Serenity Investing™: Controlling the Controllable

Most people are familiar with “the “Serenity Prayer”-“God grant me the serenity to accept the things I cannot change; courage to change the things I can, and wisdom to know the difference.” Now add the wise advice of Ben Graham-“Investing intelligently is about controlling the controllable. ” That explains the concept of serenity investing.

Despite what some people may claim, no one can control the stock markets. However, investors can control certain aspects of investing, aspects that directly impact an investor’s investment return. Investment fees/expenses and investment risk are two aspects of investing that investors can, and should, control.

Investment fees/expenses
Investors often overlook the impact of investment fees/expenses or fail to understand the true impact of investment fees/expenses. In some cases, investors make the mistake of evaluating fees/expenses on a relative basis. A stockbroker or other financial adviser may recommend various mutual funds that essentially charge similar annual fees/expenses. As a result, an investor may feel that such fees/expenses are fair or normal. They’re not.

Stockbrokers and other commission-based financial advisers often recommend expensive, and often under-performing, actively managed funds. Stockbrokers and other commission-based financial advisers can do this because, generally speaking, they are not required to act in a customer’s best interests. In fact, since their primary duty is to the broker-dealer  they represent, it can be argued that their primary legal duty is to make money for their broker-dealer and themselves.

When an investor looks at fees/expenses in absolute terms, one sees a substantially different picture. Each additional 1 percent of fees and expenses reduces an investor’s end return. Over a twenty year period, each additional 1 percent in fees/expenses reduces an investor’s end return by approximately 17 percent. That is why variable annuities, which often charge cumulative annual fees of 3 percent or more are such horrible investments. An annual fee of 3 percent would mean that an investor would lose approximately 51 percent of their return over a twenty year period.

Investors would also benefit from using the same relative/absolute analysis in assessing a potential investment’s performance. Mutual fund ads often reference relative performance during periods of poor performance, e.g., #1 fund in their category. Funds can make such claims even when they actually lost money as long as they lost the least amount within their fund’s category.

However, investors typically are not looking for funds that lost the least amount of money. For that reason, investors should evaluate a fund’s performance in terms of absolute returns. One common method of evaluating a fund’s performance is to perform a stress test for the fund, looking at consistency of absolute performance over different time periods such as 3 and 5 years, rolling returns over such time periods, and best and worst one year performances. Stress testing can help detect poorly performing funds whose true quality is camouflaged  by a one-time exceptional performance.

Investment Risk Management
The other key “controllable” for investors is investment risk. The most common, and effective, approach to risk management is portfolio diversification. Unfortunately, many people are misled into thinking that diversification requires nothing more than holding different types of investments. Stockbrokers and other financial advisers often further this idea of diversification through the use of multi-colored pie charts advising customers to diversify by buying a large cap mutual funds, a small cap mutual fund, a growth oriented mutual fund, a value oriented mutual fund, and an international.

What stockbrokers and other financial advises often fail to mention is that over the past decade, equity-based mutual funds, both domestic and foreign, have proven to high correlations of return between each other. Having a collection of investments whose returns are highly correlated denies an investor the downside protection against large losses that most investors desire. The key to effective diversification is to put together a portfolio of investments that behave differently under different market and economic conditions, and thus have low, or even negative, correlations of return.

Another aspect of risk management is the monitoring of one’s portfolio and the willingness to make changes when economic and/or market conditions indicate the need for such changes. There are those who advocate a “buy-and-hold” approach to investing, dismissing the idea of any portfolio change as “market timing.” Interestingly enough, those same people have no problem with the idea of re-balancing a portfolio, restoring a portfolio to predetermined allocations.

Classic “market timing” involves shifting one’s assets either 100 percent into stock or 100 percent into cash, with no middle ground. Repositioning one’s assets slightly in the face of secular changes in the economy or the stock market is simply a wise defensive strategy. Holding steadfast in the face of proven signals of economic and/or stock market vulnerability is poor wealth management. The again, one has to wonder if the opposition to strategic asset allocation is due to the 12b-1 fees that stockbrokers and other commission-based financial advisers receive annually from mutual fund companies as long as their customers own such commission-based mutual funds.

As Chinese philosopher Lao Tzu advised, “the best way to manage anything is by making use of its nature.” History has proven that the stock market is cyclical. While investors should not try to avoid every short-term downturn in the stock market, indications of potential secular or long-term changes in the economy and/or stock market should not be ignored.

Legendary investor Ben Graham recommended a simple portfolio initially consisting of 50 percent stocks and 50 percent bonds. He also recommended that changes be made in the portfolio when conditions merited such changes, with the allocation to either stocks or bonds never exceeding 75 percent and never being less than 25 percent. There’s a reason he’s considered one of the greatest investors of all time. There’s a reason why his book, “The Intelligent Investor,” is considered one of the best investment books of all time.

Conclusion

“Life is really simple, but we insist on making it complicated.” – Confucius

Many people are intimidated by the idea of investing. The concept of “serenity investing” attempts to remove such intimidation by focusing on controlling the controllable, addressing issues that directly impact an investor’s return, yet issues that can be controlled by any investor with just a little understanding, combined with little time and effort.

Copyright © 2014 InvestSense, LLC. All rights reserved.

 This article is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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