One of my Advisor friends in Vancouver BC, Clay, told me how he communicates the volatility of markets to clients. He said, “I remind them, ‘I have been doing this for more than 20 years and there is one thing I know for sure. Out of any 10-year period, you will NOT like me very much TWO of those years. THREE of those years you will not care one way or the other, and in FIVE of the years you will be very glad you listened to me and followed our advice.'”
Clay was very prescient. As I have said to most all of our friends and clients, markets go up and markets go down. It is a fact of life. The key to investing long term, according to Warren Buffet (in his 2010 letter to shareholders) is that “To be successful, you need an intellectual framework for your investment portfolio, based on research and data. But equally important, you need an emotional construct that will protect you from your natural aversion to loss.” Risk aversion is the enemy of long term, successful investing according to most all of the behavioral academics.
Buffet capsulized what behavioral finance author and Nobel Prize winner Daniel Kahneman identified the as Prospect Theory. It is based on happiness and peace, which is called utility within this theory. What Kahneman discovered is that happiness associated with gain is only half as intense as the fear of loss, which is double any joy. People would far rather not lose something they have, than gain something they don’t yet have.
This theory ties directly to investing. While every investor hopes for their portfolio to grow at an expected return, their biggest concern is loss. When the market does what it inevitably does – goes down – the natural reaction is to believe all will be lost and the portfolio will never recover. Historically, this has been an irrational fear. But the future is not the past. So, it is far too easy to extrapolate into the future our worst fears and then act on them, which inevitably causes the loss they fear the most.
The reason I am so convinced Wealth Teams Solutions and the DFA construct is the right thing for our clients, is that it is built on normative, rational research and data. The emotions of behavioral finance are not embedded in this math which means over the long run, it is reasonable to expect that markets will regress to the mean and perform as they always have. In fact, over the last 15 years, which have been awful by almost any standard, DFA has done quite well.
Our Wealth Team is committed to helping you weather the storm of volatility and hold fast while others are jumping ship, basing decision about investing in the market on instinct and fear. In the final analysis, everyone has to answer this question – Are you an investor or are you a gambler? The market can actually serve both. Investors do not let the market movements dissuade them from their long term objective. They understand expected return and are willing to let the market work to that end. Gamblers, on the other hand, seek to take advantage of what they believe are market shifts. They try to exploit the purported inefficiencies in market prices. Some get lucky and win, for a time. Most do not.
I wish we could make this a smooth ride for everyone. It would be my hope, using DFA, we could remove most of the volatility and deliver compounded growth over all time periods. But it is not realistic or possible to experience a market that only goes up. So we do what Warren Buffet said to do. We build the best framework, using the most up to date academic research and data possible, and we cling to the emotional construct and remind our clients that their biggest risk is their own worst fears.
As always, I am here to discuss this approach to investing with you at your convenience. It is my hope and prayer that during those TWO inevitable years out of TEN, we can still remain friends, so we can enjoy the inevitable FIVE years that will make all the difference. Please call if you would like to discuss further.