Opinion: Be a better investor, and behave like one
By Brian Portnoy
For most of us, much of life, including our finances, is premised on the idea that the freedom to choose is a good thing. And the more choice, the better: A wide range of options brings with it many positive benefits, including the increased chance we’ll be able to get what we want, competition among vendors, and the inherent virtue of variety.
This desire is not just some arbitrary state of affairs. There is substantial evidence from the behavioral and neurosciences that we are hard-wired this way. Our brains react more positively when facing a rich set of choices, versus a limited one.
Up to a point, that is.
Indeed, there is equally compelling research suggesting that there are mental “tipping points,” after which we face the negative consequences of what some social psychologists refer to as “choice overload” . More becomes less. Accordingly, in wealthy societies we face a “paradox of choice” — we naturally crave more choice, but the more we obtain the more miserable we become.
While it may sound trivial, anyone who has tried to pick out the right flavor of jam at a supermarket knows exactly what this overload feels like. Unfortunately, while this problem applies to wide swaths of our social lives, it has been barely mentioned in the world of investments. But its profound relevance requires much more consideration .
Let’s start with a couple of facts:
The number of funds from which to choose has grown exponentially, with now upwards of 10,000 available mutual funds. Exchange-traded funds (ETFs) add another 1,000 choices to the pile.
Second, our choices are growing considerably more complicated, especially after the shock of the 2008 financial crisis and our current low-interest rate environment, in which lower-risk yield is hard to come by. Most notably, there is the stratospheric rise of hedge fund-style investments that are accessible to mom-and-pop investors.
Often referred to as “liquid alternatives,” this emerging category is expected to garner close to $1 trillion in new investments by the end of the decade. There are already hundreds of these products available. And for many fund companies, their top marketing priority in 2014 and beyond is extending their suite of alternative offerings. Long/short equity, hedged credit, merger arbitrage, global macro — these complex strategies and others can now rest in your portfolio with only a few clicks of a mouse.
But distinguishing among these countless choices has never been more difficult.
So what to do? While the challenge is thorny, here are three ways to find simplicity in a world of overwhelming choice:
1. Be proactive
Sometimes just knowing what we’re up against is half the battle. We all intuitively understand the paradox of choice, and that often more is less. Yet with investing, like other forms of consumption, there is often pleasure in the process of discovering the new, new thing and sometimes even acquiring it.
Somewhat ironically, the most foundational modern principle of building portfolios is based on the idea of owning a lot of different investments, ones that ideally have low correlations. Diversification, in a sense, is about having more. But accumulating more in the hope of finding diversification often doesn’t work.
Building the right portfolio is a demand-side challenge: it should be based on one’s particular needs and constraints. Don’t aggravate it with supply-side problems. It should not be based on what’s for sale. I don’t know how many books and shirts I’ve bought in the middle section at Costco that I’ve neither read nor worn.
2. Be skeptical
Just because something is interesting or new doesn’t mean we should pick one up.
There are now hundreds of alternative mutual funds that give access to strategies that the supposedly most sophisticated investors in the world have been using for decades.
Why shouldn’t the individual investor have access to the same strategies and solutions? Fair point. We all should.
But do hedge funds for the everyman make much sense? Maybe, but there’s no easy answer without understanding two things. First, what does the fund do? With alternatives, this is much harder to answer than with traditional long-only products. A hedged equity fund and global macro offering are wildly different, for example. Even within a Morningstar category such as “Market Neutral” there are funds with significantly different risk profiles.
Second, and more importantly, what do we need to meet our objectives? One of the hallmark features of many alternative strategies is that they have a lower correlation to traditional long-only stock and bond investments. Low correlations are what make modern portfolio theory work — they are the engine of diversification. Stocks and bonds already have a lower correlation to one another. Alternatives may buttress a portfolio further — or might just complicate an already unwieldy roster.
Another feature is downside protection. Because hedge funds hedge, most of them tend to lose less money in down markets. But for a goal that’s far in the future, such as college or retirement, why give up long-term return potential in exchange for near-term insurance?
3. Be patient
That’s right. Sit on your hands. Resist the temptation to fix what might not be broken. Of course, this is not advice to naively “set and forget” one’s investment line-up. But it pertains to not chasing the latest hot dot. And it certainly pertains to resisting selling when markets are down and buying when markets are up. Our biology and smart investing are at odds here; doing nothing sounds easy, but it’s actually quite hard.
This is a skill where arguably individual investors have an advantage over the professionals. The latter almost always feel the need to do something in order to appear in control. Everyday folks with neither the time nor inclination to trade and tinker are often better able to separate signal from noise by staying somewhat out of the fray.