Friday, November 2, 2012

Product Performance vs. Personal Discipline

As a financial planner, I often hear people talking about the latest investment portfolio or the latest product on the market. While product is important, I believe that the most important piece of financial security is personal discipline: how you handle your life circumstances and how you will react to inevitable market volatility.

What does this mean? Well, imagine you found a magical product that earns 10% a year. You still could have other areas that need to be taken care of, such as insurances in case of death or becoming disabled, health insurance, auto insurance and having emergency cash set aside to allow that magical 10% product to grow uninterrupted.

You’re not likely going to find a 10% rate of return in today’s market unless it's extremely risky. And if it is, you should still consider having other products in place for a rainy day, short-term cash needs, and, if you're within five years of retiring or five years into retirement, you will probably want to think about a product that will provide income and potentially balance out your losses should your more risky investments suffer from a temporary market fluctuation.

Certain historical studies have been conducted that focus specifically on investment behavior. In studies where the market has gained a percentage of rates of return over a period of time, the average investor has not fared as well.

DALBAR’s1 Quantitative Analysis of Investor Behavior shows that over a 20-year period, from 1990-2009, the S&P 500 has experienced an 8.2% rate of return (not including fees). However, they also found that over that same 20-year period, the average equity investor only earned a 3.17% rate of return. The main key to that difference is personal discipline. The study found that over the 20-year period, investors held their investments for an average of 3 years each.

Past performance may not indicate future performance, but even if there was a way to guarantee an 8.2% rate of return with no fees, you would need to have personal discipline enough to ride out the scary and troubling times that the market will inevitably have.

As my children went through the DARE anti-drug program at school, I constantly reminded them that it’s not if their friends or classmates ever use drugs but when a friend or classmate uses drugs. Now, apply that to the market. It's not if the market is volatile, but when it's volatile.

As an investor, you need to be prepared for the potential and very certain possibility that there will be a time when your hypothetical $100,000 investment drops to $60,000. Economists would argue that hopefully, over time, that investment will come back and that would be the desire of everyone involved. But, as an investor, you need to be able to say that you’re not going to look at the investment and that you will leave it alone. The optimist would say, “not only am I going to leave it alone and not look at it - I might even buy more because it's potentially undervalued at its current price.” Regardless, if you cannot practice this very necessary personal discipline, it's not market performance of the product that matters.

At Kemp & Associates, we know how difficult it can be to choose your investments wisely. For advice on managing your savings, contact us today.

"Quantitative Analysis of Investor Behavior (QAIB)" DALBAR, 2011;

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