William Bernstein2

IFA's Quote of the Week - 40 (William Bernstein)

William Bernstein2

“No one in his right mind would walk into the cockpit of an airplane and try to fly it, or into an operating theater and open a belly.  And yet they think nothing of managing their retirement assets.  I’ve done all three, and I’m here to tell you that managing money is, in its most critical elements (the quota of emotional discipline and quantitative ability required) even more demanding than the first two."

 

William Bernstein, July/August Journal of Indexes, also the author of The Intelligent Asset Allocator, 2000 and The Four Pillars of Investing, 2002

 

 

Don’t Try This At Home

An October 20, 2008 Investment News article stated that 75% of affluent investors make their own investment decisions. This somewhat stunning statistic arises from a survey of 200 investors. Indeed, in light of the recent hideous blows dealt to investors, it is likely that many more may contemplate joining the ranks of the do-it-yourselfers, but IFA recommends that investors take time to learn before they leap.

The ranks of disgruntled investors are swelling, according to the September 30, 2008 issue of the The Wall Street Journal, which quotes a survey citing that "81 percent of investors with $1 million or more in investible assets plan to take money away from their current advisor. An even larger number — 86% — plans to tell other investors to avoid their advisor." The article cites that "irritation is especially high at the “brand” firms — large brokerages and banks." Not surprisingly, investors have awakened to the realization that if these big firms can't properly manage their own investments, they have no right to be managing the investments of individuals, Indeed, the Journal states "90% of clients of brand firms plan to take money away from their advisor and 70% plan to leave the advisor altogether. That compares with a mere 29% for the boutique, local advisory firms."

It is truly unfortunate that it has taken a devastating market blow to wake up investors to the destruction of speculation. But, we take life's lessons as they are handed to us. Clearly, the recent market downturn provides the proof-putting necessity for an understanding of what constitutes prudent investing. In part, IFA implements prudent investing in the following ways:

A prudent investment is one that looks at risk and the returns of the entire portfolio, not simply a single fund's risk or performance. IFA's 20 Index Portfolios provide risk-proportionate blends of as many as 15 IFA Indexes.

The portfolio must be properly diversified so as to avoid overconcentration that can result in unrecoverable losses. IFA Index Portfolios invest in as many as 17,000 companies.

The investments should be consistent with the overall portfolio objectives. For IFA, the portfolio objectives are established in accordance with an investor's risk capacity.

Prudent investing is fundamentally simple, but it is not easy. As legendary investor Benjamin Graham said, “People don’t need extraordinary insight or intelligence. What they need is the character to adopt simple rules and stick to them.”

By anyone’s measure, Graham is one of the most successful investors in American history. Indeed, Graham is widely known as the investing mentor to Warren Buffett. Why is it that Graham’s instructions for investing success can be so straightforward, so elementary, so respected and yet, so widely ignored? The answer to this question lies in a fascinating and emerging field of study referred to as “neuroeconomics.”

In Your Money and Your Brain, author and journalist Jason Zweig explains why our brains are programmed to work against our ability to achieve long-term investing success. Zweig describes the processes that the brain undergoes in search of ferreting out predictive patterns where there are none. He says, “Unlike other animals, humans believe we’re smart enough to forecast the future even when we have been explicitly told that it is unpredictable.”

Zweig tells us that this need to predict has served us well as we have evolved over time. In fact, it is this ability to anticipate that is largely responsible for our ability to thrive against nature in the early going. It enabled early man to anticipate both prey and predators. But, this overriding need to find predictable patterns where there are none — such as news and the resulting price movements — is destructive to our long-term ability for investing success.

Zweig tells us, “It’s vital to recognize the basic realities of pattern recognition in your investing brain.” He elaborates that the predictive brain leaps to conclusions, it is unconscious, it is automatic and it is uncontrollable. His advice? “Stop predicting and start restricting. Presented with almost any data, your investing brain will feel it knows what’s coming — and it will usually be wrong.”

Studies regarding investor behavior in the wake of market activity lend strong support to Zweig’s assertions. The results of Dalbar’s annual study called Quantitative Analysis of Investor Behavior show that for the 20 years ending December 2007, the average equity-fund investor earned an annualized return of just 4.5%, despite the fact that the S&P 500 Index earned a significantly higher 11.8% return. IFA’s Index Portfolio 100 showed simulated returns of 13.38% for the same time period. The study shows that investors, overcome by the urge to predict news or the future, acted on their impulses, got it wrong, and suffered significantly lower returns as a result.

Further support for the ill-fated predictions of investors is shown in data released from Trim Tabs, a fund research firm that tracks inflows and outflows of cash in the markets. The chart below illustrates their findings. Looking at the chart, you can see that in the first quarter of 2000 — not so fondly referred to as the Tech Bubble — investors rushed in thinking returns were higher, instead of constant and stock prices were cheap, as opposed to fairly priced for relatively low expected returns. Expected returns can be best estimated using the Fama French 5 Factor Model. For an explanation of this model, please call an Index Funds Advisor. Think of today's market as being an "unbubble."

In fact, the amount of money that flooded the market at that time was nearly double that of the previous two quarters combined. This rush into the market occurred right before the S&P 500 peaked in March of 2000, leaving many investors vulnerable to massive losses when the market quickly collapsed. To further that point, in the third quarter of 2002, investors withdrew huge sums of cash in capitulation of the battering markets. A whopping $41 billion headed to the exits just before the market bottomed in October, 2002, missing out on the big market run-up in 2003.

More recently in the unbubble, we see the same sort of behavior as $56 billion fled the markets in the first ten days of October, despite the fact that the price had already given up a punishing 25%. More than likely, those investors were still on the sidelines, denying themselves the returns that came from the best week the S&P 500 had in 34 years. Quite simply, investors do not stand a chance of investing success if they rely on their need to predict future events based on the past. We cannot know with certainty when the markets will turn around, but those who flee will likely not be properly positioned to benefit from the inevitable upturn.

Clearly, we see that the very essence of our human intelligence programs us to invest poorly. Our instincts work against us as we futilely seek predictive patterns of short-term movements against a future clouded by randomness. “Financial decision-making is not necessarily about money,” says psychologist Daniel Kahneman at Princeton University. “It’s also about intangible motives like avoiding regret or achieving pride.”

The key to achieving long-term investing success is to avoid predicting the future movement of the stock market and focus instead on your own personal ability to manage risk through investor prudence. Make sure that you are properly invested in a portfolio that you can hold despite market conditions. To learn which portfolio is right for you, go to ifa.com and take the risk capacity survey. By answering a few simple questions, you will be matched to an Index Portfolio that is appropriate for you and your circumstances. This portfolio is risk-calibrated, style pure, globally diversified, passively managed, fully liquid and transparent. Additionally, this portfolio can be implemented by using a variety of different indexes. Best of all, IFA’s prudent investment strategy is supported by some 200 peer-reviewed academic studies that reveal the wisdom and success that comes from abandoning the prediction addiction in favor of simply buying and holding a risk-appropriate blend of passively managed indexes, and enjoying your life.