as opposed to settling for rolling promises of gigantic, game-changing revenues to come, it is over.

We went on to talk about the insanity of yield-hungry investors practically throwing cash at borrowers while demanding little in return. I also showed how this is not simply a junk-rated company problem, since almost half of investment-grade companies are rated BBB and could easily slip to junk status in a downturn.

Growing Leverage

The week after we turned to Europe in The Italian Trigger. Unfortunately, Italy isn't Europe's only problem. The big Kahuna is Germany, which spent years offering generous vendor financing to the rest of the continent to entice the purchase of German goods. The result: a giant trade surplus for Germany and giant, unpayable debts for those who bought German goods.

The Euro currency union is fatally flawed because it leaves each member state to set its own fiscal policy. There are good reasons for that, but it is not sustainable indefinitely. The Eurozone must get either much more centralized or fall apart. All the Rube Goldberg contraptions the ECB and others invent are temporary fixes. They've worked so far. They won't work forever.

I still think the most probable scenario is that Germany and the Netherlands (and the rest of the northern European cabal) reluctantly agree to let the European Central Bank mutualize all the sovereign debt, taking onto their balance sheet and issuing new ECB-backed debt for the entire zone. There would have to be serious constraints on running deficits after that point, but it would prevent a breakup, or at least delay it for another decade or so.

Of course, within a few years those new deficit constraints would be ignored. I said in a previous letter Germany will need to collect almost 80% of GDP in 30 years in order to be able to deliver its promised healthcare and pensions. Their inability to do that will be evident much sooner. Germany will end up becoming one of the biggest problems.

The next installment, Debt Clock Ticking, was a bit philosophical. I talked about debt letting you bring the future into the present, buying things you couldn't afford if you had to pay for them now. But the entire world went into debt for the equivalent of tropical vacations and, having now enjoyed them, realizes it must pay the bill. The resources to do so do not yet exist. So, in the time-honored tradition of lenders everywhere, we extend and pretend. But with our ability to pretend almost gone, we're heading to the Great Reset.

Source: Moody's Investor's Service

Then I reviewed some of the McKinsey and IIF numbers and described the amount of leverage that's built up in the system. Just a decade after the Great Recession, the average non-financial business went from 3.4x leverage to 4.1x. They are now roughly 20% more leveraged than they were the last time all hell broke loose. CEOs and boards seem to have learned little from the experience—or maybe learned too much. If you believe the Fed has your back, then leveraging to the moon makes sense.

Pension Problems

The last three letters in the series got personal for many readers as I talked about pension debt. In The Pension Train Has No Seat Belts, we looked at the demographic challenge facing US pension funds, mainly state and local government plans but also some private ones. We are asking a shrinking group of working-age people to support a growing number of retirees and that's just not going to work.

Source: Peter G. Peterson Foundation

The promises employers made to workers are a kind of debt. They're the borrowers, workers are the lenders… and unlike in 2008, this time it will be lenders who get hurt the most. A new report by the American Legislative Exchange Council (ALEC) shows the unfunded liabilities of state and local pension plans jumped $433 billion in the last year to more than $6 trillion. That is nearly $50,000 for every household in America.

Nor is this only a US problem, as we saw in Europe Has Train Wrecks, Too. According to the World Economic Forum, the United Kingdom alone has a $4-trillion retirement savings shortfall that will rise to $33 trillion by 2050. This in a country whose entire GDP is only about $2.6 trillion and doesn't account for the increasingly likely disaster Brexit will be. Switzerland, Spain, and others have similarly dire outlooks, often driven by even worse demographics than we have in the US. Germany, as noted above, is simply off the rails.

Finally, in Unfunded Promises, we reached the ultimate debt problem: US government unfunded liabilities. On paper, Washington's debt is about $21.2 trillion… but that doesn't include the $13.2-trillion unfunded, off-the-books Social Security liability, or the $37-trillion Medicare unfunded liability. Those aren't my numbers, by the way; they come from the Social Security and Medicare trustees and are probably understated. My friend, Boston University professor Larry Kotlikoff, thinks it should be more like $210 trillion. He has a considerable amount of published works and a book he co-authored with fellow Texan Scott Burns.

