An advisor once said he did not so much have people with investment problems as he had investments with people problems. Your assumed rationality can vanish in a crisis. So why not build your human imperfections into your game plan? When unsettling news is breaking there’s a natural inclination among people to want to adjust their portfolios in response. When uncertainty looms larger than before and volatility spikes, investors can feel tempted to tinker with the plan designed for them.
So it makes sense to build into any long-term investment plan a virtual firedrill that seeks to minimise the chances of making impulsive changes or allowing your in-built “fight-or-flight” response to take charge in the face of external, uncontrollable events.
A geopolitical catastrophe, a financial crisis or just a routine market movement are all times when the urge to act can be hard to ignore. Nobel laureate Daniel Kahneman called this type of thinking ‘System 1’—an automatic fight-or-flight response to a stimulus.1
This is contrast to what Kahneman calls ‘System 2’ thinking—a type of effortful reflection that involves individuals carefully weighing options and making deliberative choices. This latter approach is less about instinct and more about executive control.
You can guess which system is dominant at times of perceived danger. We have a natural urge to protect our wealth. The big question is whether instinctive, emotionally driven reactions are the best way of achieving that.
Listen to Australian Football League coach Paul Roos, who took the Sydney Swans club to a premiership in 2005 and another grand final a year later. He tells his players to stop looking at the scoreboard and stick to the plan agreed upon before the opening whistle.
“I tell them the scoreboard will look after itself,” Roos told a public forum in Melbourne recently. “What the players have to do is focus on all the little things they can control. So my message to them is to trust each other and stick to our game plan. That way, we maximise the chance of getting a good result.”
Naturally, there are times in the game when the unexpected can happen. The team can be penalised; a key player may get injured and have to leave the field; the weather can change. But a good coach builds these eventualities into the pre-agreed game plan.
“Sport is an emotional business. There are always going to eventualities you didn’t plan for,” Roos says. “So the coach’s job is to take the noise and emotion out of the process as much as possible and to stay focused on getting the little things right.”
This is uncannily similar to the role of a financial advisor with a client’s long-term investment plan. Markets naturally will go up and markets will go down. News—by definition events that are novel, unexpected and dramatic—will occur along the way.
But a good financial game plan is one that uses design, diversification and discipline to maximise the chances of investors getting to their desired destinations whatever may occur.
It goes without saying that we need to start with a sound design. In football, that might mean understanding the factors that drive success on the sporting field, identifying the controllable and non-controllable variables and building a sound process for victory.
In investment, it means identifying what drives return over the long term and then using the information in prices to build portfolios that emphasise the dimensions of higher expected returns across all asset classes.
The second element is diversification. This is about eliminating unnecessary risks. Think about the football team that pins its success on the uncanny abilities of one or two star players. What happens if one or both of them are injured?
Likewise, a highly diversified portfolio is one that seeks to minimise the guesswork of investing and improves the reliability of outcomes. That means diversifying across securities, across industries and across countries.
Third, we need discipline. Like any good football coach, Paul Roos admits it is unrealistic to win every game. But he says that doesn’t mean he shouldn’t build a team culture that expects to win every time by doing all the things within its control to get there.
“Success is not defined by the outcome of every game day, but what we learn from our losses, the culture we develop and how we progress from season to season,” he says.
In investment, it’s a similar story. Returns are inherently volatile and will not always go your way. So it’s critical you adopt an approach that you can live with when markets are turbulent. A skilled advisor can show you how you can use the factors within your control to both stay on target and smooth out the bumps along the way.
When the unexpected occurs, there is a pre-agreed response. When circumstances change, there is a process to follow. You can never totally eliminate doubt and uncertainty, but you can build a structure that is resilient, that gives you flexibility and that increases the odds of getting you to where you want to go.
That is a systematic approach. That is a disciplined approach. And that is a game plan.
Outside the Flags
Dimensional Fund Advisers
1. ‘Thinking Fast and Slow’; Daniel Kahneman; Farrar, Straus and Giroux; 2011
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