SEEKING TO PROFIT FROM INVESTMENT REGRET
Don't let your emotions get the best of you
SUMMARY OF INVESTMENT THEMES
I was sitting down to write this month's newsletter to address the recent volatility in the market when I decided to take a break and read this month's issue of Morningstar from the venerable research company.
Low and behold there was a well written article from John Rekenthaler in there that expressed essentially what I want to say, but maybe even better. You can find the entire article on the web. I have included a guest excerpt from the article below. Here it is.
SEEKING TO PROFIT FROM INVESTMENT REGRET, EMBRACING YOUR LEAST-SUCCESSFUL ASSETS CAN LEAD TO SMARTER DECISIONS
16 Oct 2018
Two Views on Target Dates
"To understand how regret informs our real-life investments, consider target-date funds. Nine years ago, nobody criticized such funds for being too conservative. Nobody said such a thing, at least publicly. Most target-date funds had suffered heavily during the 2008 financial crisis, leading to criticism that, as a breed, they held too many equities. The Senate convened a subcommittee to determine whether target-date investment policies should be more tightly regulated. (It decided not.)
In contrast, a current article on a site called Mathematical Investor, by “Mathematicians Against Fraudulent Financial and Investment Advice,” frets that target-date funds are overcautious. “Given [rising] life expectancy projections, we need to ask whether most target-date strategies, typically an equity/bond mix varying from 80/20 at the start to 40/60, 30/70 or even 20/80 at the target retirement date, really make sense in today’s world. Aren’t these figures, which are so commonly used in the investment world, a bit out of date?”
The authors continue, “[P]erhaps investors should be advised to remain in a mostly equity portfolio longer into their careers and, depending on circumstances, perhaps even after retirement.”
That is a reasonable perspective, as were the 2009 suggestions that target-date funds approaching maturity should reduce their stock positions, to ease the volatility for new retirees who roll over their 401(k) funds. Both beliefs have their merits. Target-date funds come off the rack; the outfit that is too long for this investor will be too short for that one. No target-date family’s asset allocation can be ideal for all shareholders.
However, one side of the argument could only be published now, and the flip side only then. (That is not strictly true. Countercycle articles can indeed be published at any time—but they will be ignored.) The reason is regret. It motivates the reader. Remorse about being reckless entering the 2008 financial crisis sold 2009’s bearish admonishments, and remorse for money left on the table propels 2018’s bullish thoughts.
This has a ripple effect, albeit gradually, on the investment policies of target-date funds. Although portfolio managers strive for independence, so that they are not swayed by investor demand, the truth is that shareholder preferences do affect target-date funds’ tactics. Inevitably, the funds’ asset allocations drift toward what the market desires.
This process, clearly, can be harmful. Regret about relinquishing future gains, as with my time-travel daydream, unquestionably improves investment results. Regret about the past is less helpful. Regret encourages investors to seek that which is currently fashionable, and to avoid that which is not. Blindly obeying its urges is a prescription for buying high and selling low. That is no way to live.
The target date is the approximate date when investors plan to start withdrawing their money. The principal value of a target fund is not guaranteed at any time, including at the target date.
However, there is a way to use the desire constructively. That involves accepting the emotion, rather than rejecting it.
What I mean, specifically, is that every portfolio should contain unpleasant investments— securities that would have been uninspiring choices during the past few years, if not outright poor. Fleeing from regret involves jettisoning such holdings. The classic example consists of selling stock funds in 2009, and replacing them with bonds, alternatives, or tactical-allocation funds. Such decisions did not fare well.
Embracing regret, on the other hand, means swapping popular securities for unpopular. Perhaps such trades will not take place. The investor who conducts a regret test to see which portfolio holdings make her wince may decide that she already has enough problems. But, perhaps, the portfolio should be changed. It looks lovely in hindsight—but is dangerous with foresight, because it leans heavily on a handful of the hottest asset classes.
This suggestion hits home. Currently, my portfolio contains only assets that provide no regret: U.S. equities that have increased in price, and the funds that own such securities. That feels great. Some days, the portfolio even convinces me that I am smart. That belief is rash. My portfolio needs an overhaul.
Easier to write than to do! It is easy to cast aside investments that have caused pain, but difficult to scrap those that have provided pleasure. This column, I suppose, can be regarded as a self-motivational speech—the attempt to convince myself to do what I should. It is, however, equally good advice for all."
 Mathematical Investor. 2018. “Are Target-Date Funds the Answer?” July 21, 2018. //mathinvestor.org/2018/07/are-target-date-funds-the-answer/
This article originally appeared in the October/November 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit their corporate website. The views expressed in this excerpt are that of the author, John Rekenthaler and not necessiarly mine.
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
- A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.
- Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
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- The fast pricing swings in commodities and currencies may result in significant volatility in an investor's holdings.
- There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
- Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
- The prices of small and mid-cap stocks are generally more volatile than large-cap stocks.
- An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
- High yield/junk bonds (grade BB or below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
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