That's not all. The federal government also has liabilities for civil service and military pensions, veteran benefits, some defaulted private pensions via PBGC, and open-ended guarantees to entities like FDIC, Fannie Mae, and more.

The budget outlook is horrible even without all that, too. The Congressional Budget Office thinks federal debt will be 200% of GDP by 2048, and that by 2041 it will take all federal tax revenue just to support Social Security, the various health care programs and pay interest. That's before defense or anything else the government does. And that's assuming relatively high growth and NO recessions and a rising stock market forever as we ride off into the sunset.

I wrapped up quoting my friend Dr. Woody Brock, who thinks the most likely outcome will be wealth taxes at federal, state, and local levels. I truly hope he's wrong about that, but I fear he is not. My preferred new tax for the US would be a VAT that eliminates the Social Security tax (thus giving lower-income workers and businesses a raise) but still funds Social Security and healthcare. Other government expenditures would be funded from income taxes which could be reduced significantly, and even eliminated on incomes below $50,000. Now that's a tax cut that would boost the economy and balance the budget.

There really are only two ways to solve this problem: massive taxes on someone, or a debt liquidation of some kind. And remember, if you are getting a retirement pension fund and/or healthcare, your benefits are part of that "debt liquidation." Both will be painful. We have pulled forward our spending and must eventually pay for it. The time is coming. Please don't shoot the messenger.

Let's summarize. Global debt is over $225 trillion. By the beginning of the next decade it could be over $300 trillion. Global government unfunded liabilities are easily in the $100-trillion range today and could easily double by the end of the next decade. Debt service, pensions, and healthcare will take 20-25% of GDP in many countries (more in some of Europe).

Your mileage may and will vary by country. In some, there will be inflation and in others, deflation. We will be thinking the unthinkable and choosing policies that seem insane to even mention today. But then, think about what Japan is doing. And the ECB. Add in automation and the loss of hundreds of millions of jobs in the OECD countries. Then think about what will happen in the emerging economies.

We Give Up! China Stops Deleveraging, Tells Cities To Ramp Up Spending

China's growth over the past decade has been not just impressive, but historically unprecedented. No single country has ever added this many factories, roads, airports and entire new cities in so short at time. 

But the transformation has come at a cost, in the form of a debt bubble that's starting to look unstable. Beginning in 2015 non-performing loans and bond defaults both started trending upward and are now close to levels at which the risks become systemic. The following three charts tell that tale:

In response, China's government has been trying to slow the bubble's expansion without bursting it (which a quick glance at America's track record would imply is impossible). Among other things, Communist Party leaders (that's right, the Party is still in charge) have been tightening bank lending regulations and telling local governments to cut back on the empire-building.

But then – and this is how it always works for debt-addicted systems – a couple of things happened to make staying on the wagon much harder. The US began a trade war with China and other major trading partners (though mostly with China), which will if it continues, slow down global trade and cut the inflow of foreign capital to export-dependent economies. And the past couple of years' credit restrictions have started to bite, slowing China's domestic economy and making it harder to provide jobs for all the people who have come to expect upward mobility and might take to the streets if they don't get it. 

So – again as addicts tend to do – China has decided that maybe it's wise to delay the tightening for a while and allow the leverage machine keep running. According to yesterday's Wall Street Journal, 

China's Effort to Control Debt Loses Steam

BEIJING—China is letting up on its drive to keep a lid on debt growth as it faces a softening economy at home and escalating trade tensions with the U.S.

Senior Chinese leaders led by President Xi Jinping have been sending unmistakable signals that the campaign to rein in financial risk isn't the overriding priority it has been. Financial regulators are delaying the release of rules to curtail risky lending by banks and other institutions out of concern that the regulations would choke off a source of funding and rattle financial markets already shaken by worries over trade and the economy, people familiar with the decision said.

In a turnabout, the State Council, China's cabinet, stopped hectoring city halls and townships to restrain spending and instead last week launched an inspection to urge them to speed up already approved investment projects to re-energize growth. The central government often uses inspections as a way to evaluate local officials and get top-level directives across.

An April meeting of the Politburo, the inner sanctum of power, offered an initial sign of the shift in government priorities toward growth. Mr. Xi, who presided over the meeting, called for expanding domestic demand as authorities continued to contain financial risks. Such pro-growth emphasis had been absent in Politburo meetings since 2015.

