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The second most important investment decision you must make » PRINT

By Paul Merriman
November, 2001

In the following article from the FundAdvice.com archives, Paul Merriman discusses the second most important decision investors have to make. Though the article was written a few years ago in the midst of a severe bear market, its insights and lessons are just as important now as they were then.

We've said before that the most important decision investors must make is their choice of assets. That's called asset allocation, and it has more impact on your long-term returns than your timing of sales and purchases. Asset allocation also has more impact in the long run than your selection of which mutual funds you invest in.

But neither your timing nor your investment selection is the second most important decision. Your No. 2 decision is every bit as important as asset allocation - and for some investors it is a tougher decision.

Here's a true story. A prospective client came into our office this fall with an unusual question: Why hadn't he done what he knew he should do with his investment portfolio?

This man was sophisticated and well informed about financial matters, a professional in his 50s who had managed to accumulate more than $1 million for his retirement.

We met with this investor almost a year ago and tried to get him to diversify his portfolio, most of which was invested in technology stocks and technology funds. He had attended two workshops I led and heard me speak on another occasion. Without any doubt, he knew he needed to make some major changes in his portfolio.

When he came back this fall, he had lost more than 60 percent of the value of his portfolio since the bull market peaked in early 2000. The losses had set him back years in his goal of retiring early. Even as we talked, the market continued to deteriorate.

"Why haven't I done what I know I should do?" he asked. "Why didn't you tell me something that would have motivated me to make this obvious change?"

This intelligent, accomplished man was staring into the face of what I think is the second-most important decision investors face: The decision to take action or not.

In every area of life, there's a big difference between knowing that you should do something and actually doing it.

This investor was essentially telling me that I had convinced him that he should have a more diversified portfolio, but that I had not persuaded him to do anything about it. For his sake, I wish I had been able to persuade him to change his asset allocation and invest in a more sensible mix of funds. But you know the old saying: You can lead a horse to water, but you can't make him drink.

I conduct myself as an advisor and an educator, not a salesman. I think it's my job to inform you, educate you and convince you. But I don't think it's my job to manipulate you into doing something, even if I am sure it is in your best interest.

This investor is not the only one struggling with this issue.

At a workshop last month, I asked for a show of hands. "How many of you have made major changes in your investments in the past year and a half?" About 5 percent of the hands went up. "How many of you wish you had made major changes in your investments?" A majority of hands were raised.

If the investor in his 50s with the battered technology stocks is engaging in irrational and self-defeating behavior, he is certainly not alone. In thinking about his situation lately, I have recalled how I smoked cigarettes for several years when I was young, even though I knew without a doubt that it was bad for my health. I've thought about the difficulties I have experienced keeping my weight and my diet under control and maintaining an exercise program that I know would be good for me.

The psychological phenomenon of "being stuck" is outside my field of expertise. But I do understand a lot about how investors think, feel and behave.

I think the investor who came to see us is experiencing two kinds of pain. First there's the financial pain, the shocking loss of the majority of this man's investment assets. This financial pain can be measured and described fairly easily, and I'll take a crack at doing so in a moment.

Second, there's emotional pain: the pain of being wrong. I think what might be going through his mind is something like this: "If I sell now, as I know I should, then I will really, really, really be wrong. It will be impossible to deny the big mistake I made, and it will be obvious that I have failed."

For awhile last year, he felt just the opposite. He bought 6,000 shares of a technology stock at $4 a share and watched it go up to $80. That's enough to make most investors feel they have at least a touch of genius. Then the stock started falling. When it got down to $20, he sold half his shares. He still owns 3,000 shares, which are selling for about what he paid for them.

He bought the stock without a plan, and now he is stuck not knowing what to do. I think he's afraid to sell the rest because he thinks the stock might immediately start going back up. And even though it would be the result of pure luck, that would make him feel doubly wrong and doubly stupid.

As long as he holds onto his technology investments, he has an emotional crutch: the hope that maybe this long bear market is just a bad dream. He can hope that his investments will bounce right back and resume their upward course toward the future he once thought they had.

In this investor's mind, the financial pain and the emotional pain are in a battle. And at least so far, the emotional pain is winning the battle. For whatever reason, it's easier for him to continue to suffer financial pain than to suffer the emotional pain of owning up to the damage that has already been done to his portfolio.

This man has another problem as well: His stockbroker is a friend. If he abandons his broker's recommendations, is he also abandoning his broker's friendship?

Back in 1999, many investors (perhaps including this one) thought they had found a shortcut to quick, easy wealth. The shortcut: technology. In pursuit of that easy wealth, these investors essentially bet their futures on technology. So far that has not turned out to be a good bet.

Let's put some numbers on this man's financial pain. Using round numbers, a $1 million portfolio that suffers a 60 percent loss shrinks to $400,000. A casual observer might think he could break even with a 60 percent gain, which was not unusual for technology stocks and funds in 1999. Wrong! To get back to $1 million, this $400,000 portfolio would need a 150 percent gain. How likely is that to happen any time soon?

Even at a very optimistic annual return of 20 percent, this man's investments would require five years to recover to $1 million. And at a much more probable future return of 12 percent (still not at all guaranteed), it will take him eight years to recover.

