Many Happy Returns
By Mark Wendell
Achieving the security and freedom that wealth can provide is seldom a matter of luck. It takes persistence, patience, and focus. It can be a long, arduous journey, one mile at a time, but reaching your destination can mean a better life for you and your family.
Choosing a successful route, even with a guide, involves more than simply sticking to a narrow, fixed path. Staying focused on a goal is certainly important, but being limited to a single passive method of reaching that goal can be as costly as wandering aimlessly. When unforeseen obstacles fall in your path, as they inevitably do, you don’t want to find yourself with no alternate routes.
Perhaps the number-one risk factor in achieving your financial goals is – your own emotions. We see ourselves as the heroes of our own stories, able to rescue ourselves at the last moment from any dreadful plight through our superhuman will and genius. Nowadays, our human tendency to fantasize or catastrophize is fed by a constant media overload designed to capture our attention with emotional triggers aimed at the worst in our natures: fear and distrust, envy and greed. Rather than behaving as purely rational beings, investors react to the latest hair-on-fire “news” narratives sometimes by taking rash unnecessary actions, sometimes by not acting at all when action is required. Research studies have documented what common sense tells us: investing decisions based on emotional impulses or unexamined convictions, no matter how heart-felt, correlate to costly results. Please refer to my past published article on the subject of behavioral finance: http://mdwendell.com/the-art-of-behavioral-finance
When we’re faced with an uncertain investment choice or a challenging economic situation, our instinct isn’t to dive into stacks of statistical analysis. Instead, we’re guided by mental shortcuts like “circle the wagons” or “cut bait and run” — the pure animal impulses toward either fight or flight in a crisis. Usually investors try to convince themselves that they know when to ‘get in’ and ‘get out’ and that they know when the ‘short-term’ and ‘long-term’ market moves are happening. When markets are going up, we are brilliant and we know that sticking with our goals is the smart thing to do. And when markets are going down, we doubt and question our advisors and our own goals, and out of fear, begin to redefine our goals to match the moment. Recent research shows, as published in the journal Neuron, that people who make definitive long term goals with a “pre-commitment” will be much more likely to stick with their long term plan, to obtain a potentially larger or more satisfying reward, than by simply using their own “willpower”, when the heat of the moment presents itself.
Effective portfolio risk management replaces crisis-driven decision-making, skewed by denial, overconfidence, or fearful reactions to dire predictions, with a steady long-term strategy. Holding an actively managed diversified portfolio and making regular course corrections with a disciplined strategy is common wisdom to investment managers today, and many of the sophisticated 21st century investment strategies developed more recently are designed to counter unpredictable economic conditions and volatile markets with layers of managed diversification.
The economist Craig L. Israelsen conducted research on the effectiveness of portfolio diversification, to determine if the accepted wisdom was true: whether a highly diverse portfolio actually outperforms a narrowly focused portfolio over a long period of time. He back-tested (from 1998 to 2012) several portfolios, two of which are reported as follows: one with only two investment categories known as asset classes (70% stocks – 30% cash) and the other with 12 asset classes. His results are dramatic. The highly diversified portfolio achieved nearly double the returns of the narrowly focused portfolio — 7.95% versus 4.32%. Equal in significance is that the highly diversified portfolio produced more consistent returns, with less dramatic movements in value. Thus the risk — the degree of portfolio variability as measured by standard deviation — was less evident in Israelsen’s 12-asset portfolio.
For an investment manager, consistent returns over the long haul are more desirable than eye-popping returns one quarter, but anxiety about what catastrophe the next quarter might bring. For one thing, the negative compounding effect of a loss — particularly in the case of a retiree drawing from the funds each month — amplifies negative returns over time. Just as important, perhaps, is that the whole point of investing, ultimately, is peace of mind with a positive return.
Some investors no doubt enjoy the thrill of riding high one quarter, bottoming-out the next and often whiplashing sideways without making much forward progress, and there certainly are investment advisors who specialize in circular rollercoaster style experiences (think Disneyland Space Mountain). But for the vast majority of investors with their eye on the destination of a secure and fulfilling retirement or the preservation of a family legacy, a wealth-management professional’s job is to provide a smooth-as-possible, low-stress journey — “wafting” down the road, in the words of Rolls-Royce advertisements. A good risk management strategy, like the suspension system of 21st century cars, fine-tunes the trade-off between high performance and the driver’s willingness to ‘feel’ the bumps and jolts of the road.
One sophisticated risk-management strategy available to investment managers is the use of low or non-correlated portfolio assets whose values are unlikely to move together — with separate asset classes that are affected by separate real-world factors — increasing portfolio diversification and dampening volatility. Another tool is the multi-manager-multi-strategy approach, selecting unique strategies and managers whose styles are known to be very different. This approach provides multiple dimensions of diversification to provide an even greater degree of portfolio depth and breadth for more consistent long term results.
Everyone wants to see spectacular returns on this quarter’s statement, naturally. But when we expect to outperform an arbitrary benchmark quarter after quarter, the portfolio manager is obligated to point out the reading on another dashboard gauge — the risk factor. The investment professional must keep his/her eye on, not just the quarterly return metric, but the ongoing risk-adjusted return – the return obtained relative to the degree of risk exposure.
What matters most, of course, is each person’s unique needs and preferences, and to determine those, there’s no substitute for an ongoing advisor-client relationship – simply allowing the investment professional to get to know the individual, person-to-person.
It is essential for financial professionals to keep in view the milestones set by the investor: enough funds to cover college tuition at a certain point, a mortgage payoff or a second home, funds for retirement, or perhaps a long-awaited dream vacation. While using quantifiable risk to our advantage to obtain an acceptable, consistent, risk-adjusted return, we must be aware that portfolio “risk” can also have a very personal meaning. To that end, consideration of the importance of ongoing portfolio risk allocation to specific goals – not just to benchmarks – as well as ongoing portfolio fine-tuning, are essential to traveling the long road to a distant goal, but attention to each individuals unique comfort-level requirements along the way is just as important to a successful financial journey.
Retirement after years of hard work and planning can feel like triumphantly crossing the finish line of an exhausting marathon. But as the economic setbacks of recent years have demonstrated, the race can just be beginning at that point. Unpredictable political or natural events, “disruptive” new technologies, breakthroughs in key industries, combined with ever-improving prospects for our longevity, can stretch even the most flexible and secure-seeming financial arrangements to the limit. The best bet, given the uncertainties of life, is 1) to use a disciplined, predetermined, pre-committed approach to portfolio diversification designed to achieve steady moderate returns while avoiding high volatility, and 2) to consult with a knowledgeable professional for on-going guidance. Consistency takes on heightened importance once you retire and begin withdrawing retirement funds, because the negative compounding effect of whipsawing investment moves, combined with scheduled withdrawals, can quickly deplete funds. Consulting with a professional who appreciates your goals and has a seasoned understanding of volatility can provide valuable reassurance in times of change and stress.