Stop Following The Herd Or You May Run Right Off A Cliff

911044_s Last year was a rough year for investors, commodities took a beating, treasuries lost, bonds and stocks were volatile; heck, even Warren Buffett’s Berkshire Hathaway was down 12 percent! Matt Egan from CNN reported last week that nearly all of the stocks in the S&P 500 have fallen by at least 20 percent from their highs. He explained that broader indexes do not reflect the underlying pain because companies such as Netflix, Facebook, and Google, which are worth about $831 billion combined, have held up pretty well. Many masters of the investment world such as William Ackman, David Einhorn, Joel Greenblatt, and Larry Robbins spent their holidays penning letters that explain why 10 to 25 percent losses are “no big deal.”
This was the hot topic of discussion that I had with a very nice client of mine who is wintering down in Florida; let’s call her Joannie. After explaining the current market situation to Joannie I said that while yes, we could talk about all the inequities in the market, and how 2015 was one of the hardest years for investors since 1938. And we could talk about how this past December has been the first losing December since 2002, or how the growth of the world’s largest economy has come to a sudden crawl! All these factors contributed to the volatility that investors experienced in 2015; however, none of these factors provide answers to the basic questions on everyone’s mind, “How do I make money and protect myself in this sideways and unpredictable market?” and “How am I supposed to build a dependable and reliable stream of income throughout retirement when the markets behave erratically?”
I’m going to get a little philosophical and quote “The Art of War”, a treatise thought by many to be written by Sun Tzu, an ancient Chinese military strategist, “Every battle is won before it’s ever fought.” I often tell my girls this when they don’t want to go to softball practice. I explain that it is in the preparation that determines the outcome of their performance, before the first pitch is even thrown. What the great Sun Tzu wrote also holds true about investing. Every portfolio is won or lost before the first trade is ever placed.
I explained to Joannie that DALBAR, the nation’s leading financial market research firm, conducted an annual study of investors and found that one of the primary reasons why retail investors, or small investors fail is their investment process, or lack thereof.
The DALBAR study found that most small investors make investment decisions based only on their perceptions or instincts about the market. They lack a defined process, which often results in the all too familiar cycle of buying high and selling low.
You see, oftentimes, retail or small investors’ perception of markets is based on the actions of the masses. When people base decisions on the actions of the masses, it is referred to as herding.
Herding is a phenomenon that is found in all aspects of life, from animals in the wild to drivers on the road. I even see it in my girls when they want something because “everyone else has it.” We, as a species, are hardwired to want to follow others. It is a survival trait that has served us well for millions of years. After all, if everyone is running, chances are a predator is close on your heels, so it is a sound idea to run with the herd, right?
Hmm, not necessarily.
When it comes to investing, herding can be one of the greatest drivers of loss! Statistically, trend followers in the market, those who mirror the actions of successful investors, generally fail to realize the same returns. By the time the typical investor realizes that there is a trend to follow, it’s generally too late to profit from it.
So what makes institutional investors generally more successful? Since most institutional investors are investing on behalf of others, they follow a process, and the first step in that process is to create an investment policy statement or IPS.
In essence, the investment policy statement is a contract between the client and the investment manager. The IPS dictates all aspects of their relationship, including the goals of the investments, the chosen method to achieve those goals, and the metrics that will be used to determine success and failure.
Statistically, by using a rules-based approach to investing, institutional investors are able to realize greater returns than retail investors by changing the pattern of buying high and selling low to buying low and selling high.
This does not mean that institutional investors do not have losses; after all, Warren Buffett lost $2.5 billion in a single week. However, by following a process that dictates every investment action, institutional investors are able to shift the proportion of trades that are “wins” to their favor and provide greater returns for their investors over the long term.
Additionally, by following an investment policy that dictates their investment actions and incorporates downside risk management strategies, institutional investors are able to create a more predictable and consistent experience for their investors.
In contrast, investors on a retail investment platform will see scattered results, with unpredictable and uncorrelated gains and losses. The lack of consistency in their investment returns will provoke anxiety in most investors and cause them to continually switch investment strategies and remain in the paradigm of buying high and selling low.
As the DALBAR study demonstrates, simply having a sound investment policy that dictates your investment actions can make a considerable difference for an investor. For those in or near retirement, a significant loss in the early years of retirement can be the difference between running out of money and leaving a legacy for generations to come.
Joannie felt much better after our chat. Currently, her investment policy dictates that her portfolio be in a defensive posture, giving her some peace of mind. What is your process? What is your investment policy? Folks, what is your strategy? Now is not the time to be following the herd.
Be vigilant and stay alert, because you deserve more. Have a great week!