Asset markets are pretty unsettling these days. The S&P 500 lurches 2% in one direction, then 2% in the other direction, all in the course of a single trading day. Markets for risk assets are volatile, directionless and buffeted by multiple influencing variables. It can be unsettling even for the most seasoned veterans of many market cycles, let alone for the novice investor. In my experience following these three suggestions can help you to keep your head when everyone around you is losing theirs.
Don’t obsess over the short term (i.e. tune out CNBC)
I mean no offense to that particular network – this advice applies equally to all so-called “financial news” networks. Always remember that their real purpose for being revolves around entertainment, not thoughtful investment advice. One of the most egregiously awful phrases in the English language is comprised of these words: “The market closed up (or down) today because of X”. X is home prices or unemployment numbers or the IPO of XYZ Company, always accompanied by the stock photos of homes with foreclosure signs, long queues outside the unemployment benefits office, or XYZ Company employees popping Champagne corks. In reality there is no X. There are billions of Xs – X factors really – which interact in complex ways and shape what the market does on any given day. More than 99% of the time there is literally no correlation between any single event and the movement of the stock market.
The larger point to make here is that the short term is essentially unknowable. The financial news shows like to focus on the short term because it offers more drama – CNBC even features a “Halftime Report” in the middle of the day to give securities trading the look and feel of a sporting event. That is no doubt catchy from an entertainment point of view, but it is not going to help you make better investment decisions.
Measure risk, not just return
When it comes to investment analysis, risk and return are two sides of the same coin. Too often we forget that to properly measure the performance of our assets and portfolios we have to take into account, not just what they earned but also how much risk we assumed in getting that return. For a thorough discussion on alternative methodologies for measuring risk please see Kevin Cimring’s excellent posting of June 7 “Measurement of risk in mutual fund research”.
Risk matters for two principal reasons. First, it relates to your capacity to assume large short-term losses given your available financial means, time horizon, specific liquidity events and so forth. An asset that produces an expected 25% annual return over 5 years may not be a great investment if its average annual volatility – for example as measured by standard deviation – is also 25% and you will be needing the money two years from now to pay for your kid’s college education.
Apart from your capacity to assume risk you also need to consider your propensity to endure the kind of stomach-churning volatility you see in those short-term daily price moves the perky anchors at CNBC are babbling about. Propensity has more to do with emotion than with financial means. Some people are better at keeping their emotions in check than others and can resist succumbing to the fear and greed that lead to bad investment decisions.
Diversify, diversify, diversify
Think of this third recommendation as the Golden Rule of Investing: your chances for long-term investing success are much higher when your portfolio is properly diversified. To be diversified means to have a combination of assets in a portfolio which behave in different ways from each other. My investment advice is to start with the broad investment categories: equities, fixed income and alternative assets (things like commodities, real estate, currencies and hedge strategies). Within a single investment category (such as equities) diversification can mean having different asset classes (domestic stocks, foreign stocks, value, growth, large or small cap etc.). Within a single asset class it can mean having 20-25 different names representing different industry sectors to reduce non-systematic risk.
Diversification may seem suboptimal in the short run. If the stock market goes on a bull tear then a portfolio containing bonds and other things probably will not do as well as one hardwired to an equities index. But over the long run the economy will probably go through periods of inflation, deflation, growth, recession, euphoria and manic depression. Diversified portfolios will survive these twists and turns better than those which are more directly vulnerable to the threats each different market cycle brings.
No one single strategy is guaranteed to be a surefire success, especially in the kind of volatile market conditions we have today with a very high level of uncertainty about the economy’s long-term direction. However, following these three principles of investment advice should put you on firmer ground for weathering the storm and emerging intact in calmer seas.