China's economic growth has been on a controlled descent for most of this decade, propped up at times by shots of easy credit that have helped make debt a long-term threat for the world's second largest economy. With growth still buoyantly above the government's 6.5% target, Mr. Xi has taken aim at debt and other financial risks the past two years to put the economy on sounder footing.

Now, that campaign is taking its toll. Signs are building that the economic expansion is losing steam—from weakening investment in factories to anemic household consumption and rising corporate defaults.

The trade fight with the U.S. puts growth further at risk, making Mr. Xi's initiative look unsustainable, government advisers said.
The central bank in April began freeing up more funds for banks to make loans. The Chinese leadership is expected to further loosen China's fiscal and monetary stance at a meeting later this month of the Politburo, government advisers and economists said.

Debt levels, especially for companies and local governments, have soared since China unleased a massive financial stimulus to ward off the 2008 financial crisis. Debt stood at 242% of economic activity at the end of 2017, according to Macquarie Group. 

"If China has an across-the-board loosening up again, borrowing by state-owned enterprises might get more relentless," said Zhu Chaoping, a market strategist at JP Morgan Asset Management. "This is the risk here."

To paraphrase Joni Mitchell, all credit bubbles meet this same fate someday, as the prospect of stopping becomes too scary to contemplate. So the debt binge continues, with leaders promising to "contain financial risks" when really they're just riding the tiger, hoping to hang on until … well, something happens to save them.

But experience teaches that nothing can "save" a system that has taken on way too much debt. "Inflate or die" becomes the guiding principal right up to the end.

Ron Paul Warns When The "Biggest Bubble In History" Bursts, It'll "Cut The Stock Market In Half"

When this bubble finally bursts, will we witness the biggest stock market crash in U.S. history?  "The bigger they come, the harder they fall" is a well used phrase, but I think that it is very appropriate in this case.  From a low of 6,443.27 on March 6th, 2009, we have seen the Dow nearly quadruple in value since the last financial crisis.  It has been a remarkable run, and it has lasted far longer than virtually any of the experts anticipated.  But what goes up must come down eventually.  

This stock market bubble was almost entirely fueled by easy money from the Federal Reserve, and now that easy money has been cut off.  The insiders can see the handwriting on the wall and they are getting out of the market at a pace that we haven't seen since 2008.  Could it be possible that the day of reckoning is finally at our door?

Of course we have been hearing warnings like this for a very long time. In fact, I have been warning about a market crash for a very long time.  Just the other day, one of my readers insisted that if something was going to take place that "it would have happened by now".  In the Internet age, we have been trained to have very short attention spans, but financial bubbles don't care about the length of our attention spans.  They all inevitably come to a bitter end, but they don't reach that end until they are good and ready.

And without a doubt we are on borrowed time, but meanwhile so many of us that are continually warning about what we are facing are getting a lot of heat for it.

There's a bubble building in markets that will burst, Ron Paul says from CNBC.

For instance, when Ron Paul told CNBC that the stock market is "the biggest bubble in the history of mankind", he was strongly criticized for it, but he was 100 percent correct…

This market is in the "biggest bubble in the history of mankind," and when it bursts, it could cut the stock market in half, he told CNBC's "Futures Now" Thursday.

If the Dow only plummets to about 12,000 or so during the coming downturn we will be exceedingly fortunate, because the truth is that stock prices need to fall by at least that much just to get us into the neighborhood where stock prices will start to make sense once again.

Today, sales to stock price ratios are hovering near all-time highs.

The same thing is true for earnings to stock price ratios and GDP to stock price ratios.

The only other times these ratios have been so elevated were just before major stock market crashes.

In the end, these ratios always, always, always return to their long-term averages eventually.

It may take many years, but it always happens.

So what factors led Ron Paul to make such an ominous prognostication?  The following comes from CNBC…

"The Congress spending and the Federal Reserve manipulation of monetary policy and interest rates — debt is too big, the current account is in bad shape, foreign debt is bad and it's not going to change," he said.

Paul isn't alone in his critique. A number of politicians have voiced concern over ballooning deficits, including current House Speaker Paul Ryan, who raised a warning on the nation's debt in 2012.

Of course it isn't just the U.S. that is drowning in debt.

