Why you need a sound investment plan
(MoneyWatch) The smartest investors and advisors I know don't make investment decisions based on their opinions about where the markets are headed. Instead, they rely on what we might call "the science of investing." They use the evidence from peer-reviewed academic journals to design portfolios that provide the greatest chance of achieving their financial goals while not exceeding their ability, willingness, or need to take risk. And they use sophisticated tools such as Monte Carlo simulations to help them make the most prudent decisions regarding asset allocation, when to retire, when to take Social Security, whether or not to purchase long-term care insurance, and how much they can plan on spending in retirement.
While using the evidence and such tools provides a distinct advantage, what I have learned in over 15 years of providing advice to individual and institutional investors is that ultimately the greatest determinant of success or failure of a plan is human behavior. I was reminded of this the other day when I received a call from a very high net worth individual who wanted to discuss his personal situation.
I learned that the individual had almost all of his investable net worth (well into eight figures) sitting in cash (or the equivalent), and it had been sitting there for about four years, having sold all his equities during the bear market of 2008. The large amount of cash also reflected the fact that he also sold all his bonds as well.
The bear market, and all the doomsday forecasts that accompanied it, scared him into selling his stocks. And all he continually heard about bonds was that rates were sure to rise. While he had suffered most of the losses of the bear market in stocks, he hadn't benefited at all from the greatest rally since the 1930s. Making matters worse was that he also missed out on the bond rally as rates continued to fall, defying the so-called experts.
Having sold during the crisis he never could get back into stocks because "the coast was never clear." There was never a clear sign that stocks were once again safe. And there never will be. In fact, over the period the economic and political news continued to be bad as the crisis spread around the globe. Having sold, and without a plan, he found himself paralyzed -- unable to act. Unfortunately, this experience is all-too-common.
The focus of my discussion with him was around the need for a plan, tailored to his unique ability, willingness and need to take risk -- a plan that he lacked. Investors who don't have a plan, aren't likely to be able to withstand the psychological pressures that bear markets create. They'll always be tempted to act, when inaction (with the exception of rebalancing and tax managing the portfolio) is far more likely to be the right strategy.
I also emphasized that his plan would have to include the understanding that there will likely be more bear markets like the last one and that there are no good forecasters that can protect you from them. Such legends only exist in their own minds. Living through bear markets with equanimity is the "price" you must pay to have the best chance of earning the high returns stocks have historically provided (the equity risk premium). To be able to do so successfully, while still sleeping well and enjoying your life, requires that you don't take more risk than your stomach can handle.
Those investors who had well-developed plans that took these facts into account, and adhered to them, have likely more than fully recovered the losses they experienced during the bear market. Those who didn't have plans, or abandoned their plan, likely haven't done nearly as well. So, if you don't have a plan, take this as a call to action.
Image courtesy of Flickr user 401(k) 2013