Zweig: How Best to Invest in Times Such as These

What is surprising to me these days is how quickly investor mindset has shifted from the sheer uncontrolled fear they felt in October or November of 2008 or March of 2009. They have forgotten that they made impulsive decisions; that they made big decisions when they should have been making small ones; that, instead of making incremental adjustments to portfolios, instead of rebalancing at the margin, they bailed out of asset classes entirely or moved completely into cash. That’s very troubling to me and it suggests that we’re nowhere near out of the woods. It worries me so much I think we’re probably in for another big surprise before we have a full recovery. Words: 1489

In further edited excerpts from the original article* Jason Zweig (www.morningstar.com) goes on to say:

There’s been an enormous amount of performance-chasing. Part of it is that humans are a hopeful species. We want to believe that the worst is behind us and that happy days are here again and because of that, people are already doing some very foolish things that they will come to regret later. Instead, they should stop and reflect on what has recently transpired and take action to better invest in these difficult times.

Following are a few suggestions on how to do just that:

1. Practice Staying Calm and Making Sound Decisions
To prepare for times of financial turmoil it is important to deliberately create an environment that makes rational decision-making difficult and then develop a series of portfolio decisions. You need to consider those decisions while the lights are flashing and the bells are clanging and CNBC is full of red arrows pointing downward and all the stock charts are going through the floor. You have to come up with a way of calmly arriving at a decision that makes sense. I think one of the ways you need to do that is that you need to imagine the future. You need to frame the decision as “Let’s make sure we do something today that we won’t regret six months, a year, five years from now.”

This kind of exercise is that it’s practice for the real world because as we saw last fall, and this past spring, that’s what it was like. People made decisions every day under those circumstances, and a lot of those decisions were bad, because people had never been in circumstances like that before.

I would close this observation with a reminder to everybody, which is now part of American folklore. Think of Sully, the famous captain of the US Air flight bringing his plane down into the Hudson River and having every single passenger survive. What enabled him to do that? Not his superior knowledge, not knowing more about his airplane, or the Hudson River, than anybody else. What enabled him to do it was practice.

If you’ve never really practiced what it’s like to make a decision in a global financial panic, you can make panicky decisions in a global financial panic, and you’ll crash your plane and you’ll kill everybody but if you’ve practiced how to stay calm and make a good decision, you stand a better chance of being able to do it. Repetition is the key to calmness.

2. Understand Diversification
A lot of investors have been saying of late that strategic asset allocation is dead and that tactical asset allocation is the way to go. I don’t think that is the case. I think people have confused a whole bunch of factors. One, people really misunderstand what diversification means. People think diversification means that if you combine uncorrelated assets you end up with a portfolio that won’t go down in value but that’s not what diversification means.

First of all, you’re not diversified unless you own something that hurts to own and the second thing is that at a time when it seems the whole world is going to hell in a hand basket, everything goes down. That’s what happened this time, that’s what happened in 1973-74, and it happened in 1929 and it happened in 1907. It happened numerous times in the 19th century and as far back as you care to go.

So diversification is really powerful, but it’s not magic. It’s a very good thing but it doesn’t work miracles. So that’s a problem I have with this argument. When people say diversification failed, they’re defining failure in a very strange way. They seem to be saying if, when most assets went down, something didn’t go up, then diversification didn’t work but that’s not what it ever meant. All it ever meant is that if you have assets that are statistically not highly correlated, putting them together will give you a better trade-off of risk and return.

If you look at what happened in the financial crisis, that’s what you got. People who owned some stocks and some bonds did better than people who owned all stocks. People who had some other assets in there did better still. The fact that the U.S. market went down 37% and foreign stocks and emerging markets stocks went down also doesn’t mean that diversification didn’t work, because they didn’t all go down exactly 37%.

Diversification did work for exactly that reason–you got different rates of return. People want diversification to produce a positive return out of some asset when their favourite asset is down but there are no guarantees. Diversification isn’t a form of insurance; it’s just a form of risk control.

The problem with this whole “asset allocation is dead” argument is that, while asset allocation hasn’t worked in certain years nothing else has either. That’s the problem I have with this whole debate; it’s easy to say what hasn’t worked well lately, but it doesn’t mean that all the things that never worked have suddenly started to work.

3. Consider Indexing
There are many many reasons why I favour indexing and believe it makes sense for most investors:

a) Human life is finite, so if I find a fund manager I love, I have to ask myself if he or she is still going to be around in 30 years when I retire or 100 years from now when my kids or grandkids inherit my shares in this fund, and what confidence do I have that he’s as good at picking successors as he is at picking stocks? That would be the first.

b) In a taxable account, it’s hard to argue for active management at all. If an active manager is doing his or her job and being active, then capital gains are going to be generated. In fact, the better a person is at doing his or her job, the larger those gains are going to be over time.

c) Indexes minimize some of the worst aspects of human error. In the case of short-term bond funds in particular, a lot of the managers just yielded to the temptation of chasing yield and putting in a lot of mortgage garbage because they could goose the yield. If you bought a short-term bond index fund, you just didn’t get that sort of thing. There are short-term bond ETFs, and none of them blew up because the computers–the machines–didn’t have much interest in mortgage derivatives. The humans running active funds, on the other hand, were hell-bent on earning a bonus based on how much yield they could produce.

d) The overriding reason is that, in my opinion, it’s extraordinarily difficult to pick individual securities that will outperform a market benchmark and even harder to select managers who will outperform a category average.

e) It’s extraordinarily difficult to pick a great manager who will still be great and the most basic reason for it of all is that luck is really the driving force, to the extent that most investors don’t appreciate and can’t appreciate because it makes people uncomfortable, but it happens to be true.

I’m not saying that active management is bad or futile, or that I think everyone who invests in an actively managed fund is an idiot. What I am saying is that it’s extraordinarily hard to get it right, and maybe the best reason of all to do it is if you can find a manager whose view of the world is really similar to your own. Because then you’re a lot more likely to go along for the ride.

Index funds don’t have personalities. A great active manager can be a magnet for loyalty, and that’s really important and I would never denigrate that. In fact, most investors would probably be better off putting their money into a mediocre fund they could be loyal to than a whole series of great funds that they go barging in and out of at the worst possible times.

*http://cawidgets.morningstar.ca/ArticleTemplate/ArticleGL.aspx?id=313708

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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