Keeping Your Head When All About You…

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As of this writing (3/28/13), we’re all celebrating an impressively strong first quarter in domestic stocks. The current rally began in the middle of last November, so we’re coming up on six pretty good months for the market. A few more quarters like this and we’ll start to see stories in the news about plumbers and lawyers quitting their jobs to become daytraders. Good markets can test your resolve just as much as bad markets.

When it comes to managing an investment portfolio, people generally underperform their strategy. This is our human nature at work. We adopt an investment approach in response to one set of conditions and then become frustrated and impatient with it when conditions change, which often leads to a revision in strategy to chase the approach that would have worked best for the latest set of conditions. Wash, rinse, repeat. It’s called performance chasing and the impulse has plagued investors and speculators for as long as there have been markets.

A good memory is a useful tool for an investor. When temptation to revamp things strikes, as it inevitably will, it’s helpful to remember what led you to that approach in the first place. What’s even more useful than memory though, is imagination. Markets are wildly unpredictable. Four years ago on this date a recovery had just begun, but it didn’t feel like it. Stocks were still 48% off their highs. Real estate was in a deep crater. Anything related to the economy – gdp growth, unemployment, gas prices, home foreclosures, student loan debt, etc. – it all felt terrible. Most of those factors really haven’t improved that much. Yet, look at the stock market. It would have taken some real imagination in March 2009 to believe we would be where we’re at today. Just as it would have taken some real imagination in September 2007 to envision what the next eighteen months would bring.

Imagining things is different than predicting things. As an investor, I want to think about a range of possibilities – both good and bad. Then I want a strategy with rules that take this range into consideration. So whether we get the good end of the spectrum:

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S&P 500 from Jan 1982 – Jan 2000. Chart courtesy of Yahoo! Finance.

Or something much worse:

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Nikkei 225 from Jan 1990 – Jan 2013. Chart courtesy of Yahoo! Finance.

There’s a plan for dealing with it. Perfection is unattainable and unnecessary. We really just need a way of growing money over the long term while avoiding disaster.

Having a plan is an important first step. The much harder second step is executing the plan. These long term, smoothed out charts make things look deceptively easy. A few months taken out of one of the above images is a blip when you look at it now, but in real-time it can feel endless. Every investment approach has conditions that are favorable and those that are unfavorable. A buy & hold investor will do well in rising markets and get crushed in falling markets. A trend follower will do well in trending markets, up or down, but will suffer in choppy, sideways markets. There is no one single solution that will always be best – this is why the impulse to chase performance lets us down.

Performance has to be judged through a complete cycle. Chasing the revolving door of the newest best performers means always being late. It means never getting the full benefit of the conditions they were best suited for. In fact, due to the cyclical nature of markets, the performance chaser is very likely to show up just in time for the unfavorable part of that cycle.

Of course, most people are aware of the dangers of jumping from one bandwagon to another. It’s usually not a spur of the moment decision, but rather one that is spurred by frustration. They feel that they should be doing better and can usually find a strategy/fund/broker/newsletter with recent performance numbers that confirm that suspicion. The challenge to the investor is in figuring out the difference between making a sound decision and acting out of impatience. Like much of life, this is relatively easy if you plan it out ahead of time:

  1. Define, in advance, the criteria for how you’ll know if your plan doesn’t work. It should be measurable and related to the reason for choosing it in the first place. For example, a person concerned with limiting downside volatility might decide something like, “a drawdown in excess of 15% causes a full review; a drawdown in excess of 20% causes the plan to be suspended.” Specificity is your friend.
  2. Write down expectations in advance. Not in terms of performance, but behavior. How do you expect your portfolio to act during different types of market conditions? When these conditions occur does your portfolio behave as expected? If not, why not?
  3. What are the things that could sink you? This is the imagination part. Think not so much of trying to predict specific events, but outcomes. For example, if the market were to drop 35% in a month, what happens? If stocks and bonds were to fall significantly at the same time, what happens? This isn’t an exercise in paranoia, it’s an attempt to find weak spots. Discomfort with potential vulnerabilities can be a good reason to make changes.

Over the long haul, psychology is what determines investor success. As markets change and swirl around us, our most dependable, most valuable asset is the prior thought and planning we do at a leisurely pace, unaffected by the heat of the moment. The unpredictability of markets can be made much more comfortable by knowing in advance how and why decisions will be made. We can’t know the future, but we can know how we’ll react to whatever conditions may arise.

 

Disclaimer: Past performance is not indicative of future returns. Information displayed is taken from sources believed to be reliable but cannot be guaranteed. All indices are unmanaged and investors cannot invest directly into an index. Ideas and opinions expressed in this article are the sole responsibility of Patrick Crook/PLC Asset Management and do not reflect any stated opinions of Commonwealth Financial Network, National Financial Services LLC or any other person or entity.

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About Patrick Crook

Pat Crook is a financial advisor in Corvallis, Oregon with over twenty years of experience. He has developed a specialized form of investment portfolio management designed to address the risk concerns of those in or near retirement as well as organizations like charitable endowments and foundations. To learn more or set an appointment, he can be reached at 541.753.1808.