Hitting the right notes with your investment strategy

Posted by on August 21, 2009 @ 9:47 am in Investing

For 35 years I’ve carried a quotation in my wallet. More precisely, I’ve moved the quotation, clipped from a now-defunct newspaper, from wallet to wallet to wallet over the decades.

The quotation is from Willa Cather’s “O Pioneers”:

“There are only two or three human stories, and they go on repeating themselves as fiercely as if they had never happened before; like the larks in this country, that have been singing the same five notes over for thousands of years.”

Willa Cather is one of my favorite novelists. But that’s not why I’ve kept the quotation all this time. For years, it has been a reminder to me to keep things simple. And I’ve long thought that it applies to investing: To be successful as an investor, I think there are only a few notes you have to hit, and only a few things to avoid. (I define “successful” as reaching your long-term financial goals.)

The first thing you have to do, of course, is to spend less than you earn, so that you have something to save and invest in the first place.

At the top of the list of things to avoid, I’d put “chasing performance.” So I was happy to see this cautionary piece on our website. It uses emerging-market stocks as its poster child for asset classes where reacting to recent performance is likely to be harmful. And when you look at flows of money into and out of emerging-market funds, you can see why.

Emerging Markets-cash flow chases returns

I’m certainly not arguing against investments in emerging-market stocks. They provide exposure to some fast-growing markets and can make sense as a diversifying element in a portfolio. I personally hold shares in an emerging-market index fund. But these stocks can give you some roller-coaster rides, as they’ve historically been even more volatile than stocks from the United States or other developed markets. The problem is that it seems many investors get on or off the roller coaster at inopportune times.

For example, in 2007, when the MSCI Emerging Markets Index returned nearly 40%, aggregate net cash flow for emerging-market funds was $16.4 billion. Then emerging-market stocks (and stocks in general) began to fall: The index fell nearly 12% in the first half of 2008, en route to a full-year total return of -52.8%. Cash flow during the last half of 2008? A negative $10.3 billion in that six-month period. Cash continued to flow out of emerging- market funds through March 2009—just as global stock markets began to rebound. The Emerging Markets Index gained 56% from the end of February through June, and cash flows turned positive in April.

Cash flows in any given year are only a fraction of the total that investors have committed to emerging-markets stock funds. And it’s true that aggregate cash flows mask the actions of specific investors. Clearly, not everyone was engaged in buying high and selling low.

But it is unfortunate that investors, collectively, were pouring money into the funds near their peaks, and pulling money out at (for now at least) the low points. To the extent that investors were reacting to the markets—on the upside and downside—their collective timing stank.

I have no clue what returns emerging-market stocks will provide next week, next month, or next year. I don’t think anyone else knows, either.

Given the uncertainty of markets and the dismal track records of most investors who try to time the markets, a sensible way to avoid mistakes in timing is not to do it. Figure out what allocation—if any—you want in emerging-market stocks or other asset classes. Then rebalance your holdings to get at or near your target percentages. Rebalance either on a set schedule (yearly, semiannually, or whatever) or when market movements push your allocation away from its target by more than a few percentage points.

It’s a simple approach, but I concede that being simple doesn’t make it easy. Our emotions—the basis for those few “human stories” that repeat throughout history—tend to lead us astray. It isn’t easy to add money to an asset class that has fallen by 30% or 40% or 50% or more. And when something is performing well—as emerging-market stocks have so far this year—it can be hard to move money from that asset class toward one that has been slumping. But I know of no better way to avoid the pitfall of mistiming investments.

Notes:

• Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

• All investments are subject to risks. International investing involves additional risks, including currency fluctuations and the potential for adverse developments in specific countries or regions. Investments in emerging markets are generally more risky than those in developed countries.

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