Investing With Discipline
In my last article I discussed some of the behavioral aspects to investing that can create problems for long-term investors. These are deeply rooted, emotionally driven mental shortcuts that humans have learned to use over the millennia. They have helped us to survive as a species in the wild, but are less helpful in today’s modern world and can even be harmful to long-term investment success.
For example, many people will tell you “there’s safety in numbers.” This kind of herd mentality is very useful on the African plains, but when it comes to investing, it can lead investors to jump into an investment only after many other people have already done so. This ‘going with the crowd’ makes people feel much more confident and secure in our decision. Most people (and some professional investors) would prefer to be wrong with the crowd than wrong by themselves.
And yet, quite often the worst time to buy an investment is after it becomes the hot trend of the day. Think internet stocks in 1999 and real estate in 2005, or tulips in 1637. This is part of the reason why so many investors underperform the broad market: they buy into an investment only after a trend is well established, missing much of the early gains only to fully commit right before a crash.
Professional investors have many tools at their disposal to help them overcome these challenges. The first is that they generally have access to better research and analysis than does the average investor. This informational advantage is very important, but not sufficient by itself. It enables (though cannot ensure) better analysis and decision making based on fundamental factors, rather than emotional responses based on panic or euphoria.
A second tool that professionals use to maintain their discipline is using their research to make estimates and forecasts about the future. These expectations allow them to better determine which investments are attractive and which are less than compelling. This is not easy to do, and there are countless examples of professional investors who have been completely wrong, but it is an important starting point for disciplined investing. If something does not go as expected, it also provides them a framework for evaluating their decisions and correcting their mistakes in the future.
A tool used by investment advisors is the Investment Policy Statement. This is a simple document explaining the parameters which guide portfolio construction. For example, an investor with a moderate tolerance for risk might want to invest between 50-70 percent in stocks and 30-50 percent bonds. This gives you a range in which to work based on your personal tolerance for volatility and loss, your expectations about future gains and the rate of return you need to earn in order to achieve your goals. The importance of the Investment Policy is that it provides boundaries beyond which you will not go. Thus, even when you are feeling most pessimistic about investing, the policy limits your flexibility, keeping at least a portion of your portfolio invested.
While we’ve all heard stories about people who successfully “dodged the bullet” by getting out of the market before a crash, there are far more examples of people who sold out completely at the very bottom. Furthermore, once you have gotten out of the market, it is almost impossible to convince yourself to get back in; our brains are hard-wired to help us find reasons to confirm the decisions we make. Ironically, once an investor sells out completely, his brain works to convince him that he made the right decision and actively seeks information to confirm the decision, even as markets soar.
Having an investment policy is not a panacea, but it is a key component to enforcing a disciplined investment strategy. And that is the key to long-term success and wealth preservation.
This column is prepared by Rick Brooks, CFA, CFP®. Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Rick can be reached at (858) 755-5166, or by email at brooks@bfadvisers.com. Rick and his family live in Mission Hills.
Category: Business
