Charles Rotblut has a nice article in the American Association of Individual Investors Journal (AAII) entitled “Investing Strategies For An Irrational Brain .” First, he chronicles many ways that our brains are hard wired against making rational decisions. A combination of cognitive biases, emotions and reactive thinking leads to investing decisions that are not rational in terms of maximizing profits. Then, and most helpfully, he provides some of the best methods to prevent behavioral errors from occurring. Here are two of the easiest methods you can employ:
Use the Power of the Written Word
One of the simplest and most effective strategies is to simply use the power of the written word. Write down the rules governing how to manage your portfolio, including your long-term allocation strategy, guidelines for determining if a security or fund should be bought, and the specific circumstances under which you would sell.
Portfolio Management Guidelines
Included in your rules should be guidelines for your long-term portfolio allocation strategy. Specify how much you want to allocate to each major asset class: stocks, bond, cash, real estate, etc. Then define under what circumstances you will adjust your portfolio when it strays away from these guidelines.
We implement these ideas by first having an Investment Policy Statement for each client. An Investment Policy Statement is a blueprint for the development of your financial dream home. Like a blueprint, an Investment Policy Statement not only provides a map of the project ahead, but it also provides a tool by which you can measure your success – or the success of your investment advisor. The Investment Policy Statement includes a target asset allocation. As your investment advisor implements your investment policy, you can determine if the construction accurately matches the blueprint.
We have taken the time to provide a complete guide to creating an investment plan. We use it to show clients exactly how we build portfolios. There should be no “secret sauce” in your investment plan. We think that you should understand your investment strategy. And we think it is a red flag if your financial advisor cannot answer “Yes” to the question, “Could you teach me to implement your investment strategy and let me do it on my own?”
The second way we implement these ideas is by talking with our clients ahead of time what we will do when some portion of their portfolio inevitably drops. Having an asset allocation is important, but sticking with an asset allocation is even more important. We talk about how terrible it will feel when some portion of the portfolio drops precipitously or the panic they will feel when their entire portfolio suffers a loss. We are all emotionally wired to want to make the worry stop and get out of what we perceive as “going down” (present tense) rather than understanding that it has simply “gone down” (past tense).
We talk about how we will rebalance the portfolio although we won’t emotionally want to. Rebalancing is the act of selling whatever has done well recently and purchasing whatever has done terribly. It feels uncomfortable, but it is the right thing to do. Such discipline can result in a rebalancing bonus and better long-term returns.
We call this conversation a “market down-turn dress rehearsal.”
We set a target asset allocation and have such conversations in the hope that they will help us avoid the behavioral error of selling at the bottom instead of buying.
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