An investment policy statement takes emotion out of investment strategy

Imagine using the following rule to make investment decisions: When the market falls 30%, bail out and sit on the sidelines until it rises to a higher level. This flawed sell-low/buy-higher strategy sounds ridiculous, but it is often the result investors experience when fear overrides reason.

Turbulent markets can bring out the worst in the best-meaning investors. Worries of a market collapse can trigger short-sighted, emotional decisions that lead to poor results.

Despite, or perhaps because of, the big run-up from market lows in March 2009, anyone looking for reasons to abandon the stock market has had plenty to choose from recently. As many dour on-air financial commentators have repeated every few minutes, the euro is teetering, jobless claims remain high, healthcare reform is too expensive, the deficit is out of control, bank credit is still MIA. And so forth.

When the major indices fell seven percent in a few days in early May 2010, many investors had a bad feeling of déjà vu. A panicky sentiment swelled among many market pundits, leaving individuals wondering where to go. Some are surely heading for the exits; others are considering doing so.

Panic is not a strategy

Fear can be a rational feeling in uncertain circumstances, but retreat is not always the best response to that fear. Investors who leave the market in fear of a decline are often making a decision with long-term consequences based on short-term memories and stimuli. Moving money from stocks to fixed income investments or very low interest savings instruments can provide the emotional satisfaction of “doing something – anything!” but this kind of speculative market timing often leads to being out of the market during a big move up.

A more prudent approach is to create and follow a comprehensive long-term financial plan, guided by a disciplined investment policy statement (IPS).

The investment policy statement

An investment policy statement takes emotion out of the equation, regardless of what is going on in the markets day to day. Developed with an investment advisor, the IPS describes the investor’s risk tolerance, needs and goals and the investment strategy that will be used to pursue those goals. It should include specific allocation ranges for different asset classes – such as 10-15 percent large cap domestic stocks, 25-30 percent bonds, and so on. When price changes cause allocations to move out of these target ranges, the portfolio should be rebalanced – brought back to its original target allocation.

Because it describes a long-term plan based on long-term goals, an IPS rarely accommodates short-term moves based on fear, greed, fad, hunch, rumor, or whim. Most often an IPS reminds us to stay the course, to trust the risk and return characteristics of different asset classes, even when the path is rocky and uncomfortable. Like the golden rule of winter driving – don’t stomp on the brakes if you hit an icy patch – the IPS can provide the fortitude to do nothing when our instincts tell us just the opposite.

The statement itself should be reviewed and revised when the investor’s situation changes – income needed for retirement, the sale of a business, a death or divorce. But changes to the IPS are generally not appropriate if the only things that have changed are recent market performance and the tenor of talking heads.

Ignore the animals

Keeping emotion out of the equation gets more difficult every year. The ever-present financial news channels and web sites, celebrity market commentators, rampant blogging and real-time stock quotes on our iPhones saturate our senses. Ignoring all this minute-by-minute market data and commentary is like going to the zoo and trying not to notice the animals, but getting past all the short-term noise allows investors to stay focused on long-term goals and strategies…and sleep at night.

Warren Buffett, long known for buying when others are panicky to sell, often reminds investors that a calm, disciplined long-term perspective is crucial. “Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance,” he states in the Berkshire Hathaway 2009 annual report. “In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.”¹

Like it or not, the stock market goes up and down, sometimes violently. Over the long term, however, the prevailing direction of the market is up, driven by advances in productivity, new technologies, expansion to new markets and other ingredients of growth. No one can predict the timing of rising stock prices, of course, but one thing is certain – one must be in the market when it rises to participate in the returns. A consistent buy-hold-rebalance strategy assures exposure to the long-term potential offered by equities.

Maintaining perspective

There’s no question that economic, political and market news can be unsettling. But as consumers of the news, it is our burden to keep it in perspective, something the media often fails to do. Non-stop media coverage that hyped unlikely dangers convinced some viewers to stock up on rations for Y2K, a crisis that never materialized. We were also flooded with coverage of H1N1 flu, a serious health threat but one no more deadly than typical seasonal viruses. And highly trained meteorologists armed with the latest technology routinely predict storms that fail to form.

