Q3 2013

On Jul 04, 2013 In Goals-based Investing 

Sticking to Your Investment Diet

Government statistics tell us that more than one-third of Americans are obese1, a fact that is affirmed by television, radio, and magazine advertisements promoting an endless variety of diets and weight-loss plans. These range from well-reasoned and medically sound approaches to the latest fad diet or celebrity-endorsed regimen. All have in common that some author, promoter, or manufacturer benefits from their increased popularity, and that the majority of those who attempt these diets will not follow them well enough or long enough to achieve their weight loss goals.

As it turns out, the best diet may not be the most scientifically robust plan, but the one to which we undisciplined humans can adhere long enough to reach our target weights.

So it is with investing. Government statistics tell us that more than one-third of Americans do not regularly save for retirement (perhaps they are spending instead on excess food!) and are therefore unlikely to achieve their financial goals. Those who have accumulated some personal savings are barraged with advertisements promoting innumerable investment approaches, from get-rich-quick schemes and investment programs that allegedly "never lose money," on the one hand, to thoughtful, well-balanced investing frameworks on the other. Again, all have in common that some promoter may benefit from our choosing to follow his suggested plan, and that the majority of those who choose to invest according to the principles of a specific plan will abandon those principles at some future point of market stress. As is the case with diet plans, the best investment plan may be the one to which we can adhere long enough to reach our financial goals.

The goals-based investment framework attempts to incorporate this important fact about human behavior: despite our early intentions, it is human nature to want to switch horses mid-stream. Perhaps this tendency is an inescapable facet of our genetic heritage. As we assimilate information about our environment and make assessments regarding perceived dangers or opportunities, it is natural and advantageous that we might seek out solutions superior to our current approach and make "course corrections" to increase our chances of survival or success. One might argue that much of human progress owes to visionaries who were courageous enough to make the changes necessary to exceed typical outcomes.

Yet this conclusion misses three important nuances about human behavior as it impacts investment decision-making. First, we ought to distinguish between "switching horses" and making "course corrections." In all journeys, unexpected twists and turns are encountered, weather is hotter or colder or wetter or drier than anticipated, and roadblocks impede our progress. Our ability to realize that we have drifted off course, re-route, detour around obstacles, and take cover when necessary indicates our resourcefulness and improves our overall chances of reaching our desired destination. However, to take the travel analogy one step further, if we set out driving our automobile from Miami to Seattle, encounter some major travel difficulty somewhere in rural Missouri, and decide that a train or airplane is the better way to continue, we should expect to absorb significant costs of switching— time, energy, and money—costs which we routinely tend to underestimate on the front end. If we switch too readily from car to train to airplane to bus to bicycle, we may actually, though inadvertently, delay our arrival, exponentially expand our costs, and find ourselves in places to which we never intended to travel nor from which we know the way to our final destination. Except in emergency cases, if the car breaks down en route it is generally better to have it repaired and continue on via the planned mode and route, rather than abandoning the car to purchase a last-minute airline ticket.

Second, money and wealth have a social aspect that we cannot ignore. Research has shown our tendency to practice herding behaviors in financial decision-making, to seek alternatives which increase our self-pride within our peer groups, and to prefer investments improving our social connections or creating perceived personal benefits apart from financial return. We succumb to an adult form of peer pressure, questioning whether our established principles and ways of investing should be abandoned or re-cast in greater conformity with what appears to be that of our peers. (And we emphasize "what appears" in this context, noting that most peer pressure, be it among teenagers or adults, tends to exaggerate actual behaviors.) The message is simple: social pressures act to encourage us to "switch horses" as friends describe in colorful language their investment winners (but rarely their losers), extol the virtues of their favorite stockbrokers, and suggest that lower risk, disciplined approaches are outdated or outmoded.

Third, the fungible nature of money, especially when combined with the innovative nature of modern financial markets, tends to amplify our temptation to abandon well-reasoned investment models in favor of the latest fad. The proliferation of investment offerings, highly engineered financial solutions, alternative investments, hedging strategies, and exchange-traded funds (ETFs) heightens our belief that another approach to investing might increase our wealth. Meanwhile, the ever-expanding legion of investment firms, brokers, agents, and advisors—all of whom stand ready to help us "switch horses"—leads us to underestimate the penalties accruing from switching and overestimate the benefits. The investment industry, owning a major financial interest in our indiscipline, encourages us to frequently switch, much like an overweight person bouncing from one diet to another while losing no weight.

One of the major advantages of the goals-based approach to investing is its record in helping investors stay the course during difficult times. During the Financial Crisis of 2008-09 and its aftermath, investors who followed the goals-based approach generally fared better than the average investor. Because the goals-based approach is based on maximizing the probability of achieving investor-specific goals at the desired confidence level (i.e., priority) and according to the desired time horizon, this approach generally succeeded better than most in keeping investors focused on long-term outcomes rather than short-term volatility in markets. Goals-based investors who were tempted to sell volatile assets at the market bottom were reminded that they were not relying upon these assets to fund their short-term needs, and therefore could afford the illiquidity and daily volatility that forced other investors to capitulate at the most inopportune time. Instead, goals-based investors were more likely to be sitting on substantial cash and fixed

income assets, allowing them to acquire assets at bargain-basement prices from desperate sellers. Finally, the flexibility inherent in the goals-based approach which allows for a periodic refreshing of goals, priorities, and time horizons—and consequential automatic re-alignment of portfolio allocations—better enabled investors to maintain their calm in the midst of what was hopefully a once-in-a-lifetime storm.

There is no perfect system or framework for investing, nor can any investor follow any system in a perfectly disciplined way. Goals-based investing, we believe, is a better approach than most in helping us stick to our investment diet, reach our target, and maintain our financial "weight" over time. We must remember, however, that the investment industry consistently bets against us and has a vested interest in our ongoing failure. Better to maintain a healthy skepticism than to fall victim to the "yo-yo" effects of some modern financial diets.

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