Individual investors are often plagued with too much information, too much opinion and time horizons that are too short. The bombardment of information can often lead investors to make unwise or rash decisions, sometimes without sufficient justification. We refer to this as "sound bite" investing.
Perhaps the most important challenge an investor faces-especially in this era of continuous and often conflicting investment noise-is to construct a portfolio that achieves his specific and attainable goals and offers the highest level of return with the most reasonable level of risk.
This is more important than asking whether the market will rise or fall over the rest of the year or how it will be moved by a new occupant of the White House.
The first question I would pose to investors is, "What do the markets have to do with your individual goals?" The second question would be, "What markets are you actually referencing?" Wall Street, unfortunately, mainly uses market indices for measuring market performance ex post facto and benchmarks how well investors are faring against the market's random walk. It is our contention that investors care too much about whether the market is trading up or down in a given day, month or year without relating that information back to their financial goals.
Instead, investors must answer questions about their risk tolerance, spending needs and sources and levels of income. The answers to these questions help the advisor decide between dialing up the portfolio's risk level to meet an expected shortfall between spending and income or dialing it down because income sources are sufficient to keep up with spending and inflation. The need to get at these answers is especially important in the case of high-net-worth investors, who are often treated as institutional investors rather than individuals with particular needs and goals.
Most investors skip this first step and move directly to building portfolios that are designed to outperform some market index. For example, portfolio manager X has outperformed the S&P 500 for the past five years and therefore has a large following and a growing investor base. He is on television frequently offering his opinion on which stocks will likely outperform the market. By skipping the first step and going directly to the second, the investor may end up hiring an excellent manager who can beat the market. But his portfolio might not have the characteristics he needs to achieve his goal.
Let's assume this investor requires a 5% real rate of return over the next five years. Burton G. Malkiel, author of A Random Walk Down Wall Street, makes the argument that financial markets move arbitrarily and it is futile to try to outperform them on a consistent basis. Taking this concept one step forward, why would an investor attempt to use the equity market as a financial instrument to achieve a real return of 5% over five years when the return profile for the equity market is random? In other words, investors are prone to make large mistakes if they don't understand their investment goals.
Similarly, the daily drone of market pundits tends to shorten investor time horizons from a long-term perspective to one that is very short-term. Financial reporters are constantly searching for reasons why markets are performing in a particular way on any given day. This provides little insight or basis for long-term investment decisions. The noise in the financial media provides plenty of content about company performance but little in the way of useful strategic advice, or views about sound investing or changing market relationships.
Economic data provides us with backward-looking information only, which is not particularly useful when we're trying to understand broad economic trends. Take for example the GDP report for the second quarter of 2008 that came in at 3.3% after being revised from 1.9%-a figure that had already been revised from an original estimate of 0.6%. The original estimate ratcheted up the chatter about the U.S. being in a recession. Yet we know that U.S. and global recessions are common and short-lived, and expansions are normal and generally long-lived. This information is rarely given, yet it would arm investors with the understanding that an economic expansion comes with market dislocations that can be taken advantage of in a long-term investment portfolio.
Take, for instance, the current market for corporate bonds, particularly high-yield bonds and distressed mortgage-related debt. When high-yield spreads are approximately 850 basis points over the comparable Treasury benchmark, it reflects a sharp increase in defaults, as was the case during the 2000-2002 recession. The credit cycle ended poorly during that period because of excessively leveraged balance sheets. In today's environment, however, non-financial-company balance sheets are not overly leveraged, even though the market is assuming all balance sheets are. The market is creating a strategic opportunity by penalizing all corporate borrowers.