Ultimately, we must recognize that not every news story is a crisis, that not every fluctuation in the market – large or small, up or down – is a signal to buy or sell, that not every dire or exuberant prediction on CNBC will come true. Our best defenses against emotion-based decisions are a thoughtfully designed investment policy statement, patience and calm.

¹ 2009 Berkshire Hathaway annual report: www.berkshirehathaway.com/2009ar/2009ar.pdf

© 2010 Bright Sky Group, LLC. All rights reserved.
Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.

Bright Sky Group member firms are each registered investment advisers, which are independently owned and operated from each other. Bright Sky Group provides general financial information. The services, securities and financial instruments described by Bright Sky Group may not be available to or suitable for you, and not all strategies are appropriate at all times. The value and income of any of the securities or financial instruments mentioned herein can fall as well as rise, and an investor may get back less than he or she invested. Foreign-currency denominated securities and financial instruments are subject to fluctuations in exchange rates that could have a positive or adverse affect on the value, price or income of such securities and financial instruments. Independent advice should be sought for an investor’s specific needs.

Weighing a sure thing against an unknown payout

The game show Deal or No Deal can be painful to watch. Beyond the squirming contestants and their high-fiving families, one must often endure the melodrama of bad decisions leading to the evaporation of huge payouts.

Still, it is oddly entertaining. And odder still, the show can be an eye-opening object lesson for important investment concepts.

The premise of the show is simple enough: twenty-six sealed briefcases hide monetary values of one cent to one million dollars. The contestant chooses one sealed case to keep, and then opens and eliminates others one by one. The crux of the show is the difficult choice posed to the player periodically – keep the original case and whatever it holds or opt for a lump sum payout offered by the banker.

A sure thing or an unknown payout – this is the pivotal choice of the show…and of modern investment strategy. Amid the sizzling lights, sparkly models, and the shtick of the host, the game show replicates the key decision every investor makes, knowingly or not, when creating a portfolio – accept a known outcome, or chase a speculative one.

The fundamental choice in investing

Any investor can lock in the market return of an asset class via an index or asset class fund, or choose an actively managed fund that will deliver an unknown return that could be higher or lower than the asset class return. This seemingly simple choice may have more impact on one’s long term investment results than any other.

Let’s consider how that decision might play out on the investment version of Deal or No Deal. Take for instance large cap domestic stocks. Contestant Annie knows she can buy an asset class fund that will deliver, by definition and design, a very close approximation of the weighted return of large US stocks. She can’t know the specific numerical return the market will deliver, of course. In any given year it could be positive or negative, and far above or below the historical return for that asset class. But she can count on it being very close to the return of that asset class going forward.

If the return of large cap stocks is five percent that year, or minus ten, that will be Annie’s approximate return. She accepts that return and holds firm, committed to stay the course through whatever ups and downs the market delivers.

Contestant Phillip, on the other hand, is confident that he can do better. Instead of accepting the return of the asset class, he prefers to pick and choose specific large cap stocks himself, or hire a money manager to do it for him, or buy an actively managed mutual fund whose manager will pick securities and decide when to buy or sell them.

Is more information an advantage?

So who will have a better result? If there was ever a million dollar question, this is it. Human instinct suggests that Phillip has the advantage. Unlike the Deal or No Deal player, he is not making a blind draw among sealed briefcases. He has access to limitless information about companies, the economy, interest rates, past performance, dividend announcements, rankings of funds and managers, and so on. He also has (seemingly) far more control of the outcome. He can buy and sell at any time, overweight specific companies or industries, or get out of the market entirely if he expects a downturn. He can even sell short if he wants to enhance his return in a down market.

With all these resources and options Phillip expects that he will be able to consistently beat the market performance that Annie chose, perhaps by a wide margin. Many casual observers would agree that he has an advantage. Nonetheless, empirical evidence suggests that Annie has a considerable edge. More and more data stacks up each year that shows actively managed funds and money managers underperforming versus the asset class benchmarks they seek to beat.

Part of the disadvantage Phillip faces, of course, is the inherent cost of active management – transaction costs, the salaries of the experts making the decisions, the salaries of analysts and economists making recommendations, plus marketing and other overhead. These costs must be overcome by better investment results just to stay even with passively managed asset class funds.

