Often I am asked “How Can I Improve My Portfolio’s Performance?”
Investing can be as much art as it is science. In my opinion it may actually be more art than science. I really think investing is all about emotion and all the statistics, charts, graphs and academic white papers provide a rational cloak to mask this simple fact.
This is true when we buy anything or make a decision about a person. When asked most people will say something like “My gut tells me this.” Then we use our left brain to provide rationalizations for whatever decision was made.
It’s often been said that the stock market is driven by two primary emotions: Greed and Fear. Personally, I think that all human activity boils down to this and the stock market is just an extension of that.
Investors are not totally rational. Heck, most people aren’t rational so why would investors be any different? The many different ways that greed and fear play out in investment and financial decisions are explored in behavioral finance, a branch of finance.
There are all sorts of investor behaviors that contribute greatly to poor investment performance. Some of these include:
- Loss Aversion:
- Narrow Framing:
- Mental Accounting
- Naive Diversification
- Media Response
All of these contribute in one way or another to irrational and often detrimental financial decision-making.
Fran Tarkenton, a football legend and successful businessman, once said, “People don’t change their behavior unless it makes a difference for them to do so.”
Changes That Make A Difference
So, it’s a almost a New Year and a “new you.” And you’re looking for ways to make that New Year’s resolution work.
Well, here’s the tip that you can use to combat the fear/greed response and investment behaviors that can torpedo your investment performance: Control What You Can.
- Asset Allocation: Diversification is still the best way to minimize loss and maximize your wealth potential. But this doesn’t necessarily mean simply “Buy-and-Hold.” You don’t have to be the captain going down with the ship in a storm. Know your risk tolerance and recognize that it changes over time. You can and should have a way to flexibly respond to market conditions. A practical approach is incorporating “tactical asset allocation” rules into your overall approach.
- Investment Decision Process: The most successful investors can take a lesson from Kenny Rogers’s “The Gambler.” You got to know when to hold ’em and know when to fold ’em. This is best done not in response to some emotional event or a news story that freaks you out but before you buy. Remember what your mother told you when you went into a crowded room or theater? Know where the exits are. The same holds true for investing. Don’t buy in unless you know what your triggers will be for exiting. This will help lock in a gain or minimize or avoid a loss. Individual investors rarely use a tool that has proven to be a life-saver for this: an Investment Policy Statement (IPS). With an IPS you can outline the process you or your advisor will use for choosing, keeping or selling investments.
- Expenses: There are few things that you can control in life. Expenses in investing is certainly one of them. Understand what you own or will buy and what the costs are. Expenses act like a sea anchor putting a drag on your investments. Your investments have to work harder to overcome the drag. By lowering your expenses you lower the drag. How do you do this? Look under the hood of your mutual funds or private placements or annuities. There are expenses to run each of those. And in the case of mutual funds what’s not reported is the cost of trading those holdings. So mutual funds with high “turnover ratios” have higher costs (up to 0.50% more per year).