I had conversations with two investors recently that were very telling.
The first conversation was with a guy in his 40s who invests his own money—for a living. That’s what he does. It’s how he provides for his family.
It’s very unusual, and probably conjures up images of a day-trader, someone trying to sell positions by the end of the day for more than he paid at the start of the day.
But that’s not at all what this guy does. Importantly, he has an objective process that he follows meticulously. He’s a technical investor, using various financial indicators to determine when the U.S. stock market is likely to rise. I don’t understand the buy and sell signals he uses, but he’s been at it a long time and has found objective measures that work for him.
The key is that he has an objective process and he patiently stays with it. My sense is that very few investors can say the same.
My second conversation was with a 70-year-old retiree. At first, he seemed to be doing just fine. He was clearly very frugal and conservative. He seemed to have no problem living on a combination of dividend income and Social Security. Eventually, though, I became concerned about three things he told me.
First, the vast majority of his portfolio is invested in his former employer’s dividend-paying stock. While he was able to buy it at a discount during his career, having so much of his portfolio devoted to a single stock is dangerous. Just ask the many people who retired from GE, counting on dividend income from that once blue-chip stock to cover their living expenses.
Then he told me that he had recently taken a portion of his portfolio and started to follow one particular objective, conservative strategy. No problem there. What concerned me was how often he kept mentioning three or four other strategies he thought he should be using instead. As he implemented the one, he kept getting phone calls and marketing pieces from various advisors and investment services that he thought might be better. He kept second-guessing himself, wondering whether he should be following one of the other approaches.
While it’s appropriate to consider your options, at a certain point, it’s important to choose a path and stay on it. Otherwise, at the first sign of trouble, someone else’s shiny brochure will look better.
My third concern was that he showed a surprising amount of interest in an especially high risk/high potential return strategy. He had heard about some especially attractive recent returns and was thinking about giving it a try. From everything he had told me, he didn’t need huge returns from his portfolio, nor would he be able to withstand significant losses—financially or emotionally.
If you need an average annual return of 5-7% and are in your later years, why would you take the risks necessary to try for 12%?
The ideal approach to investing is to find and follow a strategy that, A) uses a purely objective investment selection process; B) is designed in a way you fully understand; C) has a good track record; and D) is emotionally acceptable to you—meaning you’re willing to do what’s necessary to execute it and you’re willing to keep following it no matter what happens in the market.
What I mean by a good track record is that it has generated the sort of returns you need, given your age, and it has done so with the sort of volatility you can live with. While the past certainly doesn’t guarantee the future, you should have some understanding of how a strategy you’re considering can be expected to perform in a bull market and a bear market.
Some strategies are designed to maximize returns during a bull market but are likely to fall hard during a bear. That’s okay as long as you’re willing to stay with it during the downturns. Others are designed to share in some of the gains of a bull market but protect against big losses in a bear. That, too, is okay as long as you’re okay underperforming the market in good times.
The strategy he was suddenly attracted to falls in the former camp. It’s easy to love when times are good. However, if he decided to follow it, my sense is that when the next bear market hits, it would cause him financial and emotional pain he would be ill equipped to handle.
How well does your investment selection process stack up against the four criteria I described above? How well has it served you during the remarkable bull market we’re still in? And how willing are you to stay with it during the inevitable bear market yet to come?