Investing: Are you swimming beyond the buoys?

(MoneyWatch) "Swimming beyond the buoys" refers to the tendency for inexperienced swimmers to venture beyond the marked safe areas at the beach. As Jim Parker of Dimensional Fund Advisors noted in his book, "Outside the Flags 2," "When conditions are benign, the dangers of doing so are not so evident. But when storm clouds appear and the waves come up, risk reasserts itself. So it is with investments."

Learning from painful lessons

One of the things I have learned over the years is that both bull markets and low interest rate regimes can lead to major transformations in investor behavior. Even once conservative investors start to take on increased risks, losing sight of the fact that stocks are risky assets and that higher yields (whether in the form of dividends or interest rates) are compensation for taking increased risks. This leads to taking not only too much risk, but taking the wrong kinds of risks. The painful lessons that the bear markets of 2000-02 and 2008 taught investors seem to have already been forgotten by many investors.

The bear market of 2008 led investors to pull hundreds of billions out of equity mutual funds, and it wasn't until December 2012 that stock funds generated net cash inflows. Warren Buffett warned against this type of behavior when he advised: "If you are going to time the market, buy when others are fearful and sell when they are greedy."

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The great irony and tragedy is that not only do investors ignore Buffett's sage counsel, but they tend to do exactly the opposite of what he advises. They tend to raise their equity allocation when prices have already reached high levels (and expected returns are now low), and they tend to sell after prices have already fallen (and expected returns are now high). Put another way, they paid for all the risk, but don't stick around for the returns! Selling low and buying high is not exactly a prescription for investment success. Yet, it's what many individual investors tend to do.

With the market now up about 150 percent from its 2009 lows, it's a good time to check to see if you have been taking too much risk and/or the wrong types of risks. Remember that at some point risks will once again appear, and your tolerance for risk will be strongly tested. The most likely way to avoid panicked selling is to never allow the amount of risky assets in your portfolio to exceed your ability, willingness, or need to take risk. Ask yourself the following questions:

• Have I adhered to the asset allocation in my investment policy statement, or am I outside the proscribed tolerance bands and rebalancing is required? (And if you don't have an investment plan, it's impossible to adhere to one.)
• Have I been chasing yield by moving from high quality bonds to high-yield bonds and dividend paying stocks? If so, you're taking the wrong kinds of risks.

As Warren Buffett noted: "Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing." Listen to Buffett, and stay close to shore when investing. While going beyond the buoys might provide some thrills, it's also likely to lead to more trouble than you're prepared for.

Image courtesy of Flickr user Mike Baird