For a man in his 50s hoping to retire early, eight years is a monumental setback. If he had had a more sensible portfolio that declined 20 percent in the bear market to $800,000, a compound return of 12 percent over eight years could have grown his investments to $1.9 million.

That means the real cost of his technology investments, the loss of opportunity, was $900,000 (the difference between eight years of future 12 percent returns on $400,000 and the same returns on $800,000.)

If a 60 percent loss can happen once, it can happen again if this investor persists with his technology-laden portfolio. Starting with $400,000, he could find himself a year and a half older and down to $160,000. From there, he has almost no reasonable chance of retiring without making drastic changes in his lifestyle expectations. At a steady 12 percent return, a portfolio of $160,000 would require 16 years to get back to $1 million.

One irony of this case is that this investor never needed more than a 10 percent compound return to meet his goals. He never needed to have separate technology investments to achieve such a return. But like so many other people, (and I'm sure this was with the encouragement of his broker) he wanted more.

Investing and baseball

Like many others this fall, I've been thinking about baseball. And I wonder how this investor's situation would play out in a ballpark.

Imagine you are the manager of a professional baseball team and you have a terrific pitcher, one of the best on the planet. You are in a crucial game that your team must win, and your star pitcher gets a fabulous start, allowing no hits for the first four innings.

Imagine that by the sixth inning, your beloved pitcher is not doing so well. The other team is not only getting hits but getting runs, too - and suddenly your team is seriously behind. How long would you leave your faltering pitcher on the mound to struggle while your team's chances of going to the playoffs slip away?

Would you pull that pitcher out of the game, or leave him there while you hope he would recover his magic touch?

Maybe baseball managers are smarter than investors. Most managers would have at least one good relief pitcher warming up and would not hesitate very long before making the change. Baseball managers know that the score matters more than how much a manager loves a certain player.

In this analogy, of course, the star pitcher is similar to the technology stocks that once did so well and looked as if they had stunningly bright futures. The capable relief pitcher represents the other possible investments that can get the job done. And the manager represents the investor who has the final say in all investment decisions.

If a baseball manager waited too long to pull a faltering pitcher out of play, he would have thousands of fans yelling at him to make the change. His other players would start to get restless, too. The decision to pull the pitcher or not would be a public choice, not a private one that is entirely at the manager's discretion. If the manager is making what everybody believes is a rotten decision, the public will shame him out of it.

But the investor who came to my workshops doesn't have the benefit (if you consider it a benefit) of all that public support and pressure. He can make his decisions on his own, in private, with nobody to "shame him" into doing the right thing.

I certainly don't mean to single this man out for any special criticism. He's very intelligent and accomplished, and his professional skills will allow him to keep working as long as he wants to.

The problem he faces isn't unique to him. Lots of investors get "stuck" when market cycles get in the way of making changes they need to make.

When the market is near its top, as it was in early 2000, aggressive stock investors can see that they are making money. They feel that they are "on a roll." Who wants to bail out of stocks when you're making easy money? Who wants to fix something that isn't broken? Who wants to pay a big capital gains tax?

When the market is near a bottom, as it might be now, who wants to take a big loss? Doing so could make you feel like a loser. A lot of people believe they have intrinsically great investments that will come back if they just stay the course.

And if they do stay the course, and if those investments do come back, then those investors may find themselves once again "stuck" at the top.

I'm afraid some readers may misinterpret what I'm saying, so I want to clarify it. I'm not advising investors to abandon ship when their investments are temporarily out of favor and producing disappointing returns. I still believe that the best way to be a successful investor is to make a good plan, invest your money in the right assets, and to stay the course.

In this case, I'm describing a situation in which an investor didn't do the first part of that. This investor may have had a plan. But he did NOT have a plan that led him to invest in the right assets for the job. Anybody 10 years or less away from retirement has absolutely no business investing the great bulk of his life savings in technology stocks and funds. Even young investors shouldn't normally have more than 20 percent or so invested that aggressively.

Let me say this another way: This investor's problem started when he chose the wrong assets for his portfolio. He chose the wrong tools for the job. And he has compounded the problem greatly because even after he realized he had the wrong tools, he continued using them.

Let's return to baseball to look at another analogy: I think this investor was acting like a baseball manager who had hired a world-class quarterback to do his pitching. Yes, you read that correctly. A quarterback hired as a pitcher.

Even a 6-year-old could see the silliness in what I'm suggesting. Everybody knows that you don't use a quarterback to pitch.

Pride may be part of the problem for that baseball manager. He may have an emotional attachment to the quarterback, for whatever reason. But that attachment would not last long in the public arena of a major league baseball team. The fans and owners and media would never let that manager even get the quarterback onto the field, much less throw some pitches. If the manager persisted he would quickly be out of a job.

Perhaps that comes back to the point I made to this investor. He is a fiduciary, and his responsibility is not just to his own pride and his own views. His responsibility is to his whole family. To exercise that responsibility, he must be willing and able to put his own emotions and wishes aside when they are leading him astray.

Likewise, a baseball manager is responsible to many constituencies beyond himself. He's responsible to the club owners, the players, the fans and in a way to the city or state represented by his team.

