Long-term investment strategies make good sense 17 November 2012
Avoid the temptation to overdose on financial press reports
When it comes to wealth building, long-term investment strategies hold the key to cumulative balance sheet growth. There is a difficulty in sticking to a long-term plan, however, and it is not helped by the newspapers.
In our modern world, the speed at which news and information is circulated has increased exponentially over recent years. Technology has made it possible to report almost instantaneously on events.
As a result media analysis and opinion is formulated within hours of a ‘breaking news’ event, and the more clinical, less emotional analysis that comes later often seems less interesting and relevant.
The investment world is not immune to this mindset – just think of the various business channels on television, where the fluctuating fortunes of shares and other assets are explained away on a daily basis.
But is this a desirable situation? Does it promote sound decision-making, support long-term investment strategies and reduce investor anxiety?
The intuitive answer would be no. I recently came across an interesting analogy that seeks to illustrate this in a bit more detail.
Nassim Taleb, in his book, Fooled by Randomness, imagines a fictitious retired dentist who employs long-term investment strategies and expects to earn investment returns of 15% over time on his portfolio, with an error rate (or ‘volatility’) of 10% a year.
From a statistical point of view, if one assumes a normal distribution for simplicity, it means that out of every 100 observations of investment performance we would expect that close to 68 of them would fall within a band of plus and minus 10% around the expected return of 15% (they would fall between 5% and 25% just over two-thirds of the time).
A 15% return with a 10% volatility per year translates into a 93% probability of success (a positive return) in any given year. Taleb points out, however, that the probability of success reduces as the time scale narrows.
For example, there would be a 67% probability of success with a one-month timeframe, and only a 54% probability of success if the timeframe is reduced to one day. This is common sense: in the very short term anything can happen. It takes time, or an increased number of observations, for the average long-term trend to emerge.
If the retired dentist monitored his long-term investment portfolio every minute in an eight-hour day, he would on average have 241 pleasurable (positive return) observations against 239 unpleasurable (negative return) observations.
There is an old adage in the financial advice industry:
An investor experiences the pain of a loss with twice the intensity of the pleasure of a gain!
This unfortunate dentist would probably end every day emotionally drained, stressed and uncertain about his investment strategy. The chances of a poor investment decision, based largely on emotion, are high.
If the dentist examines his long-term investment portfolio every month (perhaps he gets a monthly valuation statement), 67% of his months will be positive, as he incurs only four unpleasurable observations, and eight pleasurable observations.
There is still a good chance of a poor decision – remember that it is possible that he could experience a few negative months in a row. It takes a strong investor not to panic in a situation like this.
If he could extend his time scale to one year (where the portfolio’s performance is assessed in an annual review with a financial advisor, for example), then the picture changes dramatically. He will in all likelihood experience only one unpleasant year out of every 20. The chances of making a bad investment decision, based on emotion, are now very low.
It is important to note that the overall investment returns are identical in the above examples (the same set of data has been used and it is just the timeframes that have been changed).
Over a very short time period, one typically observes the variability of the portfolio, and not the returns. Our emotions are incapable of distinguishing between the two, and panic or disappointment can easily set in.
This principle can also be applied to other aspects of life. For example, if you watch the news on television every day you will invariably be exposed to a fair amount of short-term ‘noise’.
A weekly viewing of the news should increase your probability of receiving more accurate and dependable information; noise tends to get filtered out over time.
Our emotions and the environment that we live in can result in poor investment decisions.
A strategic long-term investment financial plan, preferably formulated and monitored by an independent financial planner, can help build wealth over time.
My advice is to engage an independent, fee-based, CERTIFIED FINANCIAL PLANNER® who is focused on your best interests and can provide impartial advice.
If you do not have a one, visit the Financial Planning Institute’s website on www.fpi.co.za to select one.
Richard Sparg CFP® is a wealth manager at Netto Invest.