by Jerry Wagner The efficient market theory asserts that the markets are made up of rational investors and, thus, are so efficient that market pricing cannot be exploited for a profit. This is the foundation upon which passive asset allocation is based. Yet, the theory took a blow several years ago when the Nobel Memorial Prize in Economic Sciences was awarded to someone who proved that investors are irrational. In a series of studies, psychologist and economist Daniel Kahneman, in collaboration with the late Amos Tversky, showed that most of us humans are incapable of fully analyzing complex situations when the future consequences are uncertain. Faced with uncertainty, investors exploit rules of thumb that systematically contradict basic logic—or, as the paper summary states, they defy “fundamental propositions in probability theory.” Unfortunately, I have seen many examples of these investor mistakes in the 40-plus years since I started Flexible Plan Investments. If the following phrases sound familiar, be careful. “I’ll sell when I get back to breakeven.” Often referred to as the “loser’s lament,” this frequently expressed statement by “buy-and-hope” investors in a declining market encourages them to hopelessly hang on. It can also be the undoing of actively managed accounts in a turnaround market. Most actively managed accounts make money because of the persistence of upside momentum. A return to breakeven on an actively managed account is a vindication of the strategy and is probably one of the best times to hold on and go with the flow. It is likely a bad time to sell and miss out on future market gains. “I’ve lost $XXXX or XX% since the market top.” Investors always want to measure their performance from the high watermark in the stock market. This is not realistic. I’ve yet to find a single professional that has been able to always sell at the top, and most investors would not and do not. Instead, studies show that most investors buy at market tops rather than sell at them. Evaluation of a portfolio should include both an up and down market. Ask yourself, “How have I done since I started?” Did you open your account at a market top, like many investors? Or did you invest long enough ago to have experienced both an advance and a decline? “I didn’t invest to lose money.” No one invests to lose money. Yet, there are no investments that outperform inflation in the long run that also have no risk of loss. Most often, investing is like an exercise program: “no pain, no gain.” The skill comes in minimizing the pain when a market correction comes along so that the portfolio can quickly bounce back to profitability. “If I’m down for the quarter, I’m selling”/“I want the strategy that did best last quarter.” Both of these statements fail for the same reason. The period for evaluating the investment is too short to be meaningful. Investment professionals uniformly agree that a meaningful period of measurement must encompass both an advancing and declining period in the stock market. Historically, that requires an investment time of five to seven years. “How did my investment do versus the S&P?” Our management has a great record of outperforming this index over a complete market cycle. But no investment professional would recommend an investor place all their assets into a fund that mirrored the S&P 500 Index. Instead, they tell investors to diversify. Actively managed investors should compare the results of their entire portfolio against indexes of passive asset-allocated funds to get a real-world measure of relative performance. Our OnTarget Investing reports, included with your quarterly statements, show how you are doing versus a benchmark customized just for your account. “The market was up last quarter. The bull market has returned.” Investors should take a broader view. “What’s the difference between active and passive management?” Imagine that you are taking a long trip. You will be gone for six months. If you can speak to a weather forecaster only once before you leave, he or she would have to tell you to be prepared for everything. Since you don’t know what climate changes you will experience over the next half year, you’ll need sunscreen, winter boots, a raincoat, a windbreaker, and so on. However, if you could speak to the weather forecaster every week, you would only need to be prepared for the current weather conditions. A passive manager looks at your investments once every three to six months and tells you to be prepared for all market conditions. You must be invested in every asset class—bonds, value, large-cap growth, small-cap growth, etc.—since you don’t know which will be the best performer. You reduce your risk, but you sacrifice return. Flexible Plan Investments attempts to have you invested in the top-performing asset classes and tries to avoid the poor performers. Of course, the weather forecaster isn’t always right—and neither is the active manager. But we think you will agree that changing with the climate makes more sense than having to carry everything in your closet every time you leave for a trip.