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Making investment decisions in a volatile economy
The market declines of the past two years have caused hordes of investors to pause at the idea of adding more risk to their portfolios. Many are suffering from "financial whiplash" as they snap back from a conditioned sense of security brought by the S&P 500 returns of 20 percent and more from 1995 to 1999. The question to ask these days is, "What have you come to view as investment reality?" Moreover, "Is that view based on fact or fantasy?"
By 1998, the historical reality that the average annual S&P return was 12 to 15 percent was discarded as passé. Many people truly believed that a new, golden age of investing had dawned -- they clamored to invest in every new IPO (particularly technology-flavored) that debuted. Unfortunately, many of these turned out to be investment versions of laetrile or chelation therapy. They sounded great on the surface, but couldn't stand up to the rigorous scrutiny of academic research or real-world application.
Is it best to continue chasing the newest investment fads? Or act like a turtle and withdraw into a shell of financial safety? Realistically, neither of these approaches is likely to prove emotionally gratifying, nor are they sound ways to accomplish your financial goals.
So where do you go from here? How do you develop a more successful, rational, balanced, and less volatile investment process without sacrificing your ability to achieve your financial goals? Here are a few tips to point you in the right direction.
Do a little soul searching
Back in the mid-1990s, it wasn't terribly important for you to know your risk profile. Although the markets were volatile, they were upwardly volatile, which was fine. Investors aren't truly "risk averse," rather they're "loss averse." For that reason it's important to know your own emotional willingness to accept short-term losses in order to achieve long-term success; we call that "risk tolerance."
You can measure your risk tolerance by asking yourself the following:
"What percentage of loss in my portfolio would make me uncomfortable, make me lose sleep, or cause me to bail out of my investments?" Then convert that percentage to an actual number.
If you answered "10 percent," and have a $4 million portfolio, that would become $400,000. How many years of that sort of loss could your psyche withstand?
"On a one-to-10 scale, with one being extremely conservative and 10 being 'wild and crazy,' where do I rate my investment practices?" The answer will give you a pretty good idea of where you fall on the continuum of risk tolerance.
Growth and safety are two of the key characteristics of most portfolios; increasing one decreases the other. If you scored each on a one-to-five scale for a total of six, how would your allocate your six points? For example, would it be "four" for safety and "two" for growth? If so, you should be cautious in building a highly aggressive portfolio.
And while it's important to accurately know your portfolio's return, that's only half of the equation. The other half of the equation is risk. Do you know what your portfolio's risk has been over the past five years? Here's why that's important. Let's say Dr. A espouses a treatment that is known to be twice as risky as the treatment used by Dr. B -- yet they had the same patient mortality rate last year. But you know that over time and with sufficient numbers of patients, Dr. A's mortality rate will become substantially higher than Dr. B's. The same is true for your investment portfolio. Some managers get lucky for a year or two, but risk ultimately catches up with return --you can depend on that.
Have a system in place
One of the greatest mistakes we see from investors and advisers alike is that they lack a rational, disciplined process. In business school we always related economic theories to the "rational consumer" or the "rational investor" -- but human beings aren't always rational. We're emotional. That's why we need systems to help us avoid compulsive, emotionally driven decisions when we invest in risky assets.
Start by evaluating investment decisions you've made in the past. Did you act on a tip? Did you read an article that touted the investment? Did you see an article that purported to reveal, "The 10 Stocks (or Mutual Funds) to Own RIGHT NOW!"? Or did you do extensive research on that particular stock or mutual fund?
For years we've been told that the pre-decision motivators of greed and fear drive all investment actions. After "behavioral finance" folks got involved, we learned that the post-decision motivators of pride and regret are far more powerful. So the important question isn't, "Why did I buy (or sell) that investment?" it's "How do I feel after buying (or selling) that investment?"
After reflecting on your past decisions and the motivators behind them, write a narrative that describes your investment process. Don't be defensive; be painfully honest and look for patterns of behavior. You'll actually learn from your successes and failures, develop a stronger investment process, and end up with a better portfolio if you "'fess up" to yourself, remembering your poor decisions and your great ones (and you don't have to show this to anyone else).
If, after this evaluation, you conclude that you're content with where you are now, where you want to be, and how you're getting there in your investment portfolio, you can stop. If, on the other hand, you want to have a clearer picture about how to measure risk and how to develop a better investment process, let me make a recommendation.
This year is the 50th anniversary of professor Harry Markowitz's "Modern Portfolio Theory" (MPT). It wasn't until 1990 that he won the Nobel Prize in Economics and gained world acclaim for his theory because it was so far exceeded the power of technology in the early '50s. And in 1991, the first "portfolio optimization" software became available, using Markowitz's theories in an attempt to protect doctors from acting as fiduciaries for their retirement plans.
Numerous Web sites and mutual fund companies now make MPT principles available to the average investor. And frankly, if you rely on a financial adviser who doesn't use MPT in the investment process he or she applies to your portfolio, I would ask, "Why not?" Making up asset class allocations by the seat of one's pants is equivalent to your selecting patient medications because of the cool ads pharmaceutical companies run in physician journals. You deserve better. It's your future to enjoy and your goals to accomplish. Enjoy and accomplish!
Rick Adkins, CFP, ChFC, MBA, is the CEO of the Arkansas Financial Group Inc. He has been listed in Worth magazine's "Best Financial Advisers" since 1997 and Mutual Funds magazine's 2001 list of "100 Great Financial Planners." He can be reached at RickA@Arfinancial.com or firstname.lastname@example.org.
This article originally appeared in the July/August 2002 issue of Physicians Practice.