As a good bit of you are probably aware, about 18-24 months ago, I introduced our quarterly investing newsletter. In developing our newsletter, I placed the focus on the conditions that have historically existed concurrently with, and some would say that have expressly caused, bear markets, which are defined as market declines of 20% or more. The conditions: recession, aggressive federal reserve, spike in commodity prices, and extreme stock valuations. The purpose of adopting this format was to try to directly address any anxiety and fear that clients might be feeling in the short-term—feelings that are ultimately the cause of poor decisions that derail investment strategies in the long-term. My thinking is that by placing the focus on helping folks better understand investments and their behavior in certain environments, clients will be better informed and prepared, resulting in less anxiety and fear.
In thinking about the times that I have experienced anxiety and fear, it seems apparent that there are certain conditions that needed to be met for those emotions to exist. I would say that there are four criteria that need to be in-place for justifiable anxiety and fear to exist. The first criterion that I would identify would be that there needs to be the threat of real harm. Second, comes via consequences from a specific triggering event—this is important, because this means that, while there is an event, the event by itself is not enough to justify anxiety and/or fear. Third, there would need to be a reasonable chance for the triggering event to occur. Lastly, the potential for harm needs to be unambiguous and relatively immediate—i.e., if you cannot define the exact potential for harm, then you might not understand the problem, or if there even is one, and I would also define immediate as being within 12 months or so.
To illustrate my point, let’s take the primary context in which I have observed anxiety and fear in clients—bear markets. If I were to describe what I have observed, I would sum it up by saying this: clients fear bear markets--not because they have proof that a bear market would actually be detrimental to their ability to achieve goals, but simply because most people don't know how it will impact the pursuit of their goals, so they assume the worst. If I were to apply the criteria above to this context, here's where I would start: there is no doubting that a bear market has the potential to compromise a person's ability to achieve financial goals--this would check the first box of the potential for harm. We also know, however, that a bear market does not guarantee that one's ability to achieve goals has been compromised (relevant to the second criterion above)--we've experienced enough market turmoil during my tenure for me to observe client plans remaining intact even after a bear market. Third, it should be no secret that bear markets occur, and it should also be no secret that we should expect to experience several over the coming decades, so there is a very good chance of a bear market occurring, generally, and that risk is certainly heightened at times. Lastly, the fact that most folks operate off of assumptions about the impact of bear markets raises the issue of ambiguity. What I have also experienced, however, is that if it is believed that a bear market is about to bear down on us, or if there is one occurring, the immediacy of it is usually enough to override any prudence that might otherwise be utilized in evaluating the situation, and this only serves to compound the anxiety produced by the ambiguity. If I was to sum this up in the form of a philosophical point, I would say this: anxiety and fear result from the question of whether that which is in our control is sufficient to withstand the impact of that which is outside of our control; and unless we are detailed in our analysis and understanding, then general anxiety and fear stand the potential of setting in, and chronic anxiety and fear are no less capable of producing the same bad decisions as acute anxiety and fear.
It was in thinking about that last point that I was struck about the similarities between investing and farming—don’t ask me what, specifically, triggered the comparison, though, because I couldn’t tell you. Much like a farmer raising crops, however, an investor has no ability to directly impact an investment’s growth. Assuming that the content of the soil in which a plant is rooted is sufficient for growth, and the plant receives enough water, we can say that what the genes of a plant actually do are control the ability of the plant to use the resources available in its environment to produce growth—i.e., genes control plant processes and plant processes produce growth, not the farmer. This is absolutely analogous to, say, a business and its ability to operate in the economic environment--something that you, or an investment manager, should definitely evaluate, if you were considering a particular stock as part of your portfolio. As an aside, I suppose you could say that genetically modified crops are an example of farmers attempting to have a direct impact on growth, but even then, that is more akin to giving the plant a new tool—it might help the plant grow more efficiently, but the farmer is still doing no work for the plant.
That last point is a very important point to consider when it comes to investing. The farmer, no matter how badly he/she might want to, can do no work that will either guarantee growth or directly lead to growth for the plant—there are simply too many variables that are outside of the farmer's control. Likewise, there is nothing that we can do, including cheering for our investment managers, that will guarantee the growth of market-related investments—there are simply too many variables that are outside of our control. In fact, the only things that we have the ability to control with investing, unless you want to manage your investments yourself, are the rate of contribution/distribution, the manager/strategy that governs how decisions regarding investments are made, product-based costs (the decision of whether to use a product or not), and the general level of risk, which is a function of the overall proportions of asset classes represented in a portfolio—noticeably, growth is absent from this list.
In thinking about this, the importance of the concept of using the things that are within our control to respond to conditions that are outside of our control, as well as the importance of understanding what falls into each category, becomes obvious. Here are some examples from farming: the farmer cannot control how much nitrogen is in soil when he/she first encounters it, but he/she can add fertilizer; the farmer also cannot control whether pests discover his/her delicious crops, but he/she can apply pesticides or even raise complimentary plants side-by-side; etc. Here are some examples with investing: if economic factors do not seem to indicate good things for stocks, then you might choose a more conservative allocation; if valuations of stocks are historically high, then you might choose a more active manager to be more selective and tactical in deciding which stocks to invest in; if performance is in-line with what we should expect, but it is insufficient to meet our goals, then we may very well have to commit to contributing more; etc.
If the farmer were to lament the things that are outside of his/her control, as opposed to focusing on what might be done with the things that he/she is able to control, then it is easy to see how the farmer could become frustrated and confused. This only serves to highlight the importance of two things, though: first, patience; and second, a deliberate approach focused on understanding. Again, upon placing seed in the ground, the farmer can literally do nothing, except to monitor and amend—soil, precipitation, temperatures (if applicable), etc. I suppose that it could be said that the farmer could attempt an extreme move, such as discarding an entire crop and attempting to grow a different one, but then we have a little something called a growing season to contend with, and the function this serves to fulfill is to effectively eliminate any thought or ability to cut corners and make dramatic moves, or at least it should. If you don’t give plants time to maximize the entirety of their growing season, then you are guaranteed to end up with compromised yields, and I haven’t even mentioned anything about the added costs of such extreme maneuvers. Again, in case you haven't caught this, the farmer can do no work for the plant, so farming is essentially the process of evaluating the environment, amending as is prudent, and staying out of the way of the plant doing its part. What this also highlights, though, is that there is plenty that the farmer can do to guarantee failure and nothing that can be done to guarantee success, so patience and understanding are vital.
The same applies to investing. Regardless of whether you want to play the role of investment manager, patience and a deliberate approach are necessary—you have to develop a thorough understanding and you have to allow your strategy time to play out. This also highlights the importance of postmortem assessments, though. Your best laid plans might not work out the way you envision, and this is not necessarily a function of poor investment manager decisions or poor strategy selection. If a farmer were raising a certain type of crop and the growing season was uniquely compromised for the entirety of the particular crop at-hand, or maybe a rare pest invaded an entire region where a particular crop was grown, it would be unreasonable to conclude that any of the farmer’s decisions were to blame for poor crop yields. The problem, because it would have affected all farms raising a certain crop, is of such a magnitude that there is nothing that our farmer, or any farmer, can do to make a difference. Conversely, if it turns out that our farmer is at fault, there is no way, other than via postmortem analysis, that decisions can be improved, giving way to the potential for better results in the future. Even then, however, the farmer must be careful not to mischaracterize what he/she perceives as being causally related.