But costs are only part of the story. Active investors are also prone to, for lack of a better term, mistakes of prediction. Based on rigorous analysis (or hunch, fear, or impatience), active management opens the possibility of selling before a big gain, buying before a big decline, chasing “hot” stocks that quickly cool, or loading up on specific companies or industries at the wrong time.

These miscalculations create the risk of significant underperformance. Over the period 2004 to 2008, for instance, the Standard & Poor’s SPIVA scorecard (which compares active versus index fund performance) shows that the S&P 500 outperformed 71.9% of actively managed large cap funds; the S&P MidCap 400 outperformed 75.9% of mid cap funds; and the S&P SmallCap 600 outperformed 85.5% of small cap funds.¹

The underperformance of active management changes the game for Phillip. It means, essentially, that he is choosing among an uneven field of briefcases, 70-85% of which hold less than the asset class return. If the asset class return of large cap stocks turns out to be five percent, Phillip will likely be choosing from a field of considerably more two percents than ten percents. He will need very good fortune or exceptional predictive skills to overcome this steep disadvantage.

Sure thing or long shot?

Without question Phillip could guess right and beat the market average in any given month, year or decade. In the research cited above, 15-30% of the actively managed funds did outperform the comparable index over the five year period. Still, picking the right stocks, funds, or manager must be considered a long shot, relative to the certainty of achieving the approximate asset class return using Annie’s passive strategy.

Picking a briefcase on TV in front of millions of viewers must be fun. Contestants on the show, even the losers, appear to have a blast. Of course they are playing with house money. Even when they lose big, they are losing money that was never theirs. Perhaps this explains some of the seemingly irrational choices of contestants – turning down a certain six figure sum for the small chance of collecting more, for instance, while millions of home viewers scream “Don’t do it!!!!” at their televisions.

Questionable choices on a chaotic game show should be expected. But some speculative choices made by investors, with their own real money on the line, are more difficult to explain.

¹ “S&P: Majority of Active Fund Managers Underperform Benchmarks Across All Categories Over Past Five Years,” Yahoo Finance, yahoo.com, April 20, 2009

© 2010 Bright Sky Group, LLC. All rights reserved.
Bright Sky Group, LLC is not a registered investment adviser. The views expressed by Bright Sky Group represent the opinions of members of Bright Sky Group, but should not be construed as financial or investment advice. Further, the views are subject to change and are not intended as a forecast or guarantee of future results. The material provided by Bright Sky Group is for informational purposes only. Statements of future expectations, estimates or projections, and other forward looking statements are based on available information deemed reliable, but the accuracy of such information cannot be guaranteed. Statements are based on assumptions that may involve known and unknown risks and uncertainties. Past performance is not indicative of future results.

Bright Sky Group member firms are each registered investment advisers, which are independently owned and operated from each other. Bright Sky Group provides general financial information. The services, securities and financial instruments described by Bright Sky Group may not be available to or suitable for you, and not all strategies are appropriate at all times. The value and income of any of the securities or financial instruments mentioned herein can fall as well as rise, and an investor may get back less than he or she invested. Foreign-currency denominated securities and financial instruments are subject to fluctuations in exchange rates that could have a positive or adverse affect on the value, price or income of such securities and financial instruments. Independent advice should be sought for an investor’s specific needs.

Deal or No Deal airs on NBC and is produced by Endemol USA, a division of Endemol Holding.

Instinct is a magical compass, pointing us toward opportunity and away from peril. When we betray our instincts, we often pay a price. So it is only natural that many investors follow their instincts as they make investment and wealth planning decisions.

Unfortunately, instinct may be highly fallible – even dangerous – when it comes to investing. It may lead us to poor choices as we select investments, allocate assets, pick advisors, evaluate advice, and decide when to buy and sell.

Here are a few ways that human nature can lead us down the wrong path:

Ditch the losers. This is the flipside of betting on winners, and perhaps even harder to swallow. Human nature tells us to learn from our mistakes and punt away our poorly performing investments. Market efficiency, however, tells us that the weakness of a laggard is discounted into its price, and therefore, a recent loser is no more likely to fall in price in the future than a recent winner.

