Locally based CPA firm since 1956

Recently I met with a client who had been investing in the stock market for more than 30 years. We began discussing lessons learned over the years which caused me to reflect on our investment philosophy here at WCM so I thought I would articulate that here.

My perspective is rooted in the fact that it’s hard to beat the market. Everyone is looking for high-return, low-risk opportunities, and if they arise, offers to buy certainly flood in, quickly pushing up prices and cutting future returns to a level commensurate with their risk.

As a result of this competitive pressure, market prices tend to do a good job of reflecting information that’s available to the public. Sure, some investors have better information than others, but it’s hard to keep an information edge in a world where it is illegal for corporate managers to disclose information that is not public. Competition between well-informed investors makes it hard to profit from fundamental research. In other words, I think the market is pretty efficient.

While I have a healthy respect for the difficulty of beating he market, I think it can be done. The market is not perfect because people are not perfect. We are all susceptible to fear and greed, which can cause us to do dumb things with our investments, like selling after a crash when markets are priced to offer higher returns going forward or losing our discipline and taking on too much risk when things feel less scary in the midst of a long bull market.

Investors are not perfectly rational. We often exhibit bias that can create mis-pricing, such as extrapolating past results far into the future, under-reacting to new information, focusing too much on the short term, and rolling the dice on risky stocks in hopes of winning big. Believe me, I’ve done all these things over the past 25 years and worse yet, I’ve seen clients do all these things over and over.

Qualitative judgment and rules-based models could both parlay these effects into market-beating performance, but I put my faith in the latter. Models are more consistent and less prone to bias. Qualitative judgement relies on intuition: knowing when certain rules apply and when they do not. But as Daniel Kahneman points out in his book, Thinking Fast and Slow (one of my favorite books), it is tough to develop reliable intuition in an environment that is tough to predict, like the stock market.

Beating the market is great if you can do it, but it’s not a requisite for investment success. It’s actually pretty far down the list of things to worry about. Even the best investment strategies can go through lengthy stretches of underperformance. It is far more important to focus on things you can control: fees, tax efficiency, diversification, the amount of risk in your portfolio, and your behavior.

Successful investing starts with risk management. Never take more risk than you can tolerate. Don’t trust your instinct here. It’s easy to think you can tolerate the risk when it has been a long time since the market has had a downturn. So before you load up on stocks, think back to your behavior the last time the market took an extended downturn. If you were nervous or lost sleep, then don’t load up on stocks. You will lose your nerve and sell out at exactly the wrong time. It is my experience that investors begin to get nervous based on a dollar amount of losses in their portfolio. We would all like to think in terms of percentages, which by-the-way, we notice folks tend to lose their nerve when the market is down about 8%. However, more often than not, folks look at the bottom-line dollar. I recently had a client call me to tell me he is down over $100,000 and it is killing him. His 401k has over $2.5 million in it so $100,000 is only 4%. I know $100,000 is a lot of money, but if a downturn of 4% scares you to death, you should not be invested in stocks.

Whatever risk-management strategy you adopt, it’s important to stick with it. Without that anchor, it’s tempting to take too little risk in bad times after prices have fallen and too much risk when times are good. That is easier said than done. Uncertainty is a constant. The best defense is to prepare for bad times before they come and diversify. This will make it easier to stay invested an enjoy the benefits of compounding. In the October MarketWatch we listed some quotes from famous investors. One of which is: “concentration builds wealth, diversification protects wealth”.

In short, when you build your portfolio, do not invest in anything that does not have a clearly defined purpose. Are you investing in that stock, fund, or ETF for; growth, for income, to counter a market draw down, to gain exposure to overseas markets, because your brother-in-law recommended it? You must build your portfolio with a purpose, with a plan, trust the process, and stick to it. Remember Peter Lynch, the manager of the Fidelity Magellan Fund for years? Peter outperformed the markets and most investors by having an average annual return nearly 19% for 10 years. During that same period, his average investor only enjoyed an average return of about 3%. Why is that? Because they did not have a process that managed risk, they did not trust the process if they had one, they sold when they lost their nerve, and bought back after the market had already adjusted for the miss-priced assets. As Peter once said: “Investors returned their money to the fund, only after the easy money was made”.

What is your investment philosophy?

Have a question? Let me know! Email me at kcompton@wsmtexas.com.