In the short run, investing is anunpredictable game with fewrelevant fundamentals. Yet inthe long run, fundamentals thatinevitably pay off are reasonableprice-to-earnings ratios, price-to-bookratios, and dividend rates. Stocks incompanies that are consistent withthose fundamentals inevitably servedthe investor profitably over the longrun. It has been said that in the shortrun, the market is a voting machine,and in the long run, a weighingmachine. It is in the long run that thefundamentals weigh in. The hedge fundtraders cast the early votes and shakethe markets on a daily basis. Thelonger-term value investors wait out thecasino bravado of traders and hedgers,as their worn dice and torn cards yieldthe spoils to the patient and disciplined.
The weakness we must exploit isthis short-term immediate gratificationattitude of the many on Wall Street.That means that at times, our strategywill be lagging behind the short termersas we try to take advantage of thequality they are overlooking. The bestexamples of this are great fund managerslike Steve Romick, Jean-MarieEveillard, Bob Rodriguez, and WarrenBuffett. All were "underperforming" in 1998 and 1999. Their value style ofinvesting was getting beat up by thelikes of technology stars Henry Blodgett(Merrill Lynch) and Mary Meeker(Morgan Stanley). This continued untilMarch 10, 2000, when the great bearmarket started and technology gotdecimated, taking with it many unfortunateinvestors.
With the money they had left, manyinvestors finally realized it was safer tobe in quality value stocks. Unfortunatelyfor many, the damage was alreadydone. That's why many value managershad significant returns during the bearmarket. Protection on the downside is aprudent investment philosophy.
Trends Don't Last
There is always a trend to chase.Earlier this year, gold, natural resources,and precious metals were hot.Investors were chasing those sectorslike long lost lovers only to be deeplydisappointed in the short term as someof those stocks dropped 30% to 50%from their highs.
As longer-term investors, we believethat having a small percentage ofmoney allocated to gold—as somewould say real money, commodities,and natural resources—is a good thing.Moderation is a critical factor. But it'sgood in the context of a well-thought-outlong-term investment strategy.
This discussion gives rise to the question,"What should be the focus ofyour portfolio?" To be a successful investor,your portfolio must be consistentlyaligned with your and your family'slifetime goals. These must includetime frame, financial goals, and risk tolerance.The most successful portfoliosare those managed with the perspectiveof long-term financial goals, ratherthan primarily trying to capitalize onperceived current trends in the markets.Your benchmark relates to this achievementof lifetime goals, not the S&P500, the Dow, the Nasdaq, or someother irrelevant index. The problemwith almost all financial journalism is atoxic assumption that you should betrying to beat the market. This impliesthat we should have mutual funds thatonly have the highest returns to timethe entrances and exits, from the marketsand switch asset classes, marketsectors, and countries—all opportunistically.This is an inevitable road to disaster.It's the short-term tail waggingthe long-term dog.
The Focus of Your Portfolio
It is important to keep in mind fourprinciples when determining the focusof a portfolio.
First, your long-term financial goalsare the only rational basis for the constructionand management of yourportfolio. Pure performance is not afinancial goal. Your portfolio goalsshould answer questions like, "Who isthe money for and what is the moneyfor?" and "When will this money beneeded?" Your portfolio should begoals-focused not market-focused.
The second principle relates to yourbehavior as an investor. Research byacademics has shown that the realdeterminant of long-term return is notwhat the portfolio does, but what theinvestor does. It is much harder to try tomanage the behavior of an investor as itrelates to their portfolio. That is whymanagers try to exercise patience andunderstanding while communicatingimportant fundamentals to investors.
The third principle is the importanceof asset allocation in your portfolio.Returns are greatly influenced by theasset mix in your portfolio. Forinstance, in a make-believe world, ifyour entire portfolio were allocated tobonds from March 10, 2000, toOctober 9, 2002, you would havemade a lot of money during the equitybear market. Active asset allocationmeans making occasional shifts in allocation.Managing a portfolio of mutualfunds is far different and far superior tomanaging a stock and bond portfolio.The obvious reason is that investorspick managers, not stocks, etc. Investorshave the advantage of being able topick the best managers for a specificallocation. What the team of managers,both offense and defense, thinks is thebest the investment world has to offer.Generally, the core holdings in a portfoliowill be managers of hybrid or assetallocation funds who have the flexibilityof finding the best investment ideasanywhere in the world. This approachprovides an anchor for each portfolioand helps reduce risk.
The fourth guideline relates tosomething that requires enormousstrength: discipline. This is not a naturaltalent for most investors. Fewthings or great rewards in life comeeasy. It takes great discipline to postponegratification and commit to theweighing machine philosophy ofinvesting. It requires a conscious decisionnot to try to make a killing inreturn for not getting killed. By beingdiversified—the natural result of assetallocation—you will be more like thetortoise than the hare. We know overthe long term who wins that race.These principles work. The secret isworking the principles.
Vern Hayden is president of Hayden FinancialGroup LLC based in Westport, Conn. He manages$80 million using mutual fund portfoliosfor clients. He welcomes questions or commentsat Hayden4T9@aol.com.