According to the Institute of International Finance, total global debt just hit a brand new record high of 247 trillion dollars…

Every quarter the Institute of International Finance publishes a new number of the total amount of global debt outstanding, and every quarter the result is the same: a new record high

Today was no exception: according to the IIF's latest Global Debt Monitor, the amount of debt held in the world rose by the biggest amount in two years during the first quarter of 2018, when it grew by $8 trillion to hit a new all time high of $247 trillion, up from $238 trillion as of Dec. 31, 2017 and up by $30 trillion from the end of 2016.

Global debt has been rising much, much faster than global GDP, and at this point there is three times as much debt in the world as there is money.

There is no possible way that all of that debt can ever be paid off.  The only way that the party can continue is for debt to continue growing faster than global GDP, and everyone knows that is simply not sustainable in the long-term.

So an absolutely monumental "adjustment" is coming.  You can call it a "crash", a "collapse" or anything else that you would like, but just as certainly as you are reading this article it is coming.

It is just a matter of time.

But for now, the talking heads on television continue to insist that everything is just fine and that the stock market still has more room to go up…

There's still room for stock markets to rise and worries of an impending recession are premature, according to Berenberg Capital Markets' chief economist.

"Even if profits peaked in (the first quarter of) 2018, which remains uncertain, history suggests the stock market has room to appreciate," Mickey Levy, Berenberg's chief Americas and Asia economist, said in a client note this week. He pointed to data demonstrating how in every economic expansion since the mid-1970s, the S&P 500 index went on to appreciate for a "significant period" after corporate profits peaked.

I wish that CNBC would have me on just one time so that I could refute some of these guys.

Since 1913, the Federal Reserve has gone through 18 rate hiking cycles.  In 18 out of 18 cases, those rate hiking cycles have ended in either a recession or a market crash.

Do you really think that the 19th time will be different?

10 years ago, virtually everyone thought that the "boom times" would last forever too.  But they didn't.  Instead, we plunged into the greatest economic and financial crisis since the Great Depression, but at this point 2008 seems like ancient history to most people.

Yet again we have fooled ourselves into thinking that the good times will just continue to keep on rolling, and once again our society will be in for a very rude awakening when the inevitable crash finally arrives.

The Best Is Behind Us": How A $139 Billion Fund Is Preparing For The Worst

While equities continue to take the risk of escalating trade wars in stride, ignoring the threat of an additional $200BN in tariffs on Chinese exports and pushing the S&P back above 2800, some investors are taking a far more cautious approach: instead of piling into tech names - the most popular trade of 2018 bar none - Australian investment manager AMP Capital Investors, which manages $139BN, is instead buying ultra-long bonds as a hedge for a worst case scenario, according to Ilan Dekell, the head of macro for global fixed income at the asset manager.

"Six weeks ago, we started increasing our duration in the 30-year part of the curve," Dekell told Bloomberg in an interview in Sydney.  "It gives us a bit of protection. I can't forecast the trade war." 

Doing the opposite of Horseman Capital, AMP Capital is also betting on continued dollar strength by shorting a basket of emerging-market currencies which have been pounded in recent months amid tightening global liquidity.

Looking ahead, Dekell said that "the best is probably behind us," referencing the environment of synchronized and rising global growth and benign inflation seen earlier this year, which have since seen the US emerge as the leading dynamo of global growth largely on the back of Trump's fiscal stimulus. And then there is the great unknown of what Trump may do or tweet at any moment: "The trade war adds to our concerns - our book overall is very conservative."

While betting on lower long-term yields, the fund is also shorting two-year government notes, betting the ongoing yield curve steepening will continue as it sees the Federal Reserve raising interest rates two more times this year and thrice in 2019.

"We held our shorts in the two-year part of the curve" because of the rate hikes, said Dekell. "We've become more concerned and conservative about tightening conditions and we think the policy bias is higher."

As the latest CFTC data reveals, the AMP position is against the market grain, with specs putting on record bets that the curve will steepen in the near future, as 2Y shorts have shrunk even as 10Y net spec shorts remain at record levels.

Dekell also has a negative outlook on emerging markets, seeing further weakness in EM assets, particularly in countries with current-account deficits such as Indonesia and India. Looking at the Australian dollar, Dekell said the currency is currently trading at "fair value" after predicting earlier in the year that the AUD would fall to 73 U.S. cents before the end of the year. "If you go down the route of trade wars and people getting concerned about China growth, then that would put downward pressure on the Aussie."

