#137 Part 4 – Early Warning Indicator

Minds are some of the most difficult things to make up, especially when your instincts and your intelligence are in conflict. In the natural world, mammals use limbic resonance to help them make decisions. Limbic resonance is what drives our ability to be empathetic, and is a deep-rooted survival instinct. Being tuned into the group, especially during times of stress, helps the individual, and the group, survive.

Unfortunately, this collusive bond means people are predisposed to be pretty terrible investors. The real world is messy, and our innate desire to be symbiotic, especially during times of heightened market turmoil, becomes the number one deterrent to an investor’s success.

This is the final column in a four-part series about my investment philosophy. So far we’ve worked on setting up your investment strategy for success through goals-based investing, risk-control measures, and three rules for choosing good investments.  This column is going to focus on behavioral finance. The most reliable early warning indicator of failure is success, so now that you’ve got the tools to set up a successful goals-based investment strategy up and running, the only thing you have to do is not screw it up.

 

Cycle of Market Emotions

Our industry has gone to great lengths to define and regulate investment risk as a measure of volatility. If volatility is defined as the uncertainty of results, this makes sense. But it’s only a partial definition. True risk is an emotional state. It is based on the uncertainty of returns, but is perceived uniquely by each individual investor. It’s also dynamic. Each person’s personal interpretation of risk is heavily influenced by their own recent experiences.

For example, if an investor has had recent success, they may perceive less risk in the markets, or may believe their decisions are so insightful they don’t need to consider risk. If instead that same investor had recently experienced downward pressure in their portfolio, they will likely struggle with the loss of supportive information, and may be more susceptible to believing rumors or other negative views than they would be otherwise.

The influence of past events on an investors’ perception of risk is why people as a whole tend to make terrible investment decisions. Driven to be part of the herd, we get caught up in the energy of others. It takes a lot of courage and an emotional disconnection to be able to stand alone – a brave silo grounded to your values; feeling like the world is leaving you behind.

We are all susceptible to the emotional reactions, but there are things you can do to help your intelligence triumph. Meaningful tools you can use to conquer your nature, and begin the disconnection away from herd mentality and towards intelligent investing.

Breaking the Cycle

First, accept that emotions are not rational, and the markets, which are driven by emotions, are not rational either. It’s like being around someone with an over-carbonated personality. It’s exhausting to watch, but you will survive if you have confidence in your own intellect and hold onto your optimism. Eventually, they’ll go home.

Second, understand that, like risk, time is also subjective. It can seem to move terrifyingly fast when looking at the past (have we really been married for three years already?) or it can seem unbearably slow in the midst of extreme volatility (only 3 hours and 41 minutes left ‘till lunch). You can control your perception of time, helping to speed through volatility while still making sure you take advantage of rebalancing opportunities, by scheduling regular annual updates. You’ll know that you looked at your portfolio recently, and that the next opportunity will come again soon.

Above all else, remain focused on your long term goals. Volatility is not risk unless you perceive it as such; taxes are not as important as choosing appropriate investments; and I don’t care whether or not your investments pay dividends -equities are never an appropriate substitute for fixed income. Your long term goals don’t care how you get there, as long as you get there. Once you’ve got an appropriate investment strategy, all you have to do is not screw it up.

Remember that if you’re hearing about it on the news, it’s already happened. Markets aren’t intelligent, but they are efficient. Anything that you hear about on the news has already been priced into the markets by everyone else who’s also concerned about it.

Investments don’t know that you own them, so avoid emotional attachments and sector loyalty. If your income, investments, and the market value of your home are all dependent on one industry, you could lose everything if that industry fails. Involve an unbiased third third-party in your investment decisions and rebalance your strategic asset allocation regularly.

Beware the five star curse. Last quarter’s results are a reliable indicator of last quarter’s results. They have no other meaning - no predictive power of future returns. If you are considering buying an investment and one of your reasons is because they’ve done well lately, keep in mind that only 14% of funds that had a five star rating in 2004 still carried that five star rating in 2014. If you’re comfortable with everything you own, then you’re not doing it right.

Avoid unnecessary trading. Good investment strategies may take years to play out. Trading adds costs, and costs lower returns. So unless something fundamental has changed, stay consistent. Allow yourself to hold investments that are out of favor, enjoy the process and realize that mistakes won’t threaten your sense of self.

Diversify extensively and buy investments with a value style. When you buy in at below-average prices, you don’t need the results to be precise. All you have to do is wait for the herd to catch up.

And finally, rather than fight your natural instincts, you can create your own herd. Establish a strong supportive bond with an advisor who is engaged and interested in investing. Find someone who has decoupled the idea of loss from risk. Someone who is comfortable taking the road less travelled – and considers that one of their best qualities. But most of all, find a personality that fits with you. Someone you will trust even if you don’t agree with them. Will you hold my hand and jump when there are rocks below if I tell you the tide will be in by the time we reach the bottom?

It’s human nature to feel safer when we’re with the herd. We crave sense of inclusion and the protection of the group. Unfortunately, this desire for inclusion can lead to some pretty terrible investment decisions. The most reliable early warning indicator of failure is success, so stick with your goals-based investment management strategy and don’t let your desire to be part of the group screw it up.

Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors

Investment Funds Representative
Manulife Securities Investment Services Inc.

The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.

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