Today’s blog topic is focused on 7 Simple Rules for Investing, but first, I wanted to take a moment and talk about what we’ve been doing during this recent market correction.
We’ve been rather absent from blogging lately because we’ve been spending all of our time speaking with our clients to ensure their investment portfolio matches their risk tolerance and reinforcing these 7 Simple Rules for Investing. And I know what you’re thinking…shouldn’t that be determined at the onset of the investment process? Absolutely. And it was. But the quirky thing about risk and behavioral finance is that our opinions of our own money change as the markets change. It’s really easy to become more optimistic about the stock market when markets are on the rise; thus causing us to want to become more aggressive when times are good. The same is true when times are bad; convincing us to become more conservative when the markets take a hit. This mental behavior has been studied for decades and a Nobel Prize in Economics was won as a result of a 1979 study in which two psychologists, Kahneman and Tversky, concluded that we feel the “pain” of the losses much more than the “joy” of the gains.1 Two authors, Thomas Gilovich and Gary Belsky, took this study a step further in their 1999 book (referenced below) to conclude “the sting of losing money, for example, often leads investors to pull money out of the stock market unwisely when prices dip.”2
In our role as an investment advisor, we have to constantly be available to manage the reins on the emotions of behavioral finance. And we do all that we can to address these topics head on. We believe that having a constant finger on the pulse of clients’ risk tolerance is far superior to setting a risk tolerance target in the beginning and never revisiting it. We use a mathematical and statistical approach, combined with group discussion to determine our clients’ risk scores.
Proper portfolio design, in our opinion, is built upon the notion that markets are going to rise and fall, have really bad times and really good times, and over the long-term, provide adequate returns to offset the risks taken. By this, we mean, markets work. We believe the markets are efficient to price in all of the known information out there about a particular security, sector, etc. And this is why we consistently avoid trying to time the markets and buy or sell on “news.” But the markets change and what looked like a promising investment, may turn out to be not-so-promising. In our business, we call these investments, losers. And even portfolios managed by professionals will have losers.
It’s important to understand and constantly refer to the basics of investment philosophy. We’re going to let Jim Parker, Vice President of Dimensional Fund Advisors, outline below 7 Simple Rules for Investing:3
- Accept that not every investment will be a winner. Stocks rise and fall based on news and on the markets’ collective view of their prospects. That there is risk around outcomes is why there is the prospect of a return.
- While risk and return are related, not every risk is worth taking. Taking big bets on individual stocks or industries leaves you open to idiosyncratic influences like changing technology.
- Diversification can help wash away these individual influences. Over time, we know there is a capital market rate of return. But it is not divided equally among stocks or uniformly across time. So spread your risk.
- Understand how markets work. If you hear on the news about the great prospects for a particular company or sector, the chances are the market already knows that and has priced the security accordingly.
- Look to the future, not to the past. The financial news is interesting, but it is about what has already happened and there is nothing much you can do about that. Investment is about what happens next.
- Don’t fall in love with your investments. People often go wrong by sinking emotional capital into a losing stock that they just can’t let go. It’s easier to maintain discipline if you maintain a little distance from your portfolio.
- Rebalance regularly. This is another way of staying disciplined. If the equity part of your portfolio has risen in value, you might sell down the winners and put the money into bonds to maintain your desired allocation.
We couldn’t have said it better ourselves. You may have a similar risk tolerance to thousands of other people, yet your portfolio could be drastically different. There are numerous, if not, infinite, ways to construct a portfolio that matches your tolerance for the risks of the stock market. When constructing a portfolio, it should be done in a way that allows you to remain invested even during really bad times. There’s a reason “don’t panic” is the mantra of most investment advisors out there…you should have built a portfolio that takes into consideration your internal panic button, or better said, “the amount of money you’re willing to lose before you make the decision to sell everything.” If you find yourself increasingly worried that your portfolio is not structured according to your risk tolerance and financial goals, give us a call. We’re a Johns Island Investment Advisor who helps clients define their risk tolerance and build a portfolio to match it.
Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission. Dimensional and Coastal Wealth Advisors, LLC are not affiliated companies. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as specific investment advice or recommendation.
1 http://prospect-theory.behaviouralfinance.net/
2 http://books.simonandschuster.com/Why-Smart-People-Make-Big-Money-Mistakes-and-How/Gary-Belsky/9781439163368
3 7 Simple Rules for Investing, Jim Parker, Unhealthy Attachments
Image: Angel Oak in Johns Island, SC