Investment decisions: Fighting the enemy in the mirror

Reacting to today’s economic events could wreck your portfolio

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by

From the Summer 2010 issue of the magazine.

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Benjamin Graham, legendary finance professor and mentor to Warren Buffett, once said “the investor’s chief problem—and even his worst enemy—is likely to be himself.” He was probably referring to market timers, performance chasers and amateur stock pickers. But I’m convinced the same is also true for Couch Potatoes.

It isn’t supposed to be that way. When you build a portfolio with index funds or exchange-traded funds (ETFs), you simply choose an asset allocation that fits your financial goals, add new money regularly, and rebalance now and then to stay on target. That’s why we call it Couch Potato investing: it’s the financial equivalent of sitting in front of the TV with a bag of Doritos.

Yet I get a lot of emails that go something like this: “I’m setting up a Couch Potato portfolio, but with interest rates rising, I don’t want to put too much in bonds right now. Plus I’m worried about the debt crisis in Europe, so I’m underweighting international stocks. Also, I think higher inflation is on the way, so I want to add gold and other commodities. What do you think?”

Whoa, back up the truck. The Couch Potato strategy is designed for the long term, not the next 12 months. It’s based on the premise that the markets, while not perfect, are the best tool we have for assessing value. That means that if more interest rate hikes are expected, or there’s uncertainty in Europe, or inflation may be looming, the markets know that already. That information is built into the price of bonds, stocks and commodities. If you think you can improve on the indexing strategy by making shrewd forecasts, then the strategy isn’t for you. You can’t have your potato and eat it, too.

“Odysseus was tied to the mast to resist the Sirens’ song. You should resist the business news.”

During his 15 years as an adviser, Keith Matthews has become a steadfast believer in the buy-and-hold indexing strategy. He’s seen investors fall prey to just about every behavioural trap there is. That’s why his Montreal firm, Tulett, Matthews & Associates, helps clients settle on an asset allocation that suits their goals and risk tolerance, then counsels them to stay the course. No market forecasts, no moving in and out of markets whenever there’s a crisis making headlines. “For most people, being less active is completely counterintuitive,” Matthews says, so educating clients is one of the most important parts of the process. Here are some of the pitfalls that Matthews has identified:

You want all your holdings to be winners all the time. Diversification can raise returns and lower risk because asset classes do not move in lockstep. Government bonds weighed you down in 2009 as stocks soared. But the year before, they helped save you when everything else was in the toilet. That’s how it’s supposed to work. Yet many investors second-guess themselves when one or two asset classes underperform. “You are always going to have something that isn’t doing as well as something else,” Matthews says.

“So you need to get over that gnawing feeling that you’re compromising your portfolio if you don’t have all your eggs in the winning basket.”

You can’t tune out the noise. What happens today or next week is mostly meaningless to the long-term investor. “There is always some concern in the marketplace,” says Matthews. Yet too many investors think about abandoning their investment principles because of what they see on the news. Odysseus tied himself to the mast and had his sailors plug their ears with beeswax so they wouldn’t be seduced by the Sirens’ deadly song. Investors should do the same whenever they turn on the business news.

You regret missed opportunities. Index investors don’t go out looking for hidden gems; they simply take what the markets offer at the lowest possible cost. That passive approach leaves many people feeling like they’re missing out on something big. “We are all biased to think there are great opportunities out there, as long as you know what to look for,” Matthews says. “We think that if we work really hard, we’re going to find all sorts of different investment opportunities. It doesn’t work that way.”

You can’t accept you’re not smarter than the market. No matter how much you know about business or the economy, you can be sure that countless others know the same things and have already assimilated them into stock prices. You need the humility to accept that even if markets do occasionally have pricing anomalies, it’s almost impossible to find and exploit them consistently.
How can index investors avoid these obstacles? Matthews and other advisers help their clients stay on track with an investment policy statement (IPS). This document lays your investment goals, risk tolerance, expected rate of return, and target asset allocation. It describes when and how changes to the portfolio will be made: for example, it could specify that your asset mix should be rebalanced to its original allocation on a set date each year. Do-it-yourself Couch Potatoes may also find it helpful to write a simplified IPS. When you put your strategy in writing, it’s that much harder to deviate from it. It’s not quite tying yourself to the mast, but it can help you to avoid becoming your own worst enemy.

2 comments on “Investment decisions: Fighting the enemy in the mirror

  1. Great article, Dan. I love that you can republish this timeless piece whenever the markets go crazy (like they have been this month) and remind us all to relax.

    Reply

  2. Well said!
    There are frequent references to the virtue of inaction in Graham’s books.

    “Incidentally, if his list has been competently selected in the first instance, there should be no need for frequent or numerous changes”
    -The Intelligent Investor

    Warren Buffett himself said:
    “Lethargy, bordering on sloth should remain the cornerstone of an investment style.”

    Reply

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