By David Lafferty
If you're like 95% of the population, the new year brings with it a crop of resolutions -- all the things you promise either not to do or to do better in 2013. Unfortunately, if you're like many people, you've long since given up on losing weight, sticking to a budget, or spending more quality time with your kids.
So maybe this year it's time to resolve to be a better investor. In that spirit, we offer our 2013 resolutions to investors everywhere.
One, we resolve to stop chasing performance.
Investors are almost hardwired to confuse the causality between manager skill and investment performance. Over market cycles, investment acumen and a disciplined process should result in solid performance. But strong performance alone isn't necessarily evidence of investment acumen or a disciplined process. Spectacular short-term performance is more likely a product of luck, excessive risk, leverage, or overvaluation -- not investment skill. So this year, let's resolve not to fall for the flashy performance ad, the "can't miss" stock, or the unsubstantiated claim ("Gold is going to $5,000/ounce!"). Let's resolve to read the footnote: "Past performance is no guarantee of future results."
Two, we resolve to stop analyzing our investments in a vacuum.
Individual investments are used to build a diversified portfolio, so they should be evaluated in that context. An asset's risk is best measured by its contribution to risk at the portfolio level -- its standalone volatility minus its correlation effect (any diversification benefits it provides). Adding the right risky assets can actually bring down overall portfolio risk if their correlations are low enough. Let's resolve to remember this the next time we hear that high yield or emerging markets are "too risky."
Three, we resolve to stop trying to time the markets.
The future is unknown and markets are relatively efficient, but they're prone to wild swings -- a recipe for poor results if ever there was one. Within a broadly diversified portfolio, we can certainly overweight cheap assets and underweight expensive ones. But jumping from asset to asset hoping to get it right is a tall order, even for professional managers with nearly unlimited access to market data and research. Our own chances for successful market timing are even slimmer.
Four, we resolve to stop thinking of asset classes as "good" or "bad."
There are cheap assets and there are pricy assets, but that doesn't make them good or bad. The so-called bad assets -- with limited upside and high volatility -- will eventually be shunned by investors, causing their prices to fall and their expected future returns to rise. Likewise, the so-called good assets -- with lots of upside at reasonable risk levels -- are likely to be in high demand, driving their prices up and their expected returns down. Markets are dynamic and generally self-correcting, so every dog has its day.
Five, we resolve to leave our emotions out of our investment decisions.
We will not regard euphoric rallies as de facto confirmation of our investing brilliance. Nor will we reflexively sell into falling markets as if the Mayans were right. Our asset allocation should entail only the level of downside risk (the potential for loss) that we can actually stomach. Putting our risk tolerance first, ahead of our return objectives, is one way to minimize our impulses to buy high and sell low.
Finally, we all know how it is with resolutions -- easy to declare and hard to follow. But they're also a statement of our best intentions. Resolving to become a better investor in 2013 is a good place to start.