Why worry about your investment style? After all, you have easy access to high quality analysis and research, up to the minute market information, and tens of thousands of mutual funds all vying for your investment dollars by providing “market beating” returns.
What’s that you say? Most funds under-perform their benchmarks? Fair enough, buy index mutual funds or ETFs. After all, there’s an ever growing universe of these unmanaged investments which provide market performance at minimal cost. Market returns are more than sufficient to build wealth over time.
With all the information and knowledge at our finger tips, it seems everybody should be on the path to long term investment success. Style should be a moot issue. But is it?
Not really. Numerous studies show that “investor performance” rarely matches “investment performance”, in fact most investors realize dramatically lower returns than the funds or indexes they claim to have invested in.
The reason for all this disparity may lie in investor behavior. A relatively new, but growing science called “Investment Psychology” is rapidly becoming required study for well qualified investment analysts and advisers. By understanding the emotions involved in the investment decision process, and anticipating the often irrational affect these emotions have on investor behavior, the adviser schooled in Investment Psychology seeks to ensure better returns by managing investor behavior.
As an individual investor, you can apply this same insight in constructing your own portfolio. Understanding your personal investment style is critical to managing your investments in volatile markets. By anticipating how you’ll react in markets which are performing differently then when you invested, you can construct a portfolio that allows you to avoid panic and properly assess risk.
When assessing how an investment fits your investment style look at how it’s performed in the past, especially in down markets. You’ll want to think in terms of dollars and not percentages. Mentally convert performance percentages to dollar amounts that correlate with the investment you’re considering, and ask yourself how you might have reacted when you opened the statement. Learning to recognize what would have made you uncomfortable in the past, can help you determine what you’ll be comfortable owning in the future.
If you’re investing in a down market, pay particular attention to your risk aversion. If you pursue slow and study but “safe” returns now, will you be inclined to get more aggressive when the hype of the next bull market reaches fever pitch?
Likewise, if you’re investing in a bull market, recognize the tendency towards overconfidence. Make sure can stomach large losses and protracted recovery periods if you invest aggressively.
Also, make sure you know why you’re investing. Taking the time to define and visualize what you’re investing for will help you to select the best investments to get you where you want to go, and keep you comfortable on the journey.
Take steps to separate your investments for near term, short term, and long term objectives; near term is 6 months to a year; short term is 2 to 5 years; and long term is anything longer than 5 years. Investing short term money in less volatile lower risk investments will emotionally enable you to invest longer term money more aggressively.
Having a fully funded (3 6 months of living expenses) emergency fund in a savings account or money market will also help. Knowing you will be able to meet unexpected expenses can give you the wherewithal to endure short term market fluctuations on your long term money.
Finally, recognize your own limits and seek help from a competent, trustworthy adviser when you’re not certain which path to take. Investing for long term wealth is a counter intuitive enterprise; buying low and selling high feels bad, and all of us are prone to act irrationally about our money.
Never, ever invest in something you don’t understand, and remember that performance and risk are inextricably linked; investments that demonstrate dramatic returns, eventually demonstrate equally or even more dramatic declines.
The most successful investors recognize that over time, the performance of individual investments contributes very little to their long term success. The hallmarks of investor success are having a well developed plan and sticking to it.
Understanding your personal style will not only help you to establish a plan, it will help you stick to it when the market environment changes. Being able to stay the course when the market tanks, and not follow the lemmings over the cliff when it balloons, will ensure your “investor” performance equals or exceeds “investment” performance in the long run.
Warren Buffet, perhaps the most successful investor in history, sums up all his investment strategy in one statement, “Be greedy when others are fearful and fearful when others are greedy,” but knowing and doing are two different things. Being comfortable with your investment style will help you seize opportunity and steer clear of excessive risk.