Market Disasters Can Shake Investors' Faith

Is it Time to Change the Way We Invest?
Adversity has a way of revealing strengths and weaknesses, and this is certainly true among financial advisors. The recent meltdown was tough enough for even the most seasoned professionals, but for those who lacked a clear underlying investment philosophy, the devastating sequence of events that began in 2008 effectively deprogrammed them from whatever belief system they had and left them searching for a new "religion" to believe in—one they could report to unhappy clients was more likely to work in this "new world."

What is an investment philosophy, and what is its role in practical terms? It is a set of core beliefs that provide a foundation for making investment decisions. It provides clarity because if those core beliefs are true, then other truths follow. Absent strong belief in a set of core principles, it is difficult to avoid being swayed by market turmoil, competitive forces, market fads, and client pressure. The cost of succumbing to those forces after the damage is done is often more damage in the form of whipsaw, which further erodes confidence. Total confidence in a set of core beliefs—an investment philosophy—is thus an important source of discipline, and is an important part of what advisors bring to the table for their clients.

While a set of unchanging beliefs is important, it is also true that in some ways we are in a new world, at least relative to the past several decades. A growing economy fueled by debt growth is being replaced with massive deleveraging that will likely reduce economic activity for years to come. Clearly there are important takeaways from these game-changing developments. So how should this new environment affect an advisor’s underlying process, and what parts of an investment approach should never change?

First, let us say that an investment approach that was undeveloped or poorly conceived in the first place deserves to be rethought or scrapped outright. To be blunt, we have seen some advisors who basically wing it and make decisions with little consistency or little research depth to support their moves or non-moves. In the life cycle of an advisor, this usually ends after the first time they get burned. Others recognize (often after getting burned) that they are not strong in the area of investment research, and as a result bring in outside expertise through various forms of outsourcing. And finally, many advisors are committed to doing their own research and work hard at it. Regardless of where an advisor falls, if they are looking to improve their decision making in the aftermath of this terrible bear market, it is important to recognize that simply switching to a new investment approach is never by itself going to substitute for discipline and hard work. A new approach that is based on avoiding whatever problems were just experienced (even though it is too late) probably fails to provide a framework to identify and make successful decisions in situations not yet faced or conceived. Remember, an investment approach can’t by itself make good decisions, it can only allow for them.

We have always believed that making good investment decisions, even through very difficult periods, must start with a confident and intellectually well-founded commitment to a sensible, rational set of investment beliefs. A good approach:

• Relies on analysis and not emotion to make decisions
• Is grounded in hard work and fundamental research
• Values intellectual honesty and recognizes that uncertainty will always be present
• Is based on principles that remain valid no matter how difficult the period.

Our investment philosophy is based on those principles, and we know that they will stand the test of time. This philosophy forms the foundation that guides our decision making. The basic tenets of Litman Gregory’s investment philosophy are the focus of the second half of this article. But first some context is in order to truly understand why these principles are so very important—especially now.

Core Beliefs Must Withstand Mistakes, Fear and New Paradigms

Providing investment advice is not easy. As financial advisors we are called on to make decisions about an uncertain future based only on the incomplete information we have today. Meanwhile our clients’ confidence is always at risk of being undermined by the wide range of competing points of view and ongoing stream of short-term news and data that are always available in this age of information overload. Maintaining confidence is critically important, and requires the advisor to honestly convey what can and cannot be known with certainty, and to share the analysis that was used to weigh those uncertainties in order to make the best long-term investment decisions.

Advisors who lack a solid rationale for their decisions are especially vulnerable to pressure from clients to adjust their portfolio based on the prevailing "conventional wisdom." Of course, this "wisdom" will have become conventional based on its strong recent performance at that time, and shifting to it really amounts to just another form of performance chasing. But the fear of losing clients, combined with superficially compelling arguments for a new paradigm, can compel advisors to shift strategies or compromise core beliefs at the most inopportune times. These are the same forces that led many advisors to pile into domestic large-cap growth and tech stocks in the late 1990s, or to finally become highly defensive in March 2009. There are countless other examples, from the Nifty 50 in the early 1970s, to gold in the late 1970s, to small-cap in the early 1980s, to international investing in the late 1980s, to the aforementioned growth and tech bubble of the late 1990s, the single-family home more recently. All caught fire, fueled by a common story that these assets had some fundamental advantage that would allow them to continue to perform well indefinitely (consider now that most worst-case home price forecasts had prices flat and failed to imagine the possibility of even a mild decline!).

Simple fear can also wreak havoc on an advisor’s ability to make sound long-term decisions. When markets are irrational, investors are most inclined to question their beliefs and give in to fear. But that is also when advisors are set up to add the most value because fear in the shorter term creates the best longer-term opportunities. While markets can stay irrational for an uncomfortably long time, they don’t stay that way forever. Having the confidence to take advantage of these opportunities requires an understanding of the cycles of fear and greed, the fundamental research to establish that a compelling opportunity exists, and the patience to ignore further short-term pain so as to generate better performance over the longer term—all of these are components of a good core belief system.

Finally, it is imperative to recognize the difference between mistakes and failure. That every investor will make mistakes is a certainty. But mistakes are not the same as a failure of philosophy or process. More likely they are a failure of execution either because of bad assumptions, research errors, or a breakdown in discipline. Mistakes should be a trigger for examining strengths and weaknesses in how a process is being implemented. They may result in refinements, a commitment to do more research work, or simply lessons learned or reiterated. Rather than reflecting a failure of the underlying philosophy, mistakes commonly reflect a failure to follow the underlying philosophy.

Supporting our core beliefs is a very detailed investment process—the actual mechanics of the research work we do, which you can learn more about here.