I don’t need to inform you that investing is dangerous business. You already know in your gut what Joseph Engelberg and Christopher Parsons at U.C. San Diego found in their new study, that there is a noticeable correlation between market gyrations and our mental and physical health.
But when do you think the financial industry will get the point?
Shortly after I became a financial advisor, I was given a book to commit to memory. It told me what my role in life would be: To make a very good living helping approximately 250 families stay in the stock market.
The text insisted that regardless of my client’s age or risk temperament, it would be in their best interest to be—and stay—in stocks, exclusively and forevermore. I was the doctor; they were the patients. I was the ark-builder; they were the—you get the point.
The book might even be right.
The Behavior Gap
My friend and New York Times contributor, Carl Richards, has been drawing a particular picture for years. He’s struck by the research acknowledging the noticeable difference between investment rates of return and what investors actually make in the markets. (Investors make materially less.)
Investors, it appears, allow emotions to drive their investing decisions. A desire to make more money causes them to choose aggressive portfolios when times are good, but a gripping fear leads them to abandon the cause in down markets, missing the next upward cycle.
Investors buy high and sell low.
Well-meaning advisors, then, including the author of the book I referenced, have claimed their collective calling to be the buffer between their clients’ money and their emotions. Unfortunately, it’s not working.
Maybe it’s because the intangible elements of life are so tightly woven into the tangible that we can’t optimally segregate them.
Maybe it’s because we’re not actually supposed to forcibly detach our emotions from our rational thought.
Maybe it’s because financial advisors and investing gurus should focus less on blowing the doors off the benchmark du jour and more on generating solid long-term gains from portfolios designed to be lived with.
Portfolios designed to help clients stay in the game.
Portfolios designed to help clients (and advisors) avoid falling prey to the behavior gap.
Portfolios calibrated with a higher emphasis on capital preservation.
How much less money do you make, anyway, when you dial up a portfolio’s conservatism?
The Same Return With Less Risk
In his book, How to Think, Act, and Invest Like Warren Buffett, index-investing aficionado, Larry Swedroe, writes, “Instead of trying to increase returns without proportionally increasing risk, we can try to achieve the same return while lowering the risk of the portfolio.”
Using indexing data from 1975 to 2011, Swedroe begins with a standard 60/40 model—60% S&P 500 Index and 40% Five-Year Treasury Notes. It has an annualized rate of return of 10.6% over that stretch and a standard deviation (a measurement of volatility—portfolio ups and downs.) of 10.8%.
Next, Swedroe begins stealing from the S&P 500 slice of the pie to diversify the portfolio with a bias toward small cap, value and international exposure (with a pinch of commodities). The annualized return is boosted to 12.1% while the standard deviation rises proportionately less, to 11.2%. (Remember, this is still a 60/40 portfolio with 40% in five-year treasuries.)
But here’s where Swedroe pulls the rabbit out of the hat: He re-engineers the portfolio, flipping to a 40/60 portfolio, proportionately reducing all of his equity allocations and boosting his T-notes to 60% of the portfolio. The net result is a portfolio with a 10.9% annualized rate of return—slightly higher than the original 60/40 portfolio—with a drastically lower standard deviation of 7.9%
Same return. Less Risk.
This, of course, is all hypothetical. This happened in the past, and for many reasons, it may not happen again. These illustrations are not a recommended course of action for you or your advisor, but instead a demonstration that it is possible—and worth the effort—to work to this end.
Because we can’t keep hiding from the following logical thread:
1) Volatile markets increase investor stress (even to the point of physical illness).
2) Heightened investor stress leads to bad decisions—by both investors and advisors—that reduce investor returns.
3) Market analysis suggests that portfolios can be engineered to maintain healthy long-term gains, while at the same time dramatically reducing the intensity of market gyrations.
How could we not, then, conclude that more investors would suffer less stress, thereby reducing (hopefully eliminating) their behavior gap, thereby allowing investors to hold on to more of their returns?
Isn’t that the point?
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