I was recently watching on The Weather Channel an episode of SOS: How to Survive. If you’re not familiar with this show, it’s essentially a re-enactment of people who got lost (in the woods, mountains, desert, etc.) and what we can do / learn to survive those types of situations. In this blog post, I will discuss the major piece of advice that experts give when people are stranded and how this advice can help you with your investment strategy.
HOW TO SURVIVE
When watching the show, an expert stated that statistics show that your best chance of survival is to stay put when you get lost. Of course, if you are in harms way then find a safe haven, but once you do, STAY PUT! The reason experts say this is because if you’re bouncing around from one place to the next, the rescue team may have already searched the area that you wander into. As a result, they will likely cross that area off their list and continue their search in other areas. Also, if you’re moving around continually you will be burning precious energy that you need to survive (especially if you are short on food and water). So, according to the experts, just stay put to increase your chances of survival and being found.
The only problem with this advice is that we are not wired to stay put. We feel as if we need to be in control doing something, finding a solution, reacting… As I was watching this show, it made me think that the advice of staying put is actually a very difficult thing to do. Many people mistakenly assume that “doing nothing” is weak and ineffective. But the reality is that it often times leads to the best outcome.
HOW STAYING PUT IS KEY TO YOUR INVESTMENT STRATEGY
Survival teaches us that patience truly is a virtue. We learn that it’s beneficial to just take a seat if you’re lost. This lesson learned is passive in nature and literally requires “doing” the most difficult thing, which is “doing nothing”.
Your investment strategy should employ a similar approach. What our industry has learned over the years is that it can be very difficult for an investor to watch their investments go down in value. Just like survival, it’s hard to stay put. We want to be in control, charter a more comfortable course, get out before any more losses are incurred, etc… In fact many investment professionals will attempt to do this for their clients. They will look at the economic landscape, study technical charts, and attempt to help their clients avoid calamities. Sounds good on the surface, right? However, the evidence is soundly against this type of approach.
There are numerous studies which show that this is an ineffective approach (known as Active Investing). Tom Allen and Mark Hebner published an article that discusses the ineffectiveness of JP Morgan’s market predictions showing that they were accurate in only 4 of 42 predictions. Even if so-called experts are correct in their predictions, it’s impossible to know the timing of when those predictions will come to fruition. As a result, an investor could literally miss out on years of stock market gains by waiting for the downturn to occur. Another article written by Larry Swedrow discusses how active investing firms underperform passive ones. Another study known as the SPIVA (S&P Indices Versus Active) report reflects that actively managed funds historically underperform passively oriented ones like index funds.
In my opinion, the premise of active investing is flawed in a couple of ways. First, no one has the crystal ball. What may seem like a sure thing is anything but. Things don’t always turn out like we expect. We don’t have to look too far back to see examples of this – Brexit and the recent presidential election. The other flaw is that active investment approaches are geared toward helping investors avoid market downturns. The reality is that market downturns (25% of the time) happen far less frequently than market upturns (75% of the time) and the gains far exceed the losses. To make matters even worse, we know historically that gains come very quickly, not slow and steady over time. As a result of this, you must be present to win. You can’t possibly capture the majority of the gains if you’re constantly moving into and out of the market. Additionally, the odds of timing when those gains come are so astronomical that it would be futile to do so.
If that weren’t evidence enough, check out this chart from Dimensional Fund Advisors that shows that over a 15 year period, only 17% and 18% of stock and bond mutual funds respectively, which employ an active investment strategy, outperformed their passively managed benchmarks.
WHAT IS A BETTER INVESTMENT APPROACH?
Since the research shows that active investment approaches are usually futile and not beneficial, what investment strategy should you engage in? The opposite of an active approach would be a passive approach. With this type of strategy, you don’t give any thought to continually moving into and out of the market. You don’t try to pick individual stocks. You don’t try to identify stocks that are overvalued or undervalued. Instead, you build a globally diversified portfolio of stocks and bond mutual funds (or exchange traded funds) and you rebalance periodically.
Stock and Bond Prices
But before you do that, you need to have an understanding of how stock and bond prices work. It’s easiest to explain this if you view the stock and bond market as a huge information processing machine. Information such as sales, profits, expectations, etc. is continually flowing into this machine which directly impacts the price you pay today. This means that the price you pay today for a stock or bond is fairly priced. Sure it will go up or down over time, but today it is fairly priced. This frees you up from trying to weed out overpriced stocks, find underpriced stocks, or find that diamond in the rough and instead allows you to tilt your portfolio toward areas of higher return.
Tilt Your Stock Portfolio Toward Areas of Higher Return
The stock market is made up of all kinds of stocks. Small, large, growth, value, U.S., International, etc… If you look at the historical research, stocks across the globe share certain characteristics. For example, over time, small stocks have outperformed large stocks, value stocks have outperformed growth stocks, and high profitable stocks have outperformed low profitable stocks. As a result of this information, you should still own all the different types of stocks, but you should at least own a little bit higher percentage than the overall market of the ones that have historically outperformed.
Use bonds in your portfolio to reduce risk. Historically stocks are more risky than bonds; therefore, we don’t want to take on a lot of risk with our bonds. There’s no sense in taking on a lot of risk on both sides. Bonds should be there to somewhat serve as your safety net in the event of a stock market decline. This means that you should own bonds that have short to intermediate maturities and are investment grade in nature. Research also shows that you should adjust your bond maturity and credit risk depending on how current yield curves and credit spreads look today rather than trying to adjust based on what you predict will happen in the future. This is much more difficult for the average investor to do on their own, but suffice it to say that if you can limit your bond exposure to investment grade bonds with short to intermediate maturities, you should be fine.
Over time, certain investments in your investment portfolio will drift from how you initially invested them. Some will represent a higher or lower percentage of your overall portfolio than you initially intended. In essence, some investments will simply do better than others. Rebalancing is the process of bringing your portfolio back in line with your initial targets. For example, if you initially wanted a 60% stock / 40% bond portfolio it is likely that over time the stocks will outpace the bonds and you will have more than 60% in stocks which is more risky than you likely desire. Rebalancing would help you to reduce that risk. You would sell the excess percentage in stocks and buy more bonds. This also serves as a way to buy low and sell high. Rebalancing should be done at least once per year.
Types of Investments to Use
This may take a little bit of investigating on your part, but don’t choose investments where their stated philosophy is to engage in an active strategy. Instead choose investments like index funds or exchange traded funds that invest into indexes. The costs will be considerably lower than actively managed funds and the performance will likely be better over time. At our firm, we use funds from Dimensional Fund Advisors (DFA). These funds operate very much like index funds, but are only available to independent firms, pension plans, and endowments. Essentially DFA builds their own index funds without some of the limitations of index funds. But for the average investor who manages their own portfolio, index funds will be fine.
For more on this passive-type approach take a look at the Investment Strategy section on our website.
So in conclusion, if you find yourself in a highly stressful situation, whether it be survival or investing, give some thought as to how you will react. Will you give in to the temptation of your emotions or will you stay put and trust that history and research are on your side?
I would love to hear any investment experiences you have had (either good or bad). What are your thoughts on market timing? Is now a good time to invest in your opinion? Do you subscribe to a buy and hold strategy?
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