Kristina Hooper, CFP®, CIMA® is head of portfolio strategies for Allianz Global Investors Distributors LLC. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
Making decisions when emotions are running high tends to lower your chances for success. But investors who have a written investment policy statement and a long-term view can stay grounded and better withstand the ill effects of market turbulence—a message best delivered during a mid-year client review.
For investors, the first half of 2012 proved a powerful lesson in the danger of letting fear and anxiety get the better of you. Despite heightened volatility and an uncertain macroeconomic outlook—along with investors’ reluctance to stick with stocks and other risk assets—the stock market posted solid returns. But those who shifted their portfolios away from equities or sat in Treasuries missed the rally. Indeed, the S&P 500 Index gained nearly 10% while high-yield bonds, as represented by the Bank of America/Merrill Lynch U.S. High Yield Master II Index, rose 7% and corporate bonds, as represented by the Barclays Aggregate Bond Index, gained nearly 3%.
In the last six months, investors who reacted to every macro event and market swoon were punished. Meanwhile, those who were well diversified, had adequate exposure to risk assets and didn’t have a kneejerk response to the noise and negative headlines were rewarded. When clients sit down with their financial advisors for a mid-year review, it’s a great opportunity to have a “teachable moment.”
The positive returns we’ve seen so far this year belie what a wild ride it has been. Capital markets have been rocked by a number of developments, particularly in the second quarter, which exerted downward pressure on stocks. Fears emerged about a hard landing for China’s economy; Greece needed to restructure its debt and then held elections in May that ignited concerns about the future of the euro zone. These jitters were exacerbated when Spain’s banks had to be bailed out and sovereign debt risk premiums for Spain and Italy rose significantly.
At home, concerns about a slowdown in the U.S. economy also grew in the second quarter, as the jobs picture became far gloomier. Adding to the turmoil were reports of a potential conflict with Iran, military interference in Egypt’s elections and continued unrest in Syria. Tuning in to CNBC
every day to check short-term market performance could easily get your temperature up. And emotion truly is investors’ worst enemy. That’s because disappointing short-term data and negative news can distract those with a long time horizon from staying focused on their long-term financial goals.
Consider the story of a 401(k) investor with a time horizon of more than 25 years who moved all of her assets to cash last summer when stocks plummeted; she is still waiting for the “right time” to move off the sidelines and has missed a solid rally in the first half of 2012.
The damage that can be done when investors allow emotions to dictate their investment decisions is evident in the data. A Dalbar study on mutual fund returns found that the average equity mutual fund investor lost 5.73% in 2011 even though the total return of the S&P 500 Index was 2.1%. Dalbar attributed this dramatic performance differential to poor timing decisions by investors, particularly when investors fled equities during the market drop last summer. Morningstar’s research on the same topic over a longer time period yielded similar results. For example, the average five-year return for international equity funds for the period ending Dec. 31, 2009 was 5.23% but the average investor return for the same period was 3.27%.
Writing a Prescription
Clearly, mutual fund investors who invest for the long term are more successful than those who time the market. But it’s easier said than done. Or, as NFJ co-founder and portfolio manager Ben Fischer explains about investment discipline, “it’s like losing weight: it’s simple, but not easy.” Perhaps the best advice comes from the institutional investor’s playbook: determine a well-diversified asset allocation that is appropriate for the investment time horizon, put it in writing and then stick to it. In “Investment Policy,” Charles Ellis writes:
“History teaches that both investment managers and clients need help if they are to hold successfully to the discipline of long-term commitments. This means restraining themselves from acting inappropriately to disconcerting short-term data and keeping themselves from taking those unwise actions that seem so “obvious” and urgent to optimists at market highs and to pessimists at market lows. The best shield for long-term policies against the outrageous attacks of acute short-term data and distress are knowledge and understanding committed to writing.”
The takeaway is that investors should adopt an institutional approach. Think of your assets as your own personal endowment, which needs to be well diversified, positioned to protect against key risks and, preferably, matches assets with spending needs. Sustainability for the long term and adhering to one’s investment policy is critical.
Looking ahead to the second half of 2012, there will likely be no shortage of bad news. Data such as last week’s ISM manufacturing and non-manufacturing indices continue to support the view that the economy is slowing down. Throw in the likelihood of continued flare-ups in the euro zone, the U.S. presidential election and looming fiscal cliff—along with the possibility of another stock-market drop—and we have all the signs of emotions dictating investor actions.
Ultimately, an emotion-free, long-term view and a good investment policy statement are what will determine whether investors are successful in meeting their long-term goals. Without these guardrails, their portfolios may not recover when the road gets bumpy.