As Malkiel describes, trying to pick tomorrow’s winners based on what happened yesterday, last week, or last year is no more reliable than choosing securities at random.

Never settle for second place. Both nature and nurture drive us to be the best. If there is any chance to be #1, we go for it. The thrill of victory is our aim, and our right.

In investing, this instinct to outperform can drive all sorts of bad decisions – accepting unwarranted levels of risk, jumping from horse to horse, ignoring costs and taxes in pursuit of short-term gains, overpaying for the guidance of so-called experts, chasing fads, and trading on rumors, among others.

A 99th-percentile-or-bust mentality is more likely to deliver the latter, not only because it is so difficult to outsmart an efficient market, but because of the high levels of expenses inherent in any investment strategy that involves frequent buying and selling.

Forget the 99th percentile; even the goal of finishing in the middle can be derailed by instinct. According to a study from Dalbar, Inc., the S&P 500 returned an 11.9% annualized return from 1985 to 2004, but the average investor in mutual funds earned just 3.7% annually, barely more than inflation. This severe underperformance likely results from investors rushing into hot funds near their peaks and giving up on faltering funds as they approached lows. No one would intentionally buy high and sell low, but instinct makes it easy to do.

Be different. In an attempt to outperform, instinct may tell us to invest outside the box, to go where lesser investors are too timid or unsophisticated to venture. This can result in a portfolio packed with risky, illiquid, and difficult to understand positions. Many specialized investment vehicles (such as “2 + 20” hedge funds), playing on their exclusivity, exact heavy sales loads (a 2 percent, or higher, upfront fee) and direct a significant share of returns (20 percent of profits) back to the manager. These built-in disadvantages make outperformance for the individual investor that much less likely.

When in doubt, trust the names you know. In the best of times, investing can be somewhat confusing, even for experienced investors. In falling markets it can be downright scary. In response, our survival instinct may lead us toward havens of familiarity. When in doubt, investors may be drawn to the best-known financial names – major Wall Street brokerages, brand name mutual fund families, and iconic analyst firms and rating organizations.

It is natural to find comfort in the names we know, but blind faith is never justified. In many cases, name recognition is driven by the size of advertising budgets, not necessarily the quality of investments offered or guidance delivered. In fact, the high overhead inherent in the largest, most heavily marketed organizations can be a direct drain on the results ultimately realized by investors.

With financial well-being hanging in the balance, no firm or advisor should be considered above the need for rigorous due diligence. Investors need to know what they are paying for, and what they will receive. For instance, the major brokerage firms may pledge to protect the interests of their clients, but because they are not bound by a legal fiduciary duty (as registered investment advisors are), they are free to act in ways that serve their own interests at the expense of clients.

Let’s be clear. The big brand names can deliver excellent service and good investment results. But size and familiarity are not, in themselves, a basis for trust. Every vendor, agent, or advisor deserves scrutiny. After all, it’s not their money at stake.

If not instinct, then what?

It’s clear that following our instincts can betray us as we invest toward long-term financial goals. But what is the alternative? How can we overcome our instincts to make better decisions?

The easiest answer is to make fewer decisions. For starters:

• Invest not in individually selected stocks, but in asset classes – groups of securities that have similar characteristics and move largely as a group. For instance, large capitalization US stocks.
• Build a diverse portfolio that represents the breadth and depth of the market. Own a mix of distinct asset classes: domestic and international securities, large and small, growth and value.
• Buy and hold for the long term, with the goal of consistently earning market level returns.
• Minimize transactions that can drive up expenses and tax liabilities.
• Rebalance as needed and make adjustments when goals or personal circumstances change. Otherwise, leave it be.

Ignore the temptation to try to beat the market. That means not trying to pick wining stocks based on past performance, earnings or anything else – and not quickly selling when a holding loses momentum. It means avoiding alternative investments, such as hedge funds and derivatives, no matter how appealingly exotic or exclusive they may seem. It means working with a financial advisor who can implement these ideas and act as a rational buffer against the urges of instinct that will inevitably arise. And it means choosing an advisor based on careful due diligence, not on blind trust of familiar brand names.

Instinct is a powerful and mysterious force. Enjoy all that adds to life, but not when it comes to investing.

This article is provided on behalf of The BrightSky Group, of which we are a founding member