The Psychology of Change

“You're not the only one
With mixed emotions
You're not the only ship
Adrift on this ocean”
(Mixed Emotions, The Rolling Stones)

“Why would you NOT invest with Cedarwinds?”

Background

Before we get to the point of asking the above question, we summarize our investment story by highlighting the six key advantages our model index fund portfolios offer to all investors committed to achieving long-term investment success.   These key advantages include:

• strategic asset allocation providing global diversification across major asset classes
• exclusive access to best-in-class index funds
• predictability of risk-correlated returns over time
• disciplined process that appropriately matches expected portfolio performance with investor risk tolerance
• superior investment returns compared to weighted benchmarks
• very low costs

If we have done an effective job explaining our story, the logic of our investment approach is irrefutable and the decision to join our program becomes a mandate. However, in some cases we get reactions that warrant more thoughtful review and analysis.  These responses, and our commentary, can be generally grouped as follows:

Response: “I like your investment approach and understand the benefits but want to think about it.”

Comment: This category of response is the basic grist for the behavioral finance theorists.  The central issue here is identifying what really motivates people to change.  This is the vast ocean of mixed emotions and behavioral traits that most investors are struggling to navigate.

Let’s make a few simple assumptions here.  First, let’s assume that investors accept the fact that active management is a losing strategy compared to a comparable index fund approach.  There is a mountain of hard evidence supporting this fact, with over 200 research papers validating this conclusion.  Second, let’s assume that investors understand the effect of negative compounding on portfolio values caused by the high fees and tax inefficiencies associated with active management.  This has been well documented in the trade journals and by the SEC.  Finally, let’s assume that investors accept that a buy and hold, globally diversified portfolio offers the benefit of reduced risk as measured by performance volatility compared to more concentrated portfolios.  Again, the research incontestably supports this. Shouldn’t investors run as fast as they can from brokers and advisors who do not share these beliefs?

The fact that this does not happen despite the overwhelming evidence can be explained by a number of behavioral dynamics:

• Status quo bias – Also known as the principle of investment inertia, this theory reflects the tendency for investors to base their decisions on the past and do nothing when action is actually warranted.  This behavior represents a form of avoidance and denial.  Even if circumstances have changed significantly, such as a large drop in a portfolio’s value, status quo bias prevents people from rationally adjusting and moving as a result of recent events.
• Buyer/seller remorse – This is the emotional “what if” trap. What if the current market cycle is about to turn?  What if I’m changing just before my portfolio turns around?  What if my manager finally gets his act together?  What if I haven’t given my manager enough time?
• Event imaging – People generally become traumatized with the prospect of “event risk.”   This phenomenon has gained credence in the aftermath of 9/11. It is also the result of media fed anxiety whereupon predictions of economic or human cataclysms, such as oil price shocks or terrorist attacks, infect investors’ imaginations and create a deer-in-the-headlights reaction to change.
• Framing – An example of this tendency would be  investors acting far too conservatively with their capital when their decisions are framed entirely around the idea of loss avoidance.
• Delay and Procrastination – The power of this form of indecision is particularly evident when individuals are locked into short-term thinking, completely absorbed by the daily events of life.  Taking the time to reflect on the longer-term consequences of making prudent investment portfolio decisions does not hit their radar screens.
• The “Cobbler’s Syndrome” – This category is related to the delay and procrastination phenomenon.  It typically involves high-achieving professionals who ignore their own personal financial welfare because they are simply  too busy helping others.

The bottom line with these various behavioral dynamics is that investors are penalized by failing to make the decisions required to optimize their long-term best interests.  We frequently hear the lament from investors who really do know better: “I am running out of time.” They appreciate  the benefits of strategic asset allocation and the importance of low investment costs. They also understand that postponing decisions to improve their chances for investment success hurts their cause.  We try to gently nudge this group from the thinking stage to the acting stage.

Response: “I wouldn’t want poor investment performance to ruin our personal relationship.”

