Feeling distressed by the market tumult over the past week? On Monday, August 24th, 2015, the Dow Jones fell more than 1,000 points in early trading. A market meltdown of that magnitude can put your investment plan to the ultimate test.
To put the current manic behavior of the market in perspective, it helps to look at history as a guide. What was the investment climate like at year-end 2011? If you don’t remember, you are in good company. In his January 2012 year-end review, Wes Wellington of Dimensional Fund Advisors called it “a difficult year,” with a lot of trying volatility along the way (sound familiar?), but scant overall growth. Sharing advice from Dimensional’s co-founder David Booth, he reminded us of one of the biggest lessons learned whenever markets are uncertain (which is pretty much always):
The most important thing about an investment philosophy is that you have one.
Why is an investment philosophy so important for building wealth, especially during market downturns? How do you build yourself a sound one?
Investment Philosophy vs. Investment Strategy
Let’s begin with what an investment philosophy is not. Your investment philosophy is related to your investment strategy, but they are not interchangeable. The philosophy comes first.
Take my financial career as an example. Through some early years of trial and error, I came to realize that I do my best work assisting people one-on-one. I enjoy applying my analytical skills and financial acumen toward making a tangible, positive difference in their lives. This philosophy explains why my earlier positions in technology, the public sector and as a Morningstar analyst were all great careers … but not for me long-term. They were not yet optimally aligned with my philosophy.
My philosophy led me to the right strategy for my career. It led me to found Pathway Financial as a Registered Investment Advisor firm. Now, I have the daily opportunity to work closely with individual families. In a nutshell, I help people build wealth to fund their desired lifestyle. Each of my past positions incorporated facets of my philosophy, but my current career captures them all.
It’s vital to let philosophy lead the way in your investment interests as well. In his Morningstar interview, “3 Keys to a Successful Investment Strategy.” financial author Rick Ferri describes it well. “Strategy comes from philosophy,” he says. “If you don’t have a philosophy, you can develop a strategy, but it’s only going to blow apart the next time it doesn’t work for a month or two. And you are going to go onto another strategy, and that’s the worst thing you can do.”
The Importance of Investment Philosophy
Semantics aside, investment philosophy matters to investment outcomes in measurable ways. When investors lack a sound philosophy, we’ve seen the unfortunate cycle Ferri describes of strategies lost and found during market tumult or whenever the winds of the market climates shift. And they shift a lot! No matter how often I see it happen, it still pains me to see it every time. I know that it represents real dollars by real people… and unnecessarily so.
Without an overarching philosophy to help you determine what makes the most sense for your personal investment activities, it becomes nigh well impossible to stay the course when markets and your account values begin to plummet–such as what we have painfully experienced this past week. You lose faith and shift your strategy. You move your money to the proverbial sidelines. (Which reminds me of a great quote by AQR fund manager Cliff Asness: “Every time someone says, ‘There is a lot of cash on the sidelines,’ a tiny part of my soul dies. There are no sidelines.”)
It’s the same on the other side. Without a guiding light, it becomes insurmountable to avoid fretting that you’re going to miss the boat whenever the market surges. This worry tricks you into piling into whatever is the latest success story. By chasing and fleeing hot and cold markets, you’re undesirably buying high and selling low. You’re also disregarding decades of empirical evidence. Research that informs us that one of the best ways to capture long-term market growth is to build a solid, individualized plan that reflects your investment philosophy. Then you need to stick to your plan by riding out the market’s near-term ebbs and flows.
These aren’t just philosophical woes, either. A 2014 Federal Reserve economic report looked at investor performance from 1984–2012. The report found annual damage of up to 5 percent because of return-chasing behavior. The Fed concluded: “[P]oor investment timing caused by return-chasing behavior has a significant impact on portfolio performance.”
The Right (Evidence-Based) Philosophy for You
As often as Dimensional’s Dave Booth has said that the most important thing about your investment philosophy is to have one, we beg to differ. For all the reasons we’ve described above, yes, we agree that it’s essential to have one. But we believe it’s equally important to ground your investment philosophy in empirical evidence. It’s that evidence that informs us how markets work to deliver returns to those who take part in its growth. If your philosophy is instead based on gut feel, false illusions or blind faith, it will hamper your ability to develop a sound investment strategy.
In another post, “Philosophy Differs From Strategy,” Ferri describes it this way: “Attaching yourself to a sound philosophy requires deep thought. It usually starts with a disappointment, a detailed investigation in the root of the disappointment, the analysis of data, confirmation through the writings and experiences of others, and then an epiphany.”
If you have been feeling acutely stressed by the events of the past week, could it be your investment philosophy is not as sound as it could be? Is it high time to put some careful thought into how to construct a better investment philosophy?
Let me know if I can help you further as you continue to translate philosophical financial insight into meaningful wealth management.