The stock market during the past 18 months has been one of the most devastating any of us can recall.  Trillions of dollars in investor’s portfolios has vaporized.  Millions of Americans at all stages of life have been shocked by the massive losses in their investment accounts.  Most investor’s had no idea about to the amount of risk they were taking and the corresponding extent of loss exposure they had.  And yet today, when it comes to fixing their investment portfolios, many investors remain in denial about correcting the problem:  “I’ll Stop When I Get Even.”  An old Chinese proverb once defined “Insanity” as:  “Continuing to do the same thing(s)…and expecting different results.” 

Most investment advisors today are recommending clients remain disciplined and not sell out at the bottom and lock in permanent losses.  I emphatically agree, but, and this is a big but, only if you are properly allocated and diversified to begin with!  Some things are NOT coming back…EVER.  Look at the Nasdaq, which today is at about 1,600, at its peak in early 2000 it approached 5,500 just before the Tech Bust.  How many examples can you recall of once prominent companies, household names, that are now extinct?  Names like Enron, WorldCom, Lehmann Brothers, Bear Stearns, and countless others that have been forced into sale or liquidation.  The simple fact is any, and I mean any, individual stock or company can go to ZERO.  Allocation and Diversification are the keys to successful investing.  Not just among a few stocks or mutual funds.  The portfolios we recommend provide exposure to more than 14,000 companies in 39 countries around the world.  Certainly some of those now extinct companies I referred to above were contained in our recommended portfolios, but the exposure was minimal as a result of the vast diversification over more than 14,000 companies.

The Point!  Is controlling risk important to you?  Most investors answer ‘Yes” to this question, as it should be.  But even though most investors know risk is important, few are able to answer my next question.  Can you show me an academic number, a study, a statistic that shows the amount of risk and volatility in your portfolio?  Most investors don’t even know you can measure volatility.  And the next question is, if you can’t actually measure risk in any meaningful way, is there any way you can control it?  The resounding answer is – NO!

In most cases investors have never been provided with any meaningful way to compare and contrast the risk inherent in creating and managing differing mixes of assets in their portfolios.  It’s no surprise that most investors were blindsided by how much their portfolios dropped in the past several months.  They had no idea they could lose that much money because they were never shown or given any statistical tool for understanding it.  There is a prudent academically meaningful way to measure volatility, its called standard deviation, and prudent investors need to know what this is.

 I have observed investors who have lost large sums of money, but vehemently defend their portfolio decisions and deny that they lost an money at all.  Much like the gambler who returns from Vegas and brags about all the money he made, but “forgets” the losing nights.  As humans, we tend to selectively remember the wins and intellectually deny the losses and give ourselves more credit than we deserve.  Psychologists call this phenomenon “hindsight bias” and in the field of investing it reigns supreme.

The next question I’ll ask is, “If you took imprudent risk to get where you are today, is this something we need to solve?  Is it a problem that needs to be addressed?”  And then, the imprudent response, “I want to fix the problem, but I’ll stop when I get even.  I had a million dollars, it’s down to $500,000 (or $400,000 or $300,000) and when it gets back up to a million dollars, that’s when I’ll stop.”  And you can sense the compulsion and the obsession in their reply.  Very much like the gambler who’s down $10,000 in Vegas, who says he’s going to stop when he gets even.

And then, I like to ask the investor:  “When is the Best time to be Prudent?”  And the inevitable response is:  “It’s always the right time to be prudent.”  And that’s exactly right!  If imprudent risk-taking and speculation has cost you money, the worst thing that you can do is continue to participate in imprudent, speculative, and such risk-taking activities going into the future.  So why do people often insist on continuing their imprudent behavior?  Because to admit there’s a better way, they, in effect, have to admit that they were originally wrong.  To admit that our own behavior or decisions were ill-founded in the past is threatening to the ego.

“If only it would come back,” many investors subconsciously muse, “Then I could feel vindicated in my actions and solve the problem.”  This fantasy that everything will soon come back and everything will be OK is often at the root of the investor’s malady.  Don’t fall victim to this trap.  The opportunity here, to avoid this trap, is to realize that you are not your decisions, and just because you made an improper decision in the past, does not mean that you are less of a person, or less intelligent.  As a matter of fact, it’s a sign of intelligence and growth to solve and put an end to a destructive process when you become aware that one exists.  

If somebody could really help you pick the best stocks and forecast which way the market was going to go, all you would need to do is look at a commonly available ranking system and see which manager had done it in the past, and give all of your money to them to repeat their performance and you could do this with very little real thought or self-introspection.  If someone could actually do all this stuff, life would get real easy as far as investing is concerned, because you would be making 20%, 30%, 40%, or 50% a year with no risk.  And who wouldn’t like that?  But it’s kind of like a belief in Santa Claus.  It’s just not founded in reality.

Investors are often sucked-in by the illusions, fantasy, and addictions of gambling while they are being led to believe by the brokerage firms that the odds are really in the investors favor. 

You can be a successful investor by utilizing the proper academic and statistical tools.  Watch for the premiere of our upcoming movie “Navigating the Fog of Investing,” it’s a must see if you’re serious about growing your wealth and achieving true peace of mind about your financial future.   If you’d like more information about how markets work and our academic based investment philosophy contact our office.  You can’t blindly entrust your financial future to anyone else, it’s up to you!

Run date:  01/23/2009