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4 Resolutions For The Behavioral Investor

01/09/2015

The following blog was originally posted on Forbes.com.

Dartboard season is here yet again.  It’s the time when prognosticators prance free, slinging predictions about hot markets, index levels, and “great funds to own” in the coming year. Good luck with that. Such attempts at forecasting, though sometimes provocative, are folly.

So instead of looking outward to an unpredictable world, let’s start 2015 by looking inward.

Arbitrary as it is, the turn of the year provides an opportune moment for introspection. In that spirit, let me offer a few suggestions for the Behavioral Investor. Just what or who is a behavioral investor, you ask? It’s anyone who recognizes that our hard-wired cognitive and emotional biases interfere with good investment decision-making. It’s someone who knows that trying to predict the future of markets or managers ranges between really hard and impossible.

Rather than run through the litany of popular biases (e.g., overconfidence, availability, anchoring, etc.), I thought it would be useful to suggest a few mental exercises – resolutions if you like –  to address some of the more common pitfalls.

1. Write a road map in advance of a potential decision.

We tend to make decisions about important matters when they are foisted upon us by time and circumstance. To the best of our ability, we react and decide. There’s no doubt, however, that urgency impacts how we make decisions, for better or worse (usually the latter). Perhaps we overemphasize certain factors and downplay others (or even forget them in the heat of the moment).

Try taking a calm, balanced, and systematic approach to portfolio decisions.  Draw a decision tree (i.e., “if this happens, then I’ll do this”) that spells out what you would do well in advance of the actual decision. Take a stock or fund you own. Is there a risk event – valuation level, growth rate, macro wobble – that would lead you to reconsider your position? At a stressful moment (my investment is down 10%!), would you sell or buy more? Think it through. And write it down. Consulting a road map that was written when the decision was not imminent will feel quite different.

Assuming that investment is tied to a financial goal (and it should be), what is your plan to sell it when it hits your hoped-for dollar target? Write that down too. We love holding onto winners, so determining when to sell is harder than one might think. Only rarely is the goal simply “more.” It’s usually about reaching your well-defined objectives. (Need help in doing this? Hiring a good financial advisor could be the best investment you make this year.)

2. Think differently about something.

Shake your brain a bit. There are lots of ways to do this. For starters, we tend to think of our investments in terms of the categories and frameworks to which we’ve become comfortable over the years. Challenge yourself on one of the categories you take for granted. Take the distinction between “domestic” and “international” holdings. What exactly is the difference when most multi-national firms earn revenue from every corner of the globe? Think you have no exposure to “risky” emerging markets? Think again – mega-corporations like Coca-Cola, Procter & Gamble, and Nestle have big chunks of their businesses in the developing world. Ask your advisor or fund manager for a clear picture of what your true global exposure is.

See performance in a new light. Instead of just looking at raw returns, examine your investments’ risk-adjusted returns, meaning how much volatility comes with those returns.

Here’s an easy case: Take two funds that each return 9%, but one is highly volatile and the other is slow and steady. Obviously, the less volatile fund is more attractive: it’s the same return with more predictability. But your portfolio may hold trickier cases, such as a fund that has gained 9% with highly volatile returns versus another that has gained 6% but has done so smoothly. Is giving up 300 basis points of performance worth the smoother ride? That’s up to you.

Understanding the standard deviation of returns (often just called “volatility”) and slightly more technical concepts like the Sharpe and Sortino ratios will help here, and a ten minute review of those concepts on Investopedia.com will get you up to speed.

Rethink time. Reframe your calendar to get past standard performance measures including “year to date” and calendar year periods. The easiest way to do this is by looking at performance over rolling time periods (e.g., rolling 3- and 5-year periods). How do your picks stack up when measured this way? Non-standard fixed periods (e.g., the previous 18 months) will also likely reveal that an investment’s relative performance is somewhat arbitrary depending on how you cut the calendar.

A bit harder but more rewarding exercise is to break the market’s performance into up and down cycles and then look to see if your portfolio holdings do relatively well in one type of market versus the other, sometimes referred to as “up-capture” and “down-capture.” Funds with high up-capture but low down-capture are the cream of the crop, while it may be time to cut loose funds with low up-capture and high down-capture records.

3. Focus on the whole instead of the parts.

This is smaller exercise, but an important one. One of our built-in biases is the tendency to focus on the pieces of the puzzle rather than the puzzle as a whole. When applied to one’s portfolio, for example, it’s often hard enough to figure out one piece, let alone how they all relate to each other and add up to something that works (or not).

This exercise taps into something called the fallacy of composition: assigning the attributes of one part to the whole. So if you own a stock or fund that’s down 30%, you will naturally fixate on it. But how does it relate to the rest of your portfolio? If the portfolio is just fine, but you’re thinking you have too much risk because just one part of it is flagging, then you have experienced the fallacy of composition.

As a practical matter, do you have an online portfolio tool or a financial advisor that’s putting underperformers in context? If not, get one or both. That will help illuminate the underlying correlation among your various holdings. Almost by definition, diversification—the cornerstone idea behind how we build healthy portfolios—necessitates that at any one time something is not working. If everything in your portfolio is working, it means that you’re extremely lucky or you are not diversified. Think about it, then do something about it.

4. Enjoy the journey.

Seriously. The objective in all of this should be to meet your financial goals, not “beat the market” or find the “best” manager. You can’t do that (almost no one can), so don’t bother. Your portfolio is but one soldier in the broader fight for fulfillment and prosperity. And never forget that in addition to being a practical matter, money also takes us on an emotional journey, one that we tend to experience individually and in isolation. But the stresses that we all endure are quietly shared by all who aspire to grow wealthier. We’re actually all in this together.

And with that, I wish you a happy 2015.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.