My holiday reading included two journal articles that challenge the notion that investing for the long term reduces risk.
The message: It's all well and good to recommend that an investor take the long view and not worry about short-term market dips, but quite another for that investor to truly maintain the strategy over multiple decades. While it's easy to be a long-term investor in good times, it's quite a different matter in times of euphoria or panic. Most investors can't resist the temptation to become short-term oriented at extreme points in the market cycle.
The researchers have plenty of evidence on their side. Academic studies consistently show that investors achieve poorer returns on average than the funds they invest in. This shortfall, which is called the behavioural gap, primarily results from too much trading and a tendency to buy what's done well in the recent past.
Many other factors can also take investors off track and expand the gap. Sometimes a change in life circumstance – a new job, a divorce, a mid-life crisis – will lead to an untimely strategy shift. There's always the promise of the cool new products that are focused on what's popular at the time – technology, gold, China, food, covered calls and/or dividends. And then there's the psychological imperative (most common in males) to just do something when markets are moving.
Clearly, it's hard being a committed, consistent long-term investor, but it can be done. During my time on the buy side, I've met thousands of investors who have let the power of compounding work for them and done well as a result.
As we start a new year, it's worth reviewing a few of the keys to staying on a long-term track. I've got five.
First, you need to recognize that investing is like no other product decision you make. It's perverse. Your best moves will feel terrible when you're making them. Your well-thought-out plan will appear to not be working for long stretches of time. And, like golf, there will always be someone telling you they've figured out a better way (usually someone who posts higher scores and lower returns than you).
Second, you should stop doing the obvious things that are causing the behavioural gap. Contribute less to the profitability of the financial services industry by trading less and avoiding high fees. And don't screen potential investments based solely on how they've done in the last three years. Look forward, not back.
The third key: You need to work from a Strategic Asset Mix. This is a plan, a place you go when you're confused, disappointed, frightened or over confident. Your SAM should be the basis from which all decisions are made. "How does this new product fit into my portfolio? Should I be buying or selling these lousy foreign stocks?" Your SAM won't vary much from year to year and should never be changed drastically at extreme times. When markets are going wild, it's time to lean on your plan, not change it.
Fourth, you need to eliminate the word "if" from your vocabulary and substitute "when." You're more likely to be surprised by ifs, as opposed to being prepared for whens. For example, when the stock market goes down 20 per cent, you'll gradually add to your equity funds. When your foreign stocks smoke the rest of your portfolio, you'll re-balance back to Canada. And when it seems you're going against what everyone else is doing, you'll smile and pour yourself a nice glass of wine.
Finally, to be a successful long-term investor you need someone to lean on. You need a veteran who has a better investing temperament than you and has experienced the end of the world a few times. We all need a touchstone (for years I've leaned on Bob Hager, Warren Buffett and Jeremy Grantham), although you shouldn't expect them to be right all the time. Rather, you're looking to benefit from their calmness, thought process and most importantly, their longer-term perspective.
It's easy building a long-term portfolio. It's tougher sticking to it. But it's not rocket science. If you're committed and consistent, the markets will present you with some wonderful opportunities and the process will be very rewarding.