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Back to Basics
Part III: How to Avoid Temptations That Threaten Your Success
Editor's Note: The recent bear market has given investors an opportunity to revisit basic ideas for successful investing and why they work in both up and down markets. This is the final article in a three-part "Back to Basics" series.
Temptations Can Pull You Off Track
Many investors follow a sensible process and sound principles in building their portfolios, only to then succumb to temptations that pull them off track. There are four categories these temptations fall into:
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- Performance hype
- Timing
- Manager selection
- Market momentum
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Let's evaluate how each can lure you away from your long-term plan, while also emphasizing how you can avoid them.
Put Performance Hype in Perspective
You've probably seen headlines in personal finance magazines that promise Our Ten Best Fund Picks for the New Year! Invariably, those "best funds" are selected through hindsight, such as last year's performance record.
These headlines do sell magazines, because so many investors want the prestige of owning a "five-star fund." Yet, authoritative studies have documented that selecting funds on past performance gives you only a random chance of success at best. In many cases, last year's best performing funds lag next year's averages, as styles that have been hot start to cool.
Avoid the Temptation
Unless you understand specifically how superior performance was generated, take it with a grain of salt. When you take the time to investigate, you will often find that a fund performed well because its specific style or economic sector was in favor, or maybe its portfolio manager was plain lucky. If you must pay attention to past performance, evaluate how the fund has performed over the past two or three economic cycles. Strong performance in both up and down markets can confirm that a manager maintained discipline and outperformed other managers of similar style ("peers"), even when that style wasn't doing so well. Focus not only on long-term performance versus benchmarks and peers but also long-term consistency.
Time Is On Your Side, But Timing Is Not
The temptation to "time the market" also can be influenced by the financial news that you hear. A gloomy report on the evening news can create enough anxiety to cause investors to pull money out of the market. If the market then goes higher, they may be reluctant to admit a mistake and miss a whole bull market. At Russell, we don't have a short-term view on which way markets are going, and we don't advocate tactical (short-term) market timing. Over many years of analysis, we have not seen timing work well for most professional investors, let alone individuals. We believe the opportunity always exists to begin a sensible investment program that is well diversified, with a long-term horizon.
Avoid the Temptation
How should you process daily bits of financial information? I recommend listening to financial news and trying to assimilate it into a context of how markets will move over time. Then, discuss with your spouse or financial advisor these "macro trends," not the day-to-day news and rumors. Even if events cause stocks to move up or down short-term, there are broad underlying currents flowing through markets which can be more powerful than the "surface news." Over longer periods of time, for example, stocks have always tended to trend upward with economic growth and corporate profits. This trend can be especially powerful for investors who have time on their side to achieve financial goals.
Manager Selection Has Grown More Challenging
Investors also go off track when they engage in the game of constantly assessing and changing portfolio managers. For example, suppose you stay true to your asset allocation by putting 30% into large-cap growth stocks, but you constantly change large-cap growth managers. This can be detrimental for three reasons: 1) It doesn't give your manager a chance to perform over a full cycle; 2) It can trigger tax consequences that erode returns; and 3) Any mistakes you make in selecting managers can damage your confidence and long-term commitment.
At Russell, we recognize that there are now more mutual funds in the world than stocks listed on exchanges, and most investors have as much difficulty selecting managers as individual stocks. Evaluating managers isn't getting easier for the individual investor, either.
Avoid the Temptation
We employ 60 analysts and spend $20 million a year researching managers and analyzing their styles and performance. We believe that individual investors who depend on active management should leverage the "manager due diligence" resources of an analytical firm like Russell. In a Russell fund, you pay a management fee comparable to the fee in a regular mutual fund. But you receive multiple managers plus Russell's comprehensive services for researching, monitoring and changing them if appropriate. We believe this is an intelligent approach for investors who: 1) want to stay well diversified in an asset allocation discipline; and 2) believe money managers can apply their insight and information to outperform market benchmarks For investors who are content to mirror the market averages, we believe participating in index funds can be a way to avoid the temptation of second-guessing manager selections.
Market Momentum Can Change Your Risk Level
The fourth and final temptation is perhaps the most subtle, because it doesn't require action on your part. At times, the market's momentum can be powerful enough to pull your asset allocation out of alignment. An example occurred in 1998 and 1999, when the spectacular run-up in large-cap growth stocks caused many portfolios to balloon with these stocks. It's important to evaluate momentum-driven changes in your risk exposure, and whether you are comfortable with them. For example, suppose you settled on an asset allocation of 60% stocks and 40% bonds, and then the stock market made a powerful move upward, so that the mix shifted to 80-20%. Ask yourself if you are as comfortable with the risk represented by 80%-20% as you were with 60%-40%.
Avoid the Temptation
By choosing an "automatic rebalancing" feature, you can anticipate and prevent momentum-driven changes in risk exposure. If your portfolio moves out of alignment by perhaps 5% in an asset class, the program automatically adjusts the mix to the original percentages.
Conceptually, you should recognize the need for a "constant level of risk" represented by a specific mix of asset classes. This can be difficult, because it's natural to want to ride a bull market all the way to the peak with the hottest stocks. But that's a little like trying to climb Mt. Everest in a snowstorm. You don't know where the peak is, and the higher you climb the farther you can tumble back down. If you don't take advantage of automatic rebalancing, it's a good idea to review your portfolio mix quarterly — especially when the market has made a significant move.
The Value of Patience + Perspective
All four temptations have one thing in common: They can undermine the process of identifying your important financial goals and building a portfolio designed to meet them over time. The solutions described for coping with temptations also have one thing in common: They help you avoid the powerful seduction of short-term news, trends, performance and momentum. Don't be distracted by news headlines or advertising hype. Look inward and be honest with yourself. Give your investment program a fair chance to succeed by being patient and putting all the "little things" in long-term perspective.
Copyright © Russell Investments Canada Limited 2008. All rights reserved. See Important Legal Information. Date of first use: 05/23/01.
Past performance is not a guarantee of future performance.
This is a publication of Russell Investments Canada Limited. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
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