ONE: Focus on the near term. A recent headline reads, Anxious financial advisers scale back summer vacations. “Still haunted by the 2008 financial crisis, many financial advisers are scaling back their summer vacations or giving up on them entirely. Many are afraid to be out of the office in case this is the third straight summer in which markets are hit with severe volatility.” Reuters (21 Jun.)
Staying home from vacation to do what? These statements seem to imply that a smart, clever advisor will know what action to take when news breaks. Buy, sell, move everything to cash until markets stabilize?
It is unfortunate that investors can only determine market stability after the market reacts to the hope or possibility of stability. It sounds so appealing to stay out of volatile markets and invest only when we can expect stable, positive returns, but by the time stability appears, prices have risen, and it’s too late. We expect successful business managers to take action when presented with new information, but an emotional reaction to new information can be very dangerous for an investor, leading them to buy high and sell low.
TWO: Touting what would have worked in the last crisis. Hedging, or insuring against volatility is also appealing – who wouldn’t want the return without the risk? Keep in mind that insurance companies make a profit by accepting a transfer of risk. The same is true in financial markets. Just like dental insurance premiums are sometimes less than what you collect in annual benefits (you win!), portfolio insurance sometimes pays off, but on average the insurance company makes money, and on average portfolio insurance reduces your expected return. Remember, expected return is a function of how much risk you are willing to accept. Therefore any strategy that reduces your risk to zero will also reduce your expected return to zero – or less because of the insurance premium.
THREE: It’s different this time. No really, it’s different. Much industry attention is now focused on the current trend of adding alternative investments like hedge funds and private equity to a portfolio because their results are not correlated with stocks. Diversification is the only free lunch in investing. Blending together a mix of different asset classes with different risk and return characteristics can produce a portfolio with a better balance of risk and return than any of the individual asset classes. However, it can be argued that calling hedge funds a separate asset class is like calling lottery tickets a separate asset class, because their results are not correlated with the stock market! Hiring a hedge fund manager to buy some stocks and sell others short is likely to produce uncorrelated results but not necessarily improve portfolio results.
FOUR: Holding up winning bets as if they resulted from skill rather than luck. The popular press, as well as the financial industry media, loves to idolize winners. They talk about trading strategies, hedging strategies, managing volatility, etc. It seems ironic to me that almost everyone acknowledges the futility of day trading, that popular pastime of the late 1990’s when people thought they could make a living buying and selling stocks in a rapidly rising market. Yet we are still seduced by the current crop of strategies that are based on the same underlying notion – that someone can outsmart markets by predicting the future when the outcome is unknowable.
Some questions to help you avoid the hype surrounding the next great idea put forth by the financial media:
- Does it make sense as a long-term strategy?
- Is it based on an understanding of how markets work, or does success hinge on someone predicting unknowable outcomes?
- Is it really a different kind of asset or just a familiar asset class in an expensive wrapper that cleverly alters short-term results (indexed annuities and buffered investment contracts come to mind)?
- Will a successful result come from skill, or luck, and is there any way to judge skill in advance?
These are important questions for long-term investors who want to avoid the pitfalls of emotional response to market volatility.