Portfolio Management: More than just a winning season
By Gary Silverman, CFP®
Lately, I’ve been sharing some pearls of wisdom I’ve learned over the years when it comes to managing an investment portfolio. Today I want to talk about playing the small game. In softball that means going for hits not home runs. It’s pretty much the same with investing. Everyone is trying to find the next wonder-stock that will quadruple in price within a year.
While I appreciate the sentiment, I don’t suggest investing in an area just because it is doing well. First, it must make sense as an investment. Next, it has to fit the goals. And, of course, it should work in concert with the rest of the portfolio. The other reason is that it’s not so much what it is doing now—rather you want to buy it for what it’s going to do going forward.
For instance, beginning in 1996 if you had purchased the top mutual fund from the previous year, over the next five years your average portfolio return would have been negative 2%. That’s not to say that every winner turns into a loser—but it does show that trying to pick your funds by looking backward can be fraught with error.
Just as we are not running toward the hot asset classes, we are not running away from the ones that were cold last year. If a particular investment type makes sense for your portfolio, that shouldn’t preclude you from adding it just because it’s recently had a rough time.
Much of this is due to a concept known as “reversion to the mean.” This means that an investment will eventually settle into an “average” return. If there is a mean reversion behavior for securities, then a period of great returns will most probably be balanced by a period of low returns.
No trend lasts forever. Cycles are a fact. When asked what the market was going to do, J.P. Morgan famously (and accurately) said, “It will fluctuate.”
Here’s a story I once heard at a conference to help pull this together:
Imagine that you had to drive from New York to Los Angeles. You are in downtown Manhattan hopelessly stuck in traffic. Bicycle delivery drivers have been whizzing past you for the last hour. Impatient, you sell your car at a loss and buy a bicycle. Now you are whizzing by all those idiots still in their cars.
Sound absurd? Investors do it every day when they make short-term decisions for long-term journeys.
We also don’t like newer investments that we don’t understand. If a prospectus or a product presentation leaves us scratching our heads, we won’t recommend it to our clients. Do the same thing. Trust me, the person hawking an investment will have all sorts of charts, stories, and reasons why it will not fail. This kind of prove-it philosophy would have saved many people grief in the limited partnership fiascoes of the ‘80s as well as the more recent problems with derivatives.
As I read somewhere, sometime, from someone: “The early bird may get the worm, but the second mouse gets the cheese.”
Gary Silverman, CFP® is the founder of Personal Money Planning, LLC, a Wichita Falls retirement planning and investment management firm and author of Real World Investing