Comment: Unlike active management strategies, our approach means never having to make excuses or apologize about performance. There are two key reasons for this.  First, it assumes that client objectives and expectations have been realistically established.  Second, it assumes we are effectively managing these based on our longer-term buy/hold/rebalance investment strategy.  As long as investors eschew market timing and stock picking strategies, we are confident that our structured index fund approach provides the best opportunity for investment success. Clearly, the markets will go down over certain periods and be volatile in others.  However, because our strategy exposes client assets to a proven, strategic mix of asset classes with long histories of favorable risk/return characteristics, we never need to apologize for portfolio performance.  In effect, our diversified portfolios are the markets.  Since the markets tend to go up over time and because our diversified, low cost approach represents the most efficient way to access broad market exposure, we can always feel good about the value we offer to our clients.

Response: “I have a longstanding relationship with my current broker/investment advisor.”

Comment: The most enduring relationships are built on feelings of trust and confidence. This is particularly important when it comes to financial relationships.  There are many excellent practitioners in the industry who continue to earn and deserve the loyalty of their clients.  However, we counsel that there is an important distinction between a relationship built on familiarity, tradition or friendship compared to one which is based on performance, value and results.  When it comes to building long term financial security, there is often a steep price paid for loyalty and accepting a strategy based on the status quo.  We have a variety of clients that have opted to maintain existing relationships but who have also joined our program by allocating part of their holdings to our indexed style.

Response: “Your approach makes a lot of sense but how can I objectively evaluate my current actively managed portfolio compared to your index strategy?”

Comment: In working with prospective clients, we ask a number of fundamental questions:

• How are the investments in your portfolio allocated across major asset classes?
• Do you know how much risk is in your portfolio?
• How is your portfolio risk being measured and reported to you?
• What is your portfolio’s performance benchmark and how have you done?
• Do you know how much you are paying in direct and indirect fees and expenses?
• Have you calculated how much of your investment returns are being eroded by fees and expenses and what this means over future periods?
• How much time do you spend reviewing your portfolio?

In the majority of instances, our experience is that investors cannot clearly articulate responses to these key questions.  Our message is that you need to feel comfortable with the answers to these basic questions in order to properly evaluate the status of your investment assets and understand the implications of your portfolio strategy.

Response: “Your investment approach is quite different from what I am used to.”

Comment: In essence, the investment management business is really a business of storytelling.  It is about concepts and abstracts, assumptions and intangibles, facts and predictions, and numbers and emotions.  We feel that many investment management firms get too bogged down with complex technical jargon, economic analysis,  forecasting and complicated “investment speak.”  Because our approach to creating portfolios is “top down” asset allocation vs. traditional “bottom up” stock picking or market timing, ours is a very simple model to understand.

Response: “I am used to the action of the markets. Your approach seems to take the fun out of it.”

Comment: Vegas, baby! There is big difference between the emotional roller coaster of actively trading the market versus managing portfolios to achieve predictable risk-correlated asset class returns. Don’t confuse daily price gyrations, hot stock stories, sector momentum, interest rate predictions and general market hype with the benefits of a disciplined and systematic approach to longer-term investing.  In our view, active management is a form of gambling where investors will always lose to the house over time. If you are addicted to market action, our buy/hold/rebalance approach will not give you your fix. However, we are highly confident our strategy will significantly reduce your level of investment stress while improving your odds for investment success.

Response:  “Because I don’t have any money!”

Comment: This is perhaps the most legitimate reason why investors should consider our program.  Unlike many investment advisors, we have no minimums because our philosophy is based on the desire to help all investors build value over time using a proven long-term investment strategy. Besides, if you had been investing regularly according to our disciplined approach, you would in fact already have a substantial nest egg!

Summary Thoughts

The very essence of the investment environment is its uncertainty and propensity to change.  It is an ocean roiling with mixed emotions. The challenge investors face is to set a course that creates relative predictability of outcome at acceptable levels of risk and cost.  Our philosophy promotes the belief that this is best accomplished by investing in a strategic blend of index funds designed to capture known risk-return relationships.  However, in order to take advantage of the benefits of this approach, investors must be willing to act.  Behavioral theory teaches that there are a variety of reasons why individuals are reluctant to change.  Our view is that investors with actively managed portfolios who fail to act are exposed to higher levels of overall risk versus our indexed program.