Alex Krawtschenko B.Eng., MBA &
John Brown
Toronto, ON

It's not exactly the formula for success in the capital markets; however, many Canadian investors do just that. Why? Because we are human, with all of the psychological traits that come with being human, and that is the greatest obstacle to becoming a successful investor.  

"We have met the enemy, it is us."
- Pogo

The human qualities that have enabled us to survive in the animal kingdom cause us to fail in the investment world. The one that is most damaging is overconfidence. Overconfidence is the one barrier that must be overcome in order to be successful with your investments. There's just one problem, even if I can sell you on the notion that overconfidence is quite common and needs to be eliminated, there is a strong chance that you'll think that it's really not a problem for you. In fact, it might even make you overly confident that you are immune from it.

Consider these amusing examples of overconfidence in our society:

• 82% of U.S. drivers consider themselves to be in the top 30% of their group in terms of safety
  
• 81% of new business owners felt they had an excellent chance of their businesses succeeding. When asked about the success of their peers, the answer was only 39%. (Now that's overconfidence!!!)
  

In terms of financial decision-making, overconfidence appears in the form of unrealistically high appraisals of our abilities to a) time the market or to b) select superior stocks, bonds, or mutual funds which I can assure you will sooner or later result in dismal returns or at the very extreme, bankruptcy. Even if you were an excellent market timer, the odds are still stacked against you.

Look at Table 1 to see the results of not being in the market during the best trading days.

Source: Ibboston Associates and Sanford Bernstein & Co.
The S&P500 delivered a 10.30% annualized return from 1989 - 1994. If you were out of the market on the best 10 trading days, your return would have been reduced by 6.02%. You would have broken even if you missed the best 20 days.

Here is the challenge of market timing. In the short-term, the market moves in a random manner. Why? Because the market reacts to news and other sources of information extremely quickly. Since we cannot predict the news, then we cannot predict the movement of the market in the short-term.

What About Our Abilities to Select Superior Stocks, Bonds, Mutual Funds and Other Investment Vehicles?
A study performed by Dalbar Inc. shows that over the past 10 years, Canadian investors underperformed the TSE 300 index by 4.3% on average per year, and underperformed the MSCI World Index by 8.2% on average per year. The study revealed that the single largest reason why investors under perform in the equity markets is by buying high and selling low. Investors remove money from securities and mutual funds that perform poorly over the short-term to invest in a different security or mutual fund that has done well in the short-term. By chasing the "hot investments", Canadian investors actually earned returns that were far less than what the various markets had to offer. Dalbar concluded,

"…investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who practice a buy-and-hold strategy earn higher real investment returns than those who attempt to time the market."

So we know that market timing doesn't work, and neither does chasing the "hot investments". But buy-and-hold seems to have some success.

So What Do We Buy and Hold?
A landmark study completed by, Brinson, Beebower and Singer, which was published in the Financial Analysts Journal in May 1999, comparing the performance and composition of the portfolios of many pension fund managers concluded that over 90% of the difference in portfolio returns was determined by asset allocation alone. Security selection and market timing played a very minor role.

What this means is that your asset mix, i.e. equities, bonds, and cash, ultimately determines the performance of your portfolio. And by combining the various asset classes in an efficient manner, you can influence (or control) the riskiness (or volatility) of your portfolio.

Risk and Return Go Hand In Hand
There is no free lunch in the capital markets. You cannot expect high returns without taking on some risk. However, you should only accept risk that the market will reward. Any additional risk should be avoided.

We are all individuals and we all have different risk tolerances. How much risk are you willing to take? There is big difference between what your logical side can take and what your emotional side can take. Unfortunately there is another psychological trait that we humans possess called Risk Aversion Myopia, which is an overemphasis on the possibility of short-term loss. During our caveman days, the ability to focus on the risks of the moment enabled us to improve our chances of survival but it has little value in our modern day society and really hampers our ability to make sound financial decisions.

An Investment Policy Statement Will Help You Avoid Any Irrational Behavior
An Investment Policy Statement (IPS) is like a financial road map. It will give you a long-term strategy that you can rely on when you start to feel a little queasy every time the market drops below your comfort zone. Now I stated earlier that we all have different tolerances to risk. The best way to find out just how much volatility you are able to stomach is through a risk tolerance questionnaire that is designed by behavioral finance specialists. If you would like to complete one, you can e-mail me and I will send you one.

After you have assessed your appetite for risk, you then need to determine your unique financial needs. You should identify your:

a. Income requirements
b. Liquidity requirements
c. Capital preservation needs
d. Investment time horizon
e. Investment return requirements

After this information is compiled, you will be able to design your individual investment policy. The money can then be invested to reflect your individual tolerance for risk and unique short-term and long-term financial needs. The portfolio should be rebalanced periodically to ensure that the asset mix stays consistent (which affects the volatility of the portfolio).

If you don't currently work with a financial advisor that uses Investment Policy Statements as an integral part of his investment practice, then I strongly encourage you to find one. After all, without a roadmap, you are likely to end up just about anywhere!!!

Alex Krawtschenko specializes in helping business owners and professionals make better financial decisions by integrating behavioral finance with investment theory. He can be reached at (416) 712-9717 or This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

John Brown has been in the life insurance and financial planning business for 31 years. He specializes in Long Range Estate, and Retirement Planning for Professionals and Entrepreneurs with a view to minimizing tax paid on assets and income during lifetime and Generational transfers. He can be reached at (800) 927-5288 or This e-mail address is being protected from spambots. You need JavaScript enabled to view it .