Monday, June 13, 2011

Stay Focused on Your Plan During the Good Times, as Well

By Larry Swedroe

Readers of my blog know that one of the keys to being a successful investor is to have the discipline to adhere to a well-developed plan through both good and bad times, rebalancing along the way. Today, I wanted to remind you to not let the bull market of the past two years cause you to become complacent about risk and lose discipline.

Disciplined investors benefited from the bull market of the 1990s, selling stocks high when their allocations exceeded the minimum and maximums for each asset class as established in their investment policy statement (IPS). Thus, they were much better prepared for the 2000-2002 bear market than if they hadn’t rebalanced.

Those investors who stayed disciplined through that bear market were buying stocks (which were now at much lower prices). The following bull market once again gave disciplined investors the opportunity to sell high, positioning themselves much better for the 2008 bear market. That bear market once again gave them the opportunity to buy low. And the past two years have once again presented you with the opportunity to sell high.

Investing is really that simple. The problem is that it isn’t easy to buy low and sell high. In fact, investors tend to do the opposite. They chase returns by buying yesterday’s winners (high) and sell yesterday’s loser’s (low). Subject to recency and the follow-the-herd mentality, they act as if they were driving forward while staring at the rearview mirror. And that leads to them underperforming the very funds in which they invest.

The winning strategy is quite simple:

  • Write an IPS tailored to your unique ability, willingness and need to take risk.
  • Only alter the plan if its base assumptions have changed.
  • Use passively managed funds to build a globally diversified portfolio.
  • Regularly rebalance and tax manage as appropriate.
  • Ignore all “guru” forecasts and the noise of the market.

And that’s about it. Simple. Unfortunately, it isn’t easy because emotions get in the way. In bull markets like the current one, greed and envy take over, and investors lose discipline and take on more risk. They forget the lessons of the past and “run with the herd.” In bear markets, it’s fear and panic that take over, and the stomach overrules the head. Stomachs rarely make good decisions.

While we’ve been lucky to experience the current bull market, it’s important not to lose sight of the fact that there are only three things we don’t know about bear markets:

  • When they will start
  • How deep they will be
  • How long they will last

I’m certainly not forecasting a bear market. However, I’m reminding you to stay disciplined. Investing in equities is always risky, no matter how long your horizon. And the risks can appear from totally unexpected and thus unforecastable sources. The recent series of revolutions in the Middle East, along with the earthquake, tsunami and nuclear disaster that hit Japan are good reminders of that. And finally, there are certainly enough issues currently making headlines to remind us of just how risky stocks are. They include:

  • The continued slump in housing prices
  • The potential for a default on the debt obligations of the U.S. Treasury
  • The potential for default of Greece, and their possible abandonment of the Euro

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