May
8
For Investors it’s Important to Know the Difference Between Scary and Dangerous
An annual rite of late spring/early summer is the outpouring of articles written by someone with “life experience” (i.e., someone, like me, whose youth is solidly in their rear view mirror) aimed at recent graduates and young adults. These articles, often transcripts of commencement speeches, are a noble attempt to impart a bit of hard-earned wisdom to those just starting out on their life’s journey. Last May, the Wall Street Journal published an article titled “A Dad’s-Eye View of Scary vs. Dangerous” written by Jim Koch, the founder of the Boston Beer Co. (brewer of Samuel Adams), which fit neatly into this mold. In the article Mr. Koch wrote that it is important for both parents and children to learn the difference between taking risks that are scary, but worthwhile, and risks that are dangerous. While this article is focused more on making big life decisions, it struck me while reading it that this way of looking at the world has some real application for investors as well.
It seems worthwhile to spend some time pondering issues that often make investors anxious or concerned and asking the question; is this simply scary or is it truly dangerous?
Rebalancing
The idea of selling an investment that has gone up in value and using the proceeds to buy an investment that has gone down in value is often a scary one for investors. Investors often state that they want to buy more of the mutual fund or invest more in the asset class that has gone up. And it’s often difficult to get them to invest in mutual funds or asset classes that have suffered from recent poor performance. However, if there is a sound and well thought out investment plan in place, this sort of rebalancing enforces the discipline of buying when prices are low (after poor performance) and selling when prices are high (after strong performance). Over time a disciplined approach to rebalancing a portfolio will provide a better result for investors. So disciplined rebalancing is sometimes scary, but definitely worthwhile. Failure to rebalance effectively can actually be dangerous, as it may result in a portfolio that is inappropriate relative to the investors’ long-term goals, objectives and risk tolerance.
Investment Selection
Selecting the appropriate investment vehicles with which to execute an investment plan is an important part of effective asset management. Oftentimes these decisions are difficult to make. If a manager or fund has performed well recently will it continue to be a good selection in the future? If it has a recent record of poor performance does that imply that it is a poor choice? Even though relying on an investment manager’s track record may provide a sense of comfort, overreliance on performance, particularly recent and short-term performance, in making investment decisions can be very dangerous for investors (hence the well-known disclaimer that past performance is not an indicator of future results). However, utilizing a more comprehensive approach to due diligence which focuses on an investment manager’s process, their people, operational effectiveness, compliance history, investment merits of their approach, and the consistent application of all of these variables over time should lead to better decisions. And sometimes these decisions may be scary, such as the decision to stick with an underperforming manager or investment when recent performance has been bad due to adverse market conditions despite the manager’s continued adherence to their investment mandate. The decision to sell an investment despite strong recent performance due to personnel changes at the manager level or asset bloat inside a mutual fund may cause fear of regret and compromise the decision making process. Having a disciplined investment selection process with a long-term perspective can be quite scary, but it is the appropriate approach to making investment decisions.
Transparency
It should be apparent that a lack of transparency is not just scary, but also dangerous. The idea of transparency should apply to many facets of the portfolio. Investors should know what they own and they should understand the risks of their investments. They should also know what fees they are being charged and have a full understanding of how their advisors and portfolio managers are compensated. All potential conflicts of interest should be disclosed upfront by investment advisors. There should be transparency around the liquidity provisions of all investments. And investment performance should be reported in a clear and timely manner. The investment industry, like all industries, is rife with insider language and jargon. This can often be confusing, and scary, and will sometimes require an explanation. But if your investment advisor is not willing to take the time to answer your questions, clarify confusing terms, and provide clear and concise answers to your questions, then you should begin to question their commitment to providing adequate transparency.
Leverage
Most of us know that a modest amount of debt, artfully applied, can be a useful financial tool. Using an appropriately sized mortgage with manageable payments make the home buying process much better for everyone. The same can be true for the use of debt on a company’s balance sheet. A thoughtful approach to capital structure can help companies grow and help them manage the uneven cash flows that most businesses face as they move through the business cycle. However, an improper use of leverage can become dangerous and scary for investors. Sometimes this leverage is apparent, as when margin is used on investment or brokerage accounts. Other times excessive levels of leverage can sneak into portfolios in more subtle ways. This can occur within investments that have inadequate levels of transparency, such as with hedge funds that use excessive leverage to boost returns on “hedged” arbitrage trades. It can also occur with real estate investments that use aggressive amounts of leverage, particularly if that leverage is based on inflated property values.
The News
In today’s oversaturated world of the 24-hour news cycle being beamed to us constantly across multiple media platforms, the “News” is probably the scariest thing investors face today. This is only compounded when investment markets react quickly and violently to a news event. There are many examples of this overreaction every year. A great example from 2016 would be Brexit, Great Britain’s unexpected decision to leave the European Union. Markets across the world reacted negatively to the news. While Brexit may indeed have long long-term economic consequences, the long-term implications of Brexit will have far more of an impact on UK citizens than US investors. Given that well diversified portfolios are not dominated by investments that will be directly and adversely impacted by Brexit, these events seem to fall more into the scary category than the dangerous category.
We can think back to events like the “Taper Tantrum” or the “Flash Crash” to see markets that react violently and quickly but ultimately rebound in fairly short order. We should acknowledge that when big events lead to market corrections it is definitely scary. Anytime there are wild swings in markets over short periods of time investors should take the time to assess exactly how dangerous these swings are to the long term health of their portfolio.
The ability to distinguish the dangerous from the merely scary is a valuable skill for investors to have. Developing a well thought out investment plan will help will help provide perspective and hopefully lend some perspective to help you determine if something is truly dangerous, or merely scary. And having a trusted financial advisor with whom you can discuss these issues will provide even more help working through difficult market environments. Using these steps to distinguish between the scary and the dangerous should help you make more informed decisions and will hopefully will lead to better long-term financial results.