Critical Investment Lessons from Japan

At the end of each quarter, I send clients a letter summarizing events of the past three months. For this quarter’s letter, I wanted to highlight two important lessons for investors. Both were made tragically apparent by the recent events in Japan. One is the need to construct portfolios that expect the unexpected. And the other is to avoid one of the costliest traps that entangle investors.

Market performance Q1 

Markets in January and February continued 2010’s positive sentiment; Due in part to solid corporate profits and a broad consensus that growth would continue.

March began with a setback. The earthquake and tsunami in Japan on March 11 clearly reduced short-term positives for the global economy; additionally we had turmoil in North Africa. By the end of March, however, positive economic growth reports in the US and Europe allowed most markets to recover their initial losses. 

                SP500      EFA Intl         Japan            Emerging

Q1 ’11:   +4.3%         +2.6%            -4.5%              +2.1%

 Learning to live with uncertainty

Market analysts spend many thousands of hours each year on many types of “Global Macro Issues” (oil, economic growth, China slowdown, etc). What can’t be anticipated are developments that are by their nature unpredictable.  We’ve had at least three such events in the past year:

• April 2010, the explosion of the oil rig in the Gulf of Mexico;
• Protests resulting in changes of leadership in North Africa (Libya);
• Of course the, earthquake, tsunami and nuclear-reactor crises in Japan.

 In light of episodes like these, investors need to take away two key lessons.

Lesson one: Expect the unexpected

The only way to deal with uncertainty and manage the impact of unforeseen events is to build strict risk controls into portfolios, similar to those used by the most sophisticated pension funds. While the risk of one-time incidents can’t be eliminated, through diversification and risk management we can limit the damage when negative events occur.

Here’s an overview of my approach to risk management in portfolio construction. There are three steps in this process.

1.  Identify target allocation
2.  Diversify across asset classes
3.  Dynamic Risk Controls

The most important is the final step; we overlay what we call “Dynamic Risk Controls”. Pre-defined levels for each asset class (large, small, international, etc) when we will begin to take money out of the market / asset class (Dollar-cost-average “Out” of the market – the opposite of Dollar-Cost-Average “into” the market). We also have pre-defined levels when the odds are in our favor to re-invest (Dollar-cost-average back “in”).

As I’ve mentioned several times before, the market has 3-4 correction of +5% each year & one correction of +10% per year: that’s the definition of a “normal” market. So, The idea here is we’re taking the emotion out of the decision – by determining the variables in advance – we already have a plan in place when / if things go bad & we have a plan in place in advance when things begin to improve.  One of our assets is the knowledge & discipline to put a plan in place (in advance) & stick to it through tough times.

Lesson two: Avoid overconfidence

Aside from the time entailed, there is one big negative to the risk-controlled approach to portfolio construction – in the short and mid-term, there will always be someone who’s made a “big bet” that’s hit the jackpot and who is doing better than you as a result. Because our strategy eliminates big bets, a risk-controlled approach to investing will seldom give you bragging rights on the golf course.

Investors who take the big-bet approach typically have a high degree of “confidence” in their investments; after all, if you’re absolutely certain about a company or industry, why bother to diversify? On the other hand, research by the University of Chicago’s Richard Thaler and others has demonstrated that “overconfidence” is among the most costly traits an investor can have.

Think no further than the last two bubbles – the Tech bubble & the Real estate bubble. Everyone was 100% confident Tech would go up forever; that Real estate prices “always” moved higher.

What gets us in trouble aren’t the things we’ve identified as causes for concern. Rather, portfolios crumble because of the things that we’re “absolutely positive” about – right until they catch us by surprise.

We’ve always had unexpected events and always will – and despite these, economies have grown, companies have prospered and stock markets have generated positive returns. The key to benefiting from this long-term growth has been to diversify so that no single event can create permanent damage to portfolios.

When it comes to long-term investing, it’s not only that a slow and steady approach wins the race, but more importantly slow and steady survives to cross the finish line ( I sometimes call it “win-by-not-loosing approach: it’s the big losses that do the most damage to portfolios).

We will work through the recent events– and investors with a balanced approach and a long-term view will be well rewarded. The approach to risk management I’ve described may not be fun or sexy in the short term, but all the evidence at hand suggests that over time it will serve you well. Why not get you to your goal with the least amount of stress & volatility along the way.

Should you have any questions in the meantime on your portfolio, the contents of this note or any other issue, please give me a call – I’d be happy to help in any way that I can.