The Danger Of Short Term-ism

I met with a client last week to effectively talk him "off the ledge." Lets name this client Bob. Bob is a successful business owner who has paid their dues and is looking forward to retirement in less than a handful of years. We created and adjusted a comprehensive financial plan for Bob to reflect the recent conversion of his variable annuities into his SEP IRA. Every contribution he made over the past few years seems to be met with a portfolio downdraft or market turbulence. Bob is either fearful or frustrated about his financial future - even though every scenario in our stress tests show that Bob is on track to ride off into the sunset. What can we do to make Bob feel better about his future?

Mean Reversion Is Real

One powerful phenomenon in financial history is called mean reversion. This term refers to the knack for things to migrate back toward their long term average behaviour. In nature we see this quite often with the ebb and flood of the tides or the north and south migration of the geese. The physical world makes such things fairly easy to grasp and predict based on their thermal or temporal cycles. In the financial world, these patterns have a very long and unpredictable frequency to their rebound - or reversion to the mean. One way of thinking of this phenomenon is to progress through time riding on a spring. We may be seated on a train car and there are unseen hills and valleys ahead on the tracks. It is hard to predict when the seat will throw us up in the air or compress below our weight.

The same analogy applies to financial markets. Sometimes the spring can be extended for a long period of time before compressing back to its "normal" state. Other times, the spring can be compressed for a short period of time and then extend out to the normal state faster than expected. Humans do not like uncertainty nor do they have unlimited patience. This is why it is often so hard to manage our own investments when there truly are dollars and dates on the line.

The Future Starts Today! ... Or Tomorrow?

The most important task I perform in my role as an Investment Advisor is to accurately gauge the individual risk tolerance for each of my clients. There are many ways to assess their current risk and align their expected risk to their risk appetite. Psychometric risk tolerance questionnaires help us determine where a client lands on a risk spectrum based on a series of behavioural questions. More quantitative methods attach a dollar - or percentage - loss to a client portfolio in adverse market conditions to determine their breaking point from their investment strategy. Another way of thinking about client risk tolerance is to ask a very simple question.

How long can you stand feeling completely stupid before you look incredibly brilliant?

The bottom line is that if we can think long term (and I mean as long as our expected lifespan), the short term decisions are quite obvious to the trained eye. The chart shown below is in stark contrast to the one shown at the top. A $1 investment in small cap stocks that was still unprofitable after 15 years became incredibly profitable over an expected lifespan. It would be a shame to make a strategic decision on such little information.

I am not saying that we need to wait 15 years for our investment strategy to finally get some serious tration. What I am suggesting is that 15 days, 15 weeks, or even 15 months is way too short of a time period to judge investment performance. Another analogy is that investing is much like fashion. The trend repeats itself about once a generation - just after we forget what was cool when we were, in fact, cool. Do NOT get me started on that topic!

We only attempt to be less wrong than most others over a long period of time. - Jamie Rice