Don’t base investment decisions on previous experience for goals

Return expectations are a critical input to the investment process. Naturally, the higher the expectations for return on a particular asset (stock, bond, real estate), the more of the asset you want to own and vice versa. When investing in a diversified portfolio, the goal is to always maximize return for a given level of risk. However, investment returns rarely come on time or as expected. This is especially true over shorter time frames. Unfortunately, this mismatch between expected returns and actual returns can cause investors to make critical allocation errors including: — Flight to Safety: An investor might expect their stock portfolios to generate 9 percent per year, in line with the very long run average. But that expectation could change if, after some period of time, their stock portfolio begins to generate a negative return. Then, the investor may decide to change his/her allocation to stocks and add more to bonds/cash, giving into the fear of “losing” more money. However, what often happens, after shifting out of the “losers” and into safety, stocks invariably settle down and begin to generate positive returns.

— Chasing Returns: An opposite example is when the stock market has performed well for a number of years and an investor develops a fear of missing out. They may then decide to sell their conservative assets and put more of their portfolio into stocks. Then, what often happens, the stock market begins to underperform, causing the investor’s portfolio to underachieve.

There are many variations on these examples. But all tend to have the aggregate effect of reducing portfolio returns over time. The core lesson is that the unexpected return, positive or negative, can cause an investor to become impatient and take action that ultimately proves detrimental to their portfolio’s long-term return.

If the goal is to maximize return for any unit of risk, then it pays to be aware of these errors and to put into place an investment process that addresses these risks. Investors should avoid relying on return expectations over short time frames. For longer time frames, expectations should be adjusted for the price paid. If investing after a big market downturn, then ratcheting up your expectations is reasonable since you are investing “low.” Investing at above average valuation levels means investors should adjust lower their expectations for future returns.

The human tendency is to allocate more to stocks as stocks rise and less to stocks as they fall. But we’re making the point this will lead to poor relative performance.

Instead, either allocate assets according to long-term investment objectives regardless of the market’s direction or at least adopt the wellknown adage of “buy low, sell high.”

Jim Rhodes is a Chartered Financial Analyst and is an Executive Director at American Money Management (AMM). His office is at 300 S. Imperial Ave. #12, El Centro, and can be reached for an appointment by calling 760-604-6310. Michael Moore is Chief Investment Officer at AMM and can be reached at 888-999-1395.