It’s a savings plan!

In Free by Cam Hui

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In the past several weeks, I have been seeing rising levels of angst in social media as the stock market tanked. While anxiety is certainly appropriate for traders, this kind of volatility shouldn’t be a concern for investors as long as they have a plan.

Learning to redefine your objectives

Here is what I mean by having a plan. In a past post (see The ABCs of financial planning), I outlined an idealized cash flow projection for a young couple with a child, with the black bars representing savings and red bars representing withdrawals from their savings.

An idealized savings plan

 

If this hypothetical couple has their portfolio structured properly and their cash flow objectives are met, why should they care if the stock market corrects by 10% if their long-term objectives are satisfied?

Don’t fight the last war

Ben Carlson at A Wealth of Common Sense wrote a terrific piece about how even endowment funds, which have a perpetual time horizon, can get gripped by short-termism. He went on to outline the problems of over-reacting to short-term market fluctuations with long-term assets:

  • You constantly change your strategy and chase past performance.
  • You ignore any semblance of a long-term plan.
  • You end up being reactive instead of pro-active with your decisions.
  • You incur higher fees from increased trading, due diligence and switching costs.
  • You lose sight of your actual goals and time horizon.
  • You end up with a portfolio that’s built to withstand the last war, not the next one.
  • You lose out on much of the long-term benefits that come from diversification, rebalancing and mean reversion.
The worst sin of over-reacting to market moves is not just the problem of chasing past performance and incurring excessive fees, it’s the syndrome of fighting the last war. In the last war in 2008, the critical failure was diversification. Bond prices did not react as expected and they went down along with stock prices. Consequently, it was not unusual to see well-constructed balanced portfolios down 20% in the crisis.

I have tried to address those issues by working on market timing, otherwise known as dynamic asset allocation techniques (see Building the ultimate market timing model), as a way of mitigating those effects. But make no mistake, my models do not represent the Holy Grail and these kinds of strategies should only be part of a well-balanced portfolio.I have always considered the term “investment plan” to be a misnomer and overly confusing. It`s not an “investment plan”, but a “savings plan”. Learn to re-define your objectives as meeting your cash flows. Learn to trust the power of the market. Then relax.

The philosophy of this site can be summarized by a variation of an old adage:

Give a man a fish, he’ll eat for a day.
Teach a man how to fish…he’ll want to get a boat.

I am not here to just give my readers a fish for the day, I would rather help them build their own boat.

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