The Importance of Intestinal Fortitude

Making Money Requires A Strong Stomach

One of the hardest things to do as an investor is to stick your hand out and buy when the market is falling.  Most likely, whatever you buy will be offered to you at a lower price within minutes to days making you feel foolish for buying and filling you with regret.  Yet you will likely still have to make decisions and keep putting funds to work.  There are bags of behavioral finance research pieces showing that we feel the pain of losing money far more than we feel the pleasure of making money and anyone who did not just fall off the proverbial turnip truck knows that emotionally-charged decisions are often poorly made decisions.  There is also ample evidence that most retail investors are very good at underperforming the market.  For example, the most recent DALBAR study indicates as follows:

"The average equity-fund investor saw annual returns of only 3.49% in the 20 years through 2011, according to the latest analysis from Dalbar. Compare that with the average 7.81% annual return of the S&P 500."

- Source: http://online.wsj.com/article/SB10001424052702303816504577307912829243848.html

So what should an investor do to avoid sabotaging themselves?

The simplest way is to pick an all-in-one fund, buy it, and forget about it (ideally adding to your investment regularly over time).  This is the essential idea behind balanced funds (VBALX, SWBGX, etc.) and target date retirement funds.  It requires little effort and you really can pretty much forget everything after buying because the funds typically rebalance themselves.  The advantage is simplicity and low cost.  The downsides are that you get whatever the market offers (and no more), and you must have the strength of will not to trade.  Considering the amazingly high number of people who manage to underperform the market, the strength of will part is probably the toughest part.

Somewhat more complicated (but still pretty simple) is to set yourself an asset allocation, buy low cost ETFs or funds that adhere to this allocation, and then rebalance whenever your portfolio drifts too far from your chosen allocation.  The set reference point of an asset allocation that you mechanically rebalance to is helpful to keep emotion out, but it does require you to go into your account and make the trades which can be hard to do when the market is falling.  The attraction of this strategy over a balanced or target fund is that you have far more control over the asset allocation portfolio and can customize things to your liking.  But it requires more strength of will than an all-in-one fund.

Finally, way high up on the intestinal fortitude scale, is buying individual securities, perhaps with an overall asset allocation in mind.  You are responsible for picking individual securities, figuring out when to buy and sell specific names, and keeping track of how all of this rolls up into an overall asset allocation.  The potential for making mistakes due to judgement errors or emotional decisions is high, but so is the degree of control and the potential for doing better than the market.

I pursue a mixture of strategies.  In one account, I use an all-in-one balanced fund.  In the rest, I pick individual securities and track my total asset allocation.  As I get older and hopefully wiser, I am drifting to a less risky asset allocation with less fiddling on my part, so I am considering moving an increasing portion of my portfolio to funds and keeping the actively managed portion restricted to my very best ideas.

Which approach is right for you?  This really depends upon your risk tolerance, investing interest and ability, and most of all your ability to look down the loaded barrel of an ugly falling market.

As always, consult your advisor, do your own due diligence, take your own risks and be careful.  This is not intended to be investment advice.

Disclosure: I am long SWBGX.

Post Scriptum: I will be out vacationing next week, so do not expect quick answers to comments.