When you drive your car to a new destination, you almost certainly use a map or GPS device. In this way, you have a clear set of instructions; have an idea of how long the drive will last; may have some visibility about traffic jams and delays that lie ahead; and know what kind of terrain you will likely encounter along the way.
Why should investing be any different? Whereas you don’t know your ultimate destination (ending account value), you are certainly driving towards your (financial) goals. Why wouldn’t you want to put in place a set of instructions (investment guidelines) to help you get there?
Sadly, many investors fail to adopt a personal investment philosophy to guide their investment decisions along the way. Given the importance of one’s financial situation, you’d think that investors would take great care to create their roadmap and follow its turns.
Alas, such is not the case. Instead, as emotion-laden human beings, we all too often allow “fear and greed” to drive our asset allocation and investment-making decisions. Of course, nothing could be farther from rational from an investment perspective. Indeed, letting emotions overrun a prudent, scripted plan of action can cause havoc to one’s long-term investment returns.
For instance, let’s look at the rates of return that investors have historically earned while owning a mutual fund. Today, there is a debate in the investment community as to whether or not an active equity manager can beat a comparable passive benchmark index over a full market cycle. What’s less well understood is that the average investor who owns a mutual fund, regardless of whether the fund is actively managed or passively tied to an index, earns a lower rate of return than the performance achieved by that fund!
How do we know this? Studies measuring in-flows and out-flows of dollars into mutual funds1 consistently show that money flows into these funds as their prices rise and money flows out of these funds as their prices fall. In other words, investors are “buying high” and “selling low” – exactly counter to what makes sense in the long-run! As such, this misguided behavior leads to inferior rates of return for investors.
And why does this occur? This mistake stems primarily from investors failing to truly understand and live by their own personal investment philosophy and risk tolerance. Said differently, do you have a firm set of investment beliefs that enable you and your investment advisor to invest in a manner that truly captures your emotional as well as intellectual limitations?
It’s easy to say that you like equities when the stock market achieves record high prices. Are you content with holding those stocks during periods of stress in the financial marketplace? Conversely, have you included in your approach to asset allocation a means to “rebalance” which effectively means periodically reducing your equity exposure during periods of rising markets? Said differently, are you willing to live with the fact that the stock market could ascend to record high prices without your full participation in the stock market if you take a more conservative approach towards asset allocation?
To be clear, this isn’t about being right or wrong; rather, it’s a question of self-advocacy. Are you willing to make the investment upfront and establish a system whereby you will not act in a way that is harmful to achieving your long-term investment goals?
A critical first step towards achieving your long-term investment objectives is to pause and reflect. Have you made an honest appraisal of your long-term needs, goals and temperament for risk? Of equal importance, are you prepared to create, implement, and adhere to your personal investment philosophy? A brain teaser indeed, but creating your own personal roadmap will allow you to better navigate the highways of investment management.
1 Vanguard's Principles for Investment Success