If he wants to have a quarterback for a pitcher on his own private team, that's nobody else's business. He will soon enough figure out the consequences. But when he's managing somebody else's team, he has to do what will work, not just what feels good.

In my workshops, I usually start by asking the participants to define their investment objectives. I give them three choices:

• Do they want to achieve the highest possible return within their risk tolerance?
• Do they want to find the lowest-risk way to achieve the return they need?
• Do they want to beat the market?

Before the current bear market, the most frequent choice was the first: the highest return within their risk tolerance. These days, I'm much more likely to see people choosing the low-risk way to achieve the return they need.

The bear market has changed the emotional climate of popular investing from one in which greed had the upper hand (in 1999 and early 2000) to one in which fear is much more likely to prevail.

Most investors need to reexamine their answer to my workshop question. If your desire for high returns tempts you to invest the majority of your portfolio aggressively, I hope you will remember the investor I have described here. His story, unfortunately, illustrates the very high price that smart people sometimes have to pay when they ignore investment risk and get carried away trying to enhance their returns.

Like the baseball manager who needs a pitcher instead of a quarterback, investors need the right tools for the job at hand. That means primarily the right mix of equities and fixed-income investments and, within each of those categories, the right kids of equity funds.

This is asset allocation, the most important decision most investors will make. Once you have that figured out, the next step is to take action. Many people find themselves "stuck" at that point and don't know how to get "unstuck." If there were an easy answer to that, the world might be quite a different place.

Sometimes it takes a shock to overcome inertia and produce action. I'm reminded of a quotation from Nadine Gordimer, a South African writer: "A good scare is worth more to a man than good advice."

Many people, especially middle-aged men, spend years avoiding what they know they should do regarding their weight, their diets and their exercise (or lack of it) until either they have a heart attack or they see undeniable medical evidence that they have serious heart disease. Then in many cases, they suddenly reorder their priorities and start "living right."

This happens on a national scale as well. For many years, study after study indicated serious security lapses at U.S. airports. Repeated recommendations for change were ignored, largely because there was little political support for saddling the flying public with the cost and inconvenience of tighter security. That all changed immediately and dramatically on September 11, 2001.

Many investors know they should make some changes in their asset allocations, but they're struggling to overcome inertia and slow to take action. If that describes you, here are some suggestions that may help to get yourself "unstuck."

• Seek the counsel of a professional money manager or financial advisor. A professional can show you choices and options that you might not see on your own. More important, a professional can help you sort through the emotions of investing.

  When I meet with a couple for the first time, I'm likely to ask them to paint a word picture of how they see their future. I'll want to know what they want and what they're worried or concerned about. Only after that discussion will I have the proper context in which to discuss the details of their portfolio.

  Most of the investment industry is designed to appeal to investors' emotions, to get them to make changes that will feel good right now. But a good advisor can help you identify and focus on what is really important, not just for now but for the long run.

• Ask yourself what you would do with your investments if all your money was in cash. If you wouldn't pick the exact same mix of investments you have today, why not? If what you have is not right for you, it is never too late to get back on the right track.

  This is a tricky topic. I am not suggesting that investors who are unhappy with their asset allocations should necessarily sell everything. In some cases, that's the appropriate thing to do; in other cases, a great deal of a portfolio can be left where it is.

  Instead of wholesale selling, I'm suggesting you put yourself into a state of mind as if you had sold everything you have. Sitting on $1 million of cash is very different from sitting on $1 million of funds and stocks you have bought at various times for various reasons.

• This one takes some creative thinking. Put yourself in the place of an advisor. Imagine that someone came to you and described exactly your situation and asked your advice. What advice would you give that person? Now, why not take your own advice?

I used one other approach with the investor we've been discussing. I told him he was acting as if this money were his and his alone. If that were true, I would not press him very hard on this issue. If he wanted to watch while his technology investments compromised his financial future, that would truly be his own business.

But I reminded him that his family is counting on him for this money. I told him he needs to act as if he were a fiduciary, a person who has financial responsibility for someone else. I know he understands the concept of fiduciary responsibility, and I think this was a sobering thought for him.

By allowing risky technology stocks to erode his family's life savings, he is certainly not acting as a responsible fiduciary. This is perhaps the closest I can come to "shaming him" into doing the right thing.

I'm pleased to report that he has taken the first steps to get his portfolio back on track. I asked him what finally nudged him into action. I wasn't surprised to find that it was the combination of several things.

He said it definitely helped to hear my pitch about the virtues of diversification several times instead of only once. Diversification, he said, "is just common sense. But apparently it's not so common."

He said he gradually realized that the early successes he had with technology stocks probably came as much from luck as from his stock-picking skill.

One other thing he said struck me in particular: "I got tired of having the market be my emotional barometer for the day".

Ultimately, nobody knows exactly what finally moves a person to take action. That's a mystery, different for every person and every situation. But if you can find a way to get yourself unstuck, you can get back on track toward the financial future you desire. It's certainly worth your while to do that. And then you won't be likely to wind up in the embarrassing position of trying to justify using a quarterback to do the pitching for a baseball team.

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