AMP Capital is not alone to seek refuge from the coming storm in 30Y bonds: as Bloomberg notes, the same strategy is being used by Goldman Sachs Asset Management and QIC, while PIMCO previously said that it would seek a Treasury safe haven "if things get worse."

The 30Y Tsy was yielding 2.93%, down from 3.26% mid-May, when it hit the highest level since September 2014. Recently, Morgan Stanley went so far as to call the peak in the 10-year yields amid trade concerns with the number of stories referencing "trade war" closely following the price on the 30Y Tsy.

Meanwhile the broader market remains overwhelmingly short the 30Y, with non-commercial net spec shorts targeting the Ultra bond in record amounts, providing continued ammo for a material short squeeze if economic growth in the US or globally were to take a leg lower, an outcome that is quite possible should the global trade wars accelerate . 

The Myths Of Stocks For The Long Run: The Problem With Psychology

The Problem Of Psychology

During this series so far we have primarily discussed the more mechanical issues surrounding "investing myths" over the duration of an individuals investing "life-span." 

Individuals are often told:

"There has never been a 10 or 20-year period in the market with negative returns."

As we showed previously, such is not exactly correct once you account for inflation.

While "buying and holding" an index will indeed create a positive return over a long enough holding period, such does not equate to achieving financial success. But even if "investing your way to wealth" worked as advertised, then why are the vast majority of Americans so poorly equipped for retirement?

Every three years, the Federal Reserve conducts a study of American finances which exposes the lack of financial wealth for the bottom 90% of households. (Read: The Bottom 90% & The Failure Of Prosperity)

Other survey's also confirm much of the same. Via Motley Fool:

"Imagine how the 50th percentile of those ages 35 – 44 has a household net worth of just $35,000 – and that figure includes everything they own, any equity in their homes, and their retirement savings to boot.

That's sad considering those ages 35 and older have had probably been out in the workforce for at least ten years at this point.

And even the 50th percentile of those ages 65+ aren't doing much better; they've got a median net worth of around $171,135, and quite possibly decades of retirement ahead of them.

How do you think that is going to work out?"

Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard's recent survey, not so much.

• The average account balance is $103,866 which is skewed by a small number of large accounts.

• The median account balance is $26,331

• From 2008 through 2017 the average inflation-adjusted gain was just 28%. 

So, what happened?

• Why aren't those 401k balances brimming over with wealth?

• Why aren't those personal E*Trade and Schwab accounts bursting at the seams?

• Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:

• Lack of capital to invest, and;

• Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to "invest" when the majority of Americans have an inability to "save."

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

While "buy and hold" and "dollar cost averaging" sound great in theory, the actual application is an entirely different matter. The lack of capital is an issue which can only be resolved through financial planning and budgeting, however, the simple answer is:

Live on less than you make and invest the rest.

Behavioral biases, however, are an issue which is little understood and accounted for when managing money. Dalbar defined (9) nine of the irrational investment behavioral biases specifically:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as "panic selling."

• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.

• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.

• Mental Accounting – Separating performance of investments mentally to justify success and failure.

• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.

• Herding– Following what everyone else is doing. Leads to "buy high/sell low."

• Regret – Not performing a necessary action due to the regret of a previous failure.

• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.

• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

George Dvorsky once wrote that:

"The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn't mean our brains don't have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we're subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions."

Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the "opposite" of what they should when it comes to investing their own money. They "buy high" as the emotion of "greed" overtakes logic and "sell low" as "fear" impairs the decision-making process.

Let's dig into the top-5 of the most insidious biases which keep us from achieving our long-term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. For instance if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.

The issue of "confirmation bias" is well known by the media. Since the media profits from "paid advertisers," viewer or readership is paramount to obtaining those clients. The largest advertisers on many financial sites are primarily Wall Street related firms promoting products or services. These entities profit from selling product they create to individuals, therefore it should be no surprise they advertise on websites that tend to reflect supportive opinions. Given the massive advertising dollars that firms such as Fidelity, J.P. Morgan (JPM), and Goldman Sachs (GS) spend, it leaves little doubt why the more successful websites refrain from presenting views which deter investors from buying related products or services. 

