Lummer's Logic

Investing Discipline and Other Life-Threatening Philosophies

By Scott Lummer
401k Forum Chief Investment Officer

The questions go something like this:

I currently have 40% of my 401(k) plan allocated to the "Yesterday's News Fund." However, it has been performing poorly lately. I am considering pulling my money out of this fund and putting it the "Johnny-Come-Lately Fund." What do you think? By the way, I think your column is the best thing on the net, and your boss should give you a really big raise.

(Okay, so I embellished a little).

First of all - I apologize to all of you who ask very specific questions. We do not give explicit investment recommendations on the 401Kafý. Our parent company, mPower, does give investment advice, but only if your employer has registered for our service.

But I would like to share with you the principles behind our investment advice, which may help you make better investment decisions.

Asset Allocation Beats Out Stock Selection

In general, when a fund has poor performance, it's usually because the asset type in which the fund invests has declined, and not because of poor individual stock selection. For example, many small-cap growth funds declined last week, but this had nothing to do with the analytical abilities of the fund managers.

Small-company growth stocks in general declined, so there was no avoiding a loss for a consistent small-cap growth-fund manager loyal to style discipline. Now, there are exceptions, which you can read about in my previous column, "Bow Wow - Is Your Fund A Dog?".

Most of the time when a fund loses money, your complaint is not with the fund's manager, but with the type of fund you chose.

Stay in for the Long Haul

For example, in January and February most large-cap funds dropped in value. Many of you wrote me asking whether you should dump your large-company investments. Then last month, most small-cap growth funds were down (and large-company funds were up), and many of you wondered whether to bail on those funds. The answer I (and most investment advisors) gave, was "no" on both fronts.

The reason is that investing discipline is a key determinant of helping good long-term investment performance. Pulling your money out after a downturn locks in your losses, and creates a "buy high, sell low"-policy mentality that, of course, hurts you in the long run. mPower has been delivering investment advice since 1997, and since then we've seen several market downturns, as early as October 1997 and as recently as a month ago. Still, we continually advocate that investors stay the course and ride out the inevitable downturns.

If investment discipline is such an important principle, and it is validated by actual market results, then why is it so tempting to not follow it? Because investing is unlike almost every other facet of our existence.

Practice Anti-drama Investing

In many events that occur in life, quick reaction is useful, if not essential. Right now, I am flying from New York to San Francisco (do you think I would be writing this column if I had a better alternative than watching James Bond in "The World is Not Enough" for the eighth time?). If the plane should suddenly lose 20% of its altitude, I would hope that the pilot would not follow a buy-and-hold strategy. What works in investing is not always advisable in the rest of our endeavors.

That example is dramatic, but the point is to not be dramatic when it comes to investing. This is hard, because when the oil pressure gauge in your car starts to drop, or your child is running at full speed toward a recently waxed floor, you don't simply assume that events will reverse themselves. So why is investing different?

Because capital markets are not a natural creation. Stock prices do not follow the laws of physics or engineering, they follow the laws of economics. And the economic principle that guides capital market values is that prices do not proceed along a set trend, unlike gravity or a speeding four-year old. After a periodic rise (or decline), stock prices are as likely to reverse course as they are to follow the same path.

So that explains why maintaining consistency in the face of a volatile market seems a bit unnatural. Overreaction based on a reflex response to market swings leads to a policy of buying at the highs and selling at the lows. In the long run, you will be very dissatisfied with this investment strategy's results. In investing, it is better to be less responsive to the events around you than to react excessively.

This analysis also explains one other occurrence - why investment advisors lead such dysfunctional lives. But I don't have time to elaborate, the James Bond film is over and the second movie is starting. "Galaxy Quest" - now that's entertainment!

Lummer's Logic Archives 

Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment Officer, is a recognized expert in the investment field. He has conducted extensive research on asset allocation, international investing, risk management, mutual fund analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook.