Investment Strategy Helps you "Know When to Hold'em"

Wondering what investment changes to make now that the stock market has experienced its sharpest drop in five years?

seamless_pattern_1000009467-120613int-web.jpgMany experts say you should just sit tight. But it is not quite that simple.

This “stay put” advice was offered recently by Mark Sellers, a successful hedge fund manager, in a talk with Harvard Business School students.  Mr. Sellers declared that “the most important, and the rarest,” trait for successful investing was “the ability to live through volatility without changing your investment thought process.”

He went on to assert that: “This is almost impossible for most people to do; when the chips are down they have a terrible time not selling their stocks at a loss.”

Mr. Sellers’ remarks could be interpreted to suggest that investors should just keep doing what their doing when markets drop.  However, I don’t think that is what he meant.

I believe that Mr. Sellers assumed that his Harvard listeners had a coherent “investment thought process” to begin with – that is, some kind of well-grounded investment strategy. If so, I agree with his advice.

Many people, however, do not have a coherent investment strategy – either because they never had one, or because they have not continued to apply it consistently.  Such people, whether unnerved by recent market volatility or not, should consider making changes to their investments.

To evaluate whether or not you have a coherent investment strategy, I suggest asking yourself two questions:

First, what is my (or my advisor’s) current approach for buying and selling my investments?

Second, what evidence supports a conclusion that such an approach will produce the return on investment that I need without generating swings in value that make me uneasy?

Only then should you consider whether or not to apply Mr. Sellers’ advice that his Harvard MBA students maintain their approach during market drops.

Consider, for example, an approach to investing used by many people who manage their own investments – buying investments that have performed well recently and selling those that have not.

This approach answers the first concern of a coherent investment strategy because it specifies how investments will be bought (when they have grown a lot recently) and sold (when they have not).

However, this approach does not pass muster regarding the second question.  In fact, research demonstrates that, for a variety of reasons, investments that have done the best recently will more often than not under-perform in the near future.  As a result, this very common approach to investing often leads to buying high and selling low – exactly the opposite of what an effective investor wants to do.

Even if you hire a professional to buy and sell stocks for you, it is still important to assess whether there is evidence that the resulting portfolio is reasonably likely to meet your long-term growth and short-term volatility goals.  To do so, simply ask about the historic results associated with that particular method.

For instance, to evaluate potential short term losses, you should ask your advisor to show you how that method of buying and selling stocks performed during the last bear market of 2000-02.  To assess how likely the method is to meet your long term growth needs, you might want to ask how that particular method has performed on average.

Though looking backward is no guarantee of future results, it can help you understand what to expect, and determine whether those results are appropriate for you or not.

Having a better idea of what to expect can, in turn, help you avoid becoming distressed when markets do drop, reducing the chance you will feel compelled to sell after the damage is already done – thus locking in the losses.

In summary, whether you pick your own investments or hire someone to do that for you, it is vitally important to assess whether you have a coherent investment strategy.

If you do, then Mark Sellers’ advice to hold your strategy when markets drop probably applies.  However, the only thing worse than changing a perfectly reasonable investment strategy when the market drops is holding onto a strategy that is not well tailored to take care of your short and long-term financial needs.