Arun Abey: Keeping your eyes on the far horizon

Opinion

One of the most important lessons we can take from the credit crisis is that of resilience and the importance of maintaining a long-term perspective. An investor who has been strong on resilience in the current market will likely begin realising the gains, over time, that make the rest of us wonder how it is done.

Resilience is a willingness to weather the difficulties of market risk and to hold firm when short-term returns fall in response. It is an expectation that a protracted slump in a share's price, or in the economy, does not spell disaster, or necessarily a reason to sell.

SHORT-TERM RETURNS CAN MAKE US CRAZY

Why do short-term returns from investments have such a profound impact on people's decisions? Why can't such returns be used to make good investment decisions? And how can you know if something has gone wrong in your portfolio - or indeed if something is going blissfully right - if recent returns do not tell you?

The most obvious reason why share portfolio returns measured over short periods have such an influence on investor behaviour is volatility. Even for investors who accept that volatility is inevitable when taking on growth assets, this can be emotionally unsettling.

Imagine that you have never flown in a plane. On your first flight you have been warned to expect turbulence but told that aircraft can withstand much more than they normally encounter. However, when the bumps begin, your mind starts racing. Is this normal? What is causing it? How do I know it will end? Is something wrong?

The experience of investing in a share-based portfolio can be similar to that of your first flight. You may know rationally that, statistically, the odds are heavily stacked in your favour, but that does not necessarily stop you from being nervous. The most important behavioural attribute in your armoury is to keep perspective during these turbulent periods.

WHY SHORT-TERM SHARE VALUES OFFER SUCH A BUMPY RIDE

Share values jump around because they reflect background market "noise", rather then continuing long-term trends that create wealth. The shorter the evaluation period, the more noise there is in price and performance, making it less meaningful.

Moreover, studies show that investors who continually react to and make investment decisions based on short-term market noise do not do as well as people who watch their investments less frequently.

WHY INVESTORS FOLLOW WINNERS AND END UP LOSERS

The simple explanation for this is that investors apply rules of thumb in order to make sense of complex situations. One of the most common of these is to use the price of an asset as an indication of its quality - in other words, to view the most highly priced investment as the best. To see why this is so, let us consider the simple example of buying a shirt at the local department store. Most people know the difference between a well-made shirt and one of inferior quality, so when quality shirts are on sale, it makes sense to buy more. That is why there is an influx of consumers at post-Christmas sales.

However, in the sharemarket, exactly the opposite behaviour takes place. Investors avoid those shares or funds where the price has fallen - those that are effectively "on sale" - and snap up those where the price (or performance in the case of a managed fund) has recently risen.

This is because, in contrast to a shirt, it is much harder to work out whether a company is of superior quality of not.

Consequently, investors sometimes apply a simple mental shortcut: they use price to evaluate quality.

If the price (past return) is high, it must be a good investment. If the price is low, it must be inferior, they tell themselves. This leads to the obvious outcome: investors buy the most highly priced investments with the least potential for future price rises.

Thus, investors actually buy more quality "shirts" when the price goes up than they do when they are "on sale".

HOW CAN WE RESPOND?

There are some practical strategies that can be applied by investors to maintain perspective.

* Have a plan that takes into account your real time-horizon for investing, not your evaluation period. Stick to your plan.

When it comes to investing money, there are various ways to allocate funds. For example, one way is to allocate your money to different pools, each with a different time period, depending on your cash needs at various times.

With this approach, spending needs for the next two years, for example, may be quarantined in a savings account. If you are planning for retirement and have no immediate spending needs because you are still earning, this would most likely see most of your money allocated to growth-oriented funds, with a significant share allocation.

* Check your fund returns regularly, but maintain perspective.

While frequent monitoring of fund returns can lead to overly conservative portfolios and poor investment decisions, it is unrealistic and unwise to "set and forget" for the long term. What matters is not so much the fact that investors check the numbers on their statement each quarter, but rather, how they respond to them.

Look behind the numbers in a report to the real drivers of performance using a sound investment framework based on principles such as quality, value, diversity and time. Portfolios based on these principles sometimes deliver lower returns for a period, but rarely result in permanent capital loss and have been a more reliable long-term payoff.

Most fund managers provide the qualitative context for their performance, enabling us to assess the true drivers of returns, although some may need prompting to provide the next layer of data, such as major fund holdings.

* Past returns are a poor guide to the future.

Studies have consistently shown that past returns, even where a long track record exists, are typically a poor guide to future returns. In fact, most studies show that investors would be better off with the fund that delivered the lowest return in the past, rather than the highest.

* Take advantage of dollar cost averaging (DCA). This is one strategy for helping to balance market fluctuations and risk. DCA can help provide a more comfortable entry point into growth assets during times of uncertainty and volatility.

DCA acknowledges that markets fluctuate in value and, by making investments in multiple stages or tranches, it averages out the entry price. What's more, if markets actually fall once you have commenced investing, you have the satisfaction of knowing that your subsequent investments are buying more assets for you due to the cheaper prices on offer.

DCA will not always produce a gain during a down market. What DCA should do is limit the initial extent of the downside by allowing the investor to buy more assets when the price is low.

In the event of markets rising rather than falling after the first investment is made, by delaying complete entry into the markets, DCA will actually produce a lower return than if the investor had just invested all of their money on day one. To many investors though, the prospect of a lower positive return in year one is an acceptable cost when compared to suffering a big fall in the first year if markets were to turn down.

Armed with the strategies above, you will be well placed to improve your investment returns and counter the distractions of market noise.

Arun Abey is executive chairman of financial planning firm ipac, head of strategy for AXA in the Asia Pacific and a director of the Spicers Portfolio Management advisory board. He is also the author of How Much is Enough? www.howmuchisenough.net