What is your investment mentality?
From my nearly twenty years of professional experience in advising clients, I have found that similar to the way individuals think with either the left or right side of their brain there are investors whose thinking supports either a "risk driven" or a "return driven" mentality when evaluating their personal investments.
Characterstics Of "Risk Driven" Investors
- Typically are risk averse and overly cautious
- Would prefer to avoid risk even though they know their money will not otherwise grow
- Not overly concerned when they are slightly underperforming during the up markets
- Have long memories and can tell you the exact dollar amount lost during the last market decline, even if it was minimal compared to the overall market
- They will sell out of positions that have grown significantly even if there is still upside potential
- As a car owner they might purchase a Volvo and still feel unsafe; as a driver they drive at the speed limit or below to ensure they arrive safely.
Characterstics Of "Return Driven" Investors
- Typically seek the highest investment return, without considering the underlying risk
- Feel uncomfortable with investments they perceive as growth prohibiting, such as fixed income
- Become concerned when markets are rising and they are underperforming, even slightly
- Have short memories and tend to forget that investments are inherently risky
- As a car owner they might purchase a Mustang and forego certain safety features to ensure maximum performance and speed.
The investment approach we advocate won a Nobel Prize for its research which has consistently proven that, over time, there is a risk and reward relationship when investing. The ability to quantify this relationship helps risk driven investors make intelligent choices on how much risk they can tolerate in hopes of achieving a higher rate of return. When the market falls, however, many of these individuals will fall into panic mode even if the drop is small relative to the markets. For return driven investors quantifying risk may initially be helpful. However, when markets rise their short term memories will take over, they will revert to their natural tendencies and have the urge to forego conservative bond and cash investments in hopes of maximizing their returns.
For both types of investors, it’s important to emphasize that a superior investment approach is to 'win by not losing'. In other words, if you capture most of the market's returns on the upside, this allows the portfolio to grow over the long term with strong results; and with more risk comes potential for higher returns. Most important, however, is that during the down markets a portfolio does not decline as much as the broader market and will have less to "catch up" when markets again return positive results. By way of example, a 50% decline requires a 100% return to break even. This was the exact scenario that played out from 2000-2002for investors who were not structured in a portfolio that was consistent with our Nobel Prize winning approach. The following chart shows the performance of a diversified portfolio with a traditional allocation (75% equity/25% bond) compared to the S&P 500 Index, one of the most common gauges for measuring the stock market:
Occasionally a diversified portfolio will underperform a broad market index. In 1998, for example, the S&P 500 Index increased 28.60%, predominantly propelled by irrational returns from a small sub-set of technology stocks. Subsequently, in 1999, this sector of the market received the largest inflow of investment ever seen, fueled by both amateur investors who followed the herd mentality of the time, as well as by seasoned investment managers who buckled into the demands of their shareholders. The following period from 2000-2002 the Index dropped 43.10%, cumulative, one of the worst declines ever recorded in market history. Even now, almost eight years later, the Index has not returned to the high levels observed during March 2000. By comparison, a well structured portfolio with substantially less volatility “won by not losing” by mitigating declines from 2000-2002 and then returning all that was lost before 2003 came to an end. Furthermore, it continued to add value the remainder of 2003, 2004, 2005, 2006 and year to date 2007!
A well structured diversified portfolio may occasionally have to endure significant underperformance, such as in 1998, and may even lead many to question whether this is a valid approach to investing. The following chart, however, should remove any doubt that it is unwise to abandon a time tested approach. Despite occasional underperformance, a diversified portfolio will outperform indices over the long run. Using the returns from the prior chart, the illustration below tracks the growth of a $1,000,000 investment during the period from 1998 through November 2007 had it been invested in a diversified portfolio compared to the S&P 500 Index:
Given that the S&P 500 Index represents a 100% allocation to equities, is market capitalization weighted and can experience periods of prolonged weakness, one might assume that this higher risk would provide a higher rate of return over the period. This has been proven time and again not to be the case and helps to clarify that higher risk does not guarantee better returns. A diversified portfolio allows for greater wealth accumulation over the period versus large swings in value, thus increasing the portfolio by an additional $334,403 and providing 19% more added value while subjecting the investor to less risk!
Presently, many investors are again being enticed by the positive investment returns being posted by equity indexes, at a time when economic fundamentals are clearly deteriorating, In the meantime, actions by the Fed, such as the recent cut in interest rates, will only postpone what is an inevitable part of the economic cycle. Furthermore, the longer it takes for the markets to recognize that a recession is looming, the louder the pop will be of the proverbial bubble. Many may be tempted to concentrate portfolios in areas of the market that have posted the most recent strength and abandon the more conservative positions which do not perform as well during these environments. As a fiduciary, however, we are required to act in the best interests of our clients, and we can not justify a “full steam ahead” approach at this time. To do so would correlate to a driver disposing of his brakes, airbags and insurance simply because he has driven down an open highway for a full day without needing them.
Finally as a reminder to all investors, whether risk driven or return driven, it is important to keep perspective when evaluating returns. The details of investment results should be evaluated to determine whether one is playing ‘catch up’ or if added value has been experienced. If one underperforms the market slightly on the upside, it is irrelevant as long as they have protected the values on the downside. We have seen investors who had to return to work or defer their plans for retirement because of losses experienced in their portfolios. However, not squeezing out the most of every up market has never prevented a client from reaching any of their goals.