As individuals, we want "affirmation" our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are "right."

This is why it is always important to consider both sides of every debate equally, analyze the data accordingly, and form a balanced conclusion. Being right and making money are not mutually exclusive.

2) Gambler's Fallacy

The "Gambler's Fallacy" is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.

The bias is clearly addressed at the bottom of every piece of financial literature.

"Past performance is no guarantee of future results."

However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.

Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. "Hot hands" only tend to last on average 2-3 years before going "cold."

We traced out the returns of the S&P 500 and the Barclay's Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years. "Performance chasing" is a major detraction from an investor's long-term investment returns.

Of course, it also suggests that analyzing last year's losers, which would make you a contrarian, has often yielded higher returns in the near future.

3) Probability Neglect

When it comes to "risk taking" there are two ways to assess the potential outcome. There are "possibilities" and "probabilities." As individuals, we tend to lean toward what is possible such as playing the "lottery." The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning it. However, it is this infinitesimal "possibility" of being fabulously wealthy that makes the lottery so successful. Las Vegas exists for one reason; amateur gamblers favor possibility over probability.

As investors, we tend to neglect the "probabilities," or specifically the statistical measure of "risk" undertaken, with any given investment. Our bias is to "chase" stocks that have already shown the biggest increase in price as it is "possible" they could move even higher. However, the "probability" is by the time the masses have come to discover the opportunity, most of the gains have likely already been garnered.

"Probability Neglect" is the very essence of the "buy high, sell low"syndrome.

Robert Rubin, former Secretary of the Treasury, once stated;

"As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.

Most people are in denial about uncertainty. They assume they're lucky, and that the unpredictable can be reliably forecasted. This keeps business brisk for palm readers, psychics, and stockbrokers, but it's a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision."

4) Herd Bias

Maybe the best way to show how susceptible we are to follow the crowd is by watching this video from Candid Camera.

Though we are often unconscious of the action, humans tend to "go with the crowd." Much of this behavior relates back to "confirmation" of our decisions but also the need for acceptance. The thought process is rooted in the belief that if "everyone else" is doing something, and if I want to be accepted, then I need to do it also.

In life, "conforming" to the norm is socially accepted and in many ways expected. However, in the financial markets, the "herding" behavior is what drives markets to extremes.

As Howard Marks once stated:

"Resisting – and thereby achieving success as a contrarian – isn't easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That's why it's essential to remember that 'being too far ahead of your time is indistinguishable from being wrong.'

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it's challenging to be a lonely contrarian."

Moving against the "herd" is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is not necessarily knowing when to "bet" against the stampede but the psychologically debilitating action of being different. As they say, "it is lonely at the top."

5) Anchoring Effect

This is also known as a "relativity trap" which is the tendency to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for.  However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger, or your first pair of shoes? Probably not.

The reason is that the purchase of the home was a major "life" event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we are likely to assume that the next home purchase will have a similar result. When we become mentally "anchored" to an event we tend to base our future decisions around it.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that stock and that outcome. Therefore, we become anchored to that stock. Individuals tend to "shun" stocks which lost value even though the individual simply bought and sold at the wrong times. After all, it is not "our" fault an investment lost money; it was just a bad company. Right?

This "anchoring" effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you "anchor" on ABC and keep buying it as it rises. When the stock begins its inevitable "reversion," investors remain "anchored" on past performance until the "pain of ownership" exceeds their emotional threshold. It is then they tend to panic "sell" and now become "anchored" to a negative experience and never buy shares of ABC again. Worse, DEF, despite your past experience owning it, may present great value at reduced prices, but your previous negative experience reduces your inclination to purchase it.

Conclusion

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Are valuations at levels that have previously lead to higher rates of future returns? Are interest rates rising or falling? Are individuals currently assessing the "possibilities" or the "probabilities" in the markets?

As individuals, we invest our hard earned "savings" into a "speculative"environment where we are "betting" on a future outcome. The reality is the majority of individuals are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

The discussion of why "this time is not like the last time" is largely irrelevant. Whatever gains investors garner in the first-half of an investment cycle by chasing the "bullish thesis" will be almost entirely wiped out during the second-half.