“Today’s investors find it inconceivable that life might be better without so much information. Investors find it hard to believe that ignoring the vast majority of investment noise might actually improve investment performance. The idea sounds too risky because it is so contrary to their accepted and reinforced actions.” So writes Richard Bernstein in his book Navigate the Noise.
Why the Noise?
At the time he provided this highly useful insight, Bernstein was Chief Investment Strategist at Merrill Lynch. What makes this a particularly interesting statement is that his then-employer (not to single out Merrill Lynch) is responsible for putting out much of the very noise Bernstein decries.
Many entities — not just investment firms, but also magazines, broadcast media outlets, newsletter publishers and the financial media in general — have a vested interest in investors becoming hooked on investment noise (or what Jane Bryant Quinn called “investment porn”).
Why? Because greater traffic and attention helps drive their profits. The interests of the financial media are not necessarily aligned with the best interests of investors. The winning strategy for them is highly likely to be the losing strategy for you. What’s more, there are far better and more important things to do with your time.
Below, we’ll discuss five areas in which paying attention to the noise can cause investors to stray from even a well-thought out investment plan.
Perhaps the most important, and most thoroughly understood, concept in the field of risk management is that diversification remains the best and simplest tool for reducing risk. Combining assets, or asset classes, where performance isn’t expected to have perfect correlation can reduce the overall risk of a portfolio.
Paying attention to the often urgent noise of the moment, however, can lead investors to abandon their diversified strategy and chase the latest mania, be it social media, tech, biotech, bowling alleys (yes, there was a bowling alley bubble) or tulip bulbs. Investors also often make the mistake of believing that diversification works “by the numbers". Owning 10 different mutual funds isn’t effective diversification if they all own the same group of U.S. large-cap growth stocks; that type of diversification only reduces single-stock risk.
Goal Setting: Stick to Your IPS
No good businessman would start a company without a well-thought out plan. And no bank or venture capital firm would finance a business that didn’t have one. Yet many investors begin investing without something similar. For investors, that “business plan” comes in the form of a written and signed investment policy statement (IPS) that articulates the goals and risk tolerances of the individual (or pension plan, profit-sharing plan or endowment).
The IPS should include both specific asset allocations and a rebalancing table. Most importantly, it should be signed by all the parties involved as a reminder that they have carefully thought out the plan and made a commitment to maintain the discipline required to stay the course. The plan should only be changed if the investment horizon shortens and/or risk tolerances and the need to take risk is altered due to life events (such as death, divorce, inheritance or job loss). Market noise causes investors to stray from their plan as they chase hot sectors, search for the next Google, or panic in down markets.
Assessing one’s ability, willingness and need to take risk is an important part of the IPS process. Paying attention to the noise tends to lure investors away from their carefully thought out and constructed plan. The noise can make investors think that an investment is less risky than it really is. The perfect example was the dot.com mania of the late 1990s. Many investors were so certain these companies would succeed that they threw caution to the wind, abandoning their plans and the concept of diversification of risk.
Time Horizon: Long Term Should Not Be a Day
With the evidence so clear that trying to time the market is highly likely to prove a losing proposition, investors are taught to think long term.
Unfortunately, noise causes investors to think short term. In fact, the “long term” for many investors has become a month, week or even a day. Noise causes investors to become traders. During such tempting times investors would be wise to remember Warren Buffet’s observation in the 1996 Berkshire Hathaway Annual Report: “Inactivity strikes us as intelligent behavior.”
Discipline: Greed May Not Always Be Good
Financial economists have found that the vast majority of a stock portfolio’s returns are determined by its exposure to the factors of size, value, momentum and profitability.
However, the returns investors actually earn from their investments are likely to be far more dependent on the discipline they maintain in adhering to their plan than on the specific allocation. The evidence demonstrates that paying attention to all the noise causes investors to lose discipline, panicking in bear markets and getting greedy in bull markets.
The discipline to stay the course is likely to prove to be at least as important a determinant of investor returns as both the asset allocation decision and the choice of actively managed funds versus passively managed ones (such as index funds). In fact, I’d even go so far as to say that if someone uses a financial advisor, and the advisor does nothing but keep their client disciplined in adhering to their plan, the advisor will likely have earned their fee several times over.
How to Screen out the Noise: Invest by the Calender
If you happen to be one of those investors who simply cannot tune out CNBC or other financial media outlets, I offer the following suggestion: make your investment decisions by the calendar. A good way to do that is to analyze your portfolio’s actual holdings on a quarterly basis to make sure it is within the tolerance levels laid out in your rebalancing table.
A quarterly review is also a good time to check for any tax-loss harvesting opportunities. Asset allocation changes should only be made because rebalancing tolerance levels have been exceeded, or a life event has occurred that impacts your ability, willingness or need to take market risk.
The Bottom Line
Investors would do well to pay attention to the following statement by Jonathan Clements of The Wall Street Journal: “Investors spend an absurd amount of time trying to control the one thing they can do the least about, which is their raw investment performance. They attempt to pick hot stocks, find star fund managers and guess the market’s direction. Yet it is extraordinarily difficult, if not impossible, to do any of these things.”