Want to be a better investor? Make your decisions ahead of time. Determining the right investment to make today is tough. As much as we strive to be logical and dispassionate in our choices, every decision we make is influenced by emotional responses to stuff that matters less than we think. Particularly when we’re stressed.
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We may know, logically, that we should put more of our cash to work in the markets for the long term, but in the short term the decision to take the plunge always causes nagging doubts. So we put off investing, and put less in than we should when we do.
Fortunately for the long-term investor (and any other sort is an oxymoron) there is one clear way of reducing the expensive effects of our gut feel: make as many decisions as possible ahead of time and stop making decisions in the heat of the moment. The vast bulk of investment decisions don’t need to be made when we’re emotionally charged and stressed. Instead, we can make them in periods of calm reflection, when we have the time and mental bandwidth to think about them objectively.
This involves setting up rules for good investing behaviour that suit your needs, your personality, and your investing style. Signing up to sensible decisions ahead of time, in bundles, means that when the moment to act arrives you don’t need to make a decision at all, and you just set into motion a plan you made earlier. This takes some thought and dedication, but the benefit is a systematic approach to investing that leads to both better investment performance and a less stressful investing experience.
Rebalancing is a key example: it is useful not just because it is good investment practice, but because by setting up a rebalancing policy you have, at a single stroke, made a whole bunch of future decisions that you don’t have to fret about when the time comes. Ideally, these are then automated (or delegated) so you don’t have to even be troubled with the decision later. A rebalancing strategy allows us to respond less emotionally to the swings and lurches of the markets, and compels us to follow that most self-evidently valuable, and yet frequently flouted, investment policy: buy low, sell high.
There are, of course many different strategies that could be chosen. Some involve rebalancing at scheduled points (for example, every quarter), and some instead when the portfolio deviates from the desired allocation by more than a certain amount regardless of when (threshold-based rebalancing). It is not often noted that this choice implies a particular tactical conviction. For example, regular monthly rebalancing implicitly expresses low conviction in momentum and keeps the portfolio as stable as possible; quarterly rebalancing or threshold-based rebalancing allows the portfolio to benefit from, or be harmed by, medium-term trends; and annual rebalancing expresses the conviction, or anticonviction, that for the long-term investor short-term movements are largely unpredictable and really don’t matter that much.
The most crucial aspect of picking a rebalancing strategy is whether it is simple enough to be carried out with ease
Despite all the reams of analysis that is done to try and determine an optimal rebalancing strategy, the truth is that there is no clear right answer, and potential gains from sophisticated strategies can easily be reversed by the complexity of implementing them. Which policy you choose matters much less than whether you have one and don’t meddle with it. The most crucial aspect of picking a rebalancing strategy is whether, given your circumstances, it is simple enough to be carried out with ease.
So, if you’re executing it yourself, simpler is usually better – don’t opt for anything that takes more time, energy and activity than you’re going to be easily able to keep on top of yourself. A really simple once-a-year portfolio spring clean, with deliberate neglect in between would make the majority of us better investors. If you’re delegating your portfolio management to a professional manager, the strategy could be much more complex (though then you also need to be confident in their ability to execute it faithfully).
Rebalancing, however, is not the only way we can make decisions ahead of time. For example, you can remove the stress of many decisions by deciding ahead of time not to do certain things. If you, like me, don’t believe you have any ability whatsoever to predict currency movements, then write yourself, as I have, an explicit rule: I will not take currency positions. In one sentence you remove a number of future temptations to jump into positions that are driven largely by in the moment gut feel, rather than objective analysis.
We can also use ahead of time decisions to help us getting invested in the first place. It is always difficult, in the moment, to pull the trigger for fear of getting the timing wrong, but in investing, accumulated procrastination is usually very costly. Much easier, however, is making a decision now to invest a fixed amount next month, and then to automate this action, or instruct someone else to carry it out on your behalf. So, if you wanted to phase in your uninvested cash over the next 12 months, you are much more likely to do so if you make a commitment now to a bundle of 12 future actions, than if every month you agonise afresh about whether to invest or not.
Lastly, we should develop contingency plans for those times when things get really stressful, such as the market turmoil we’ve just been through. There are occasions when having a rebalancing policy is not enough to contain our stress and we feel something more is required. These are the most dangerous points for investors, as the emotional component of decisions rises dramatically. The crucial thing about such market drops is that, although we don’t know when, it is utterly predictable that they will happen. Something that is predictable is something we can prepare for. So taking the time, in a period of calm, to plan how you would like to react in the next market crisis means that when it comes you don’t have to determine your response from scratch in the heat of the moment. Instead, you dust off your disaster recovery plan and put it into action with the comfort of knowing that you’ve prepared for this.
Over time you can refine and improve your ahead-of-time plans, rules and decisions, but the secret is never to do this for a specific decision. This may mean you miss out on one or two opportunities along the way, but it also means that your decisions overall will be less emotional and higher quality, and in the long run you will be a better investor as a result.
Investments can fall in value as well as rise. You may get back less than you invest.