Tuesday, April 27, 2010

Investor Architecture

By Dr. Jason White
Principal, Director of Investments
Family Investment Center

Investors are the true long-term architects of family wealth accumulation and preservation. They are a special breed who utilize the availability of professional investment management, and have the constitution to stay with the plan, even when it appears all is lost.

All is never lost, of course. Investors intuitively understand that a retrenchment in asset prices is the time to be aggressive, not to capitulate. Investors understand the importance of saving. Investors know that short-term moves in the market (up or down) are primarily noise, sentiment or whimsy, and have little to no bearing on the long-term value of equities and the businesses they represent.

Warren Buffett describes the stock market in the short-run as a “voting machine.” Popular sentiment, psychology and herd mentality (good or bad), can drive stock prices to amazing bubble peaks and gut-wrenching price nadirs. Neither is fundamental or real. The long run investor understands this, and remains true and loyal to his plan.

It is much easier on mind and spirit to be an investor in prosperous times, than in tumult. The scientific approach to the building of wealth, as embodied in Modern Portfolio Theory, has been proven the most reliable strategy for investors since this break-through approach captured headlines and professional interest in the 1950s. Unbelievers bounce in vain from strategy to strategy always seeking a better built mousetrap, and some succeed in the short run.

Our social makeup in the information age requires near instant gratification. Those who “play the market” move like a stampeding herd, always chasing the tail of out-performance, but never quite able to grasp it. In our own myopic and self-interested view of the world, we want to be unique and special. We believe that this time is truly different. We believe in a new normal of some sort or another.

Yet, business marches forward. Equity prices ebb and flow in the near term for many reasons: news, politics, taxes, earnings, war or tranquility. Business television will run a split-screen when a powerful person, such as President Obama or Chairman Bernanke, steps to the podium. Words are spoken, the Dow Jones vacillates, and commentators link the two together painting a picture of the short-run just as Buffett’s voting machine suggests.

The fact of the matter is that the short run is just as unpredictable as it appears. Daily volatility, a reaction in stock prices to an event or series of events, seems understandable when the experts explain how good or bad news caused a positive or negative reaction in the markets. We accept these notions because the human mind wants to longs for certainty. No investor on earth knows precisely when a bear or bull market will start and finish without benefit of hindsight.

Thus, the most prudent strategy with the highest probability of success is to stay properly diversified and invested, using the proven approach of Modern Portfolio Theory, all of the time. Attempts to time the market invariably result in disappointment. Behavioral finance observes that people logically want to buy when times are good and sell when times are bad. When implemented, this strategy results in buying the market peaks, and selling during the dips – exactly the opposite of family wealth building behavior.

Dr. Jason White is Director of Investments at Family Investment Center and an Economics, Ph.D. at Northwest Missouri State University.

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