The majority of advice given to individual investors relates to developing an investment plan: evaluating risk tolerance, choosing an appropriate mix of assets, controlling costs, etc. While these considerations are all important drivers of investment success, a singular focus on plan development often causes implementation to suffer.
In order to promote the disciplined execution of a portfolio’s investment strategy, pension plans, foundations and trusts often draft an Investment Policy Statement (IPS). This document formally outlines the investment objectives, philosophy, boundaries and procedures for managing the portfolio so that plan advisors don’t stray from their clients’ intentions. Individual investors can get a similar benefit by drafting their own Investment Policy Statements. A brief, well thought out IPS can help an investor stay focused on his goals and systematically resist the natural human tendencies that seriously harm investment returns.
Investors Behaving Badly
There’s an abundance of research on individual investor behavior, and very little of it is encouraging. Barber and Odean’s landmark study, in which 66,465 household accounts were examined from 1991-1996, found that individual investors trade too frequently, thus destroying returns. The most active traders in the group underperformed a buy-and-hold portfolio by over 7% annually, while the average investor’s returns lagged an inactive portfolio by over 2% per year. According to the study, the root cause of this behavior was overconfidence, a trait that was especially pronounced in men. Specifically, investors were confident in the future movements of the overall stock market or a particular sector, and they invested accordingly. Unfortunately, they were frequently wrong.
Similarly, Dalbar’s 2009 version of its Quantitative Analysis of Investor Behavior study examined the returns of mutual fund investors from the beginning of 1989 through the end of 2008. The study found that the average US equity investor earned an annual return of 1.87% compared with the 8.35% annual return of the S&P 500. The stark difference in performance, according to the study, could be attributed largely to investors abandoning equity mutual funds during declining markets (selling low) and reinvesting following a market rebound (buying high). The study doesn’t pinpoint a solitary causal factor, but this phenomenon usually occurs when investors overestimate their risk tolerance, misunderstand the risk-return tradeoff, or seek safety in numbers through “herd” behavior.
How an Investment Policy Statement Can Help
Fortunately, there are steps that DIY investors can take to counteract their destructive behavioral tendencies. First, it’s important to develop an investment plan consistent with your risk attitude and capacity. When unsure whether a certain level of portfolio volatility is acceptable, it’s prudent to err on the side of conservatism. The worst time to discover your risk tolerance is during a market decline. When determining your target asset allocation, it’s also a good idea to specify events that would trigger a portfolio rebalancing. Without specific rebalancing criteria (e.g., acceptable bands for each asset class), the door is left open for impulsive trading.
Next, formalize your plan in an Investment Policy Statement. An IPS should include your investment objectives, account balances, current income and future liquidity needs, risk profile, target allocation and rebalancing bands, investment philosophy and fund selection criteria, and plans for periodic IPS reviews. Drafting an IPS may seem burdensome, unnecessary or redundant, but without the ongoing help of an investment advisor, this simple document performs the vital role of a bad behavior gatekeeper. When you’re tempted to abandon your risk-appropriate allocation during a market downturn, your IPS will remind you of your investment plan’s rationale and encourage you to stay the course. When you get a “can’t miss” stock tip from a friend, your IPS will tell you to keep your distance. And when you get your investment account statement at the end of the year, your IPS will provide a valuable performance measuring stick. Your IPS could be all that stands between you and your return-reducing behavioral tendencies; don’t pass up this opportunity to add discipline to your investment plan.
Conclusion
Legendary investor Benjamin Graham said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” There’s plenty of research confirming Mr. Graham’s hypothesis, but fortunately, there’s hope for the individual investor. By understanding the impact of human behavior on investment returns and devising a disciplined plan of attack in the form of an Investment Policy Statement, DIY investors can overpower damaging behavioral forces and increase their chances of achieving their financial goals.
George Watkins is President of West Wind Wealth Management, an independent investment advisory firm that specializes in index portfolios. He has a BS in Economics from Duke University and an MBA from Harvard Business School. To download George’s sample Investment Policy Statement (IPS), view other tools and tips for DIY investors, or to purchase a personalized index portfolio recommendation, visit http://www.invest-it-yourself.com.
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