The bear, the bull — and the 10 lessons learned, Part 3

(Editor’s note: This is the last of three parts. Read Part 1 and Part 2.)

7. Investing with Trustworthy People is More Important than Chasing Returns

The recent market environment provided numerous examples of what can occur when thorough due diligence is not consistently applied to investment decisions. Many investors, and even financial professionals, became ensnared by the wishful thinking that past performance will be predictive of future performance (a tendency to extrapolate the recent past into the future). Perhaps the most publicized example of not using a thorough due diligence process is the case of Bernie Madoff.

A recent news article outlined an internal debate at a large private bank over whether to invest with Madoff. Many within the bank argued against investing with Madoff, citing issues such as the lack of a transparent investment process. However, others were compelled by what appeared to be an extraordinarily consistent, historical performance record. The performance numbers were adequate enough for the bank to invest $700 million of their clients’ money with Madoff’s Ponzi scheme.

The financial press is filled with tragic stories of people who mistakenly based their investment decisions primarily on past performance.  These stories about being defrauded illustrate the irreplaceable need for investors to focus on why and how a manager’s performance was achieved and on the qualitative attributes of the manager’s team and investment firm.

Admittedly this type of analysis requires significant time and effort as compared to simply ranking managers by historical performance. At Innovest, our due diligence group conducts over 250 investment manager meetings each year. We believe that our ongoing close contact with managers helps us to maintain very high standards in our selection process and to reduce our vulnerability to mistakes. We routinely pass on an investment if the manager’s process lacks the transparency necessary for our review, or if our conviction level is not extremely high. While there are no guarantees that this process with always lead to success, we contend that hard work and adherence to a thorough process adds value for our clients over time.

8. Be Mindful of Your Investment Horizon

During periods of either extreme market pessimism or exuberance, investors have a tendency to lose sight of their investment time horizon. The time period over which an investor needs to draw on his or her portfolio is a key factor in determining the ability to bear risk. Prior to the market meltdown of 2008, many investors opted to take on more risk in hopes of reaching future objectives through overly optimistic return expectations. Other essential variables, such as increasing capital contributions, were minimized. Many investors now find their portfolios at depressed levels with less time to recover their losses.

Alternatively, investment losses in 2008 prompted many investors to dramatically reduce their portfolio risk profile and move into more conservative investments. However, long-term investors who kept their portfolios aligned with their time horizon by maintaining their equity positions did not miss out on the market’s steep rebound, which began in March 2009.

Some in the academic community have long maintained that investing should be a rational process without influence from non-rational emotions. However, the study of behavioral finance shows that various emotions, including fear, pain from losses, greed and pleasure from gains, can adversely impact investment decisions and sometimes cause irreversible financial damage. While we know that it can be very challenging not to react emotionally to recent events, we continue to emphasize that investors’ risk profiles should primarily be a function of their time horizon and not swing with reactions to recent market trends.

 “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” — Warren Buffett

9. Volatile Markets Can Create Opportunities

Market volatility has prompted many investors to run for the sidelines. Despite miniscule earnings on short-term deposits, cash levels have approached all time highs. However, this volatility has created opportunities for investors with gumption and a willingness to take a forward-looking and long-term approach. From the lows of March 2009 to June 30, 2010, large cap stocks rebounded 57 percent, and small cap stocks rallied over 80 percent.

A similar rally occurred within the lower quality fixed income markets. In 2009 yield spreads for domestic high-yield bonds contracted significantly from roughly 2,000 basis points over 10-year Treasuries to less than 700 basis points. Several other asset classes that recorded their worst year on record in 2008 proceeded to have one of their best years ever in 2009.

While it is easy in hindsight to identify these examples, history has shown time and again that there are tremendous opportunities to be uncovered in volatile markets. Investors who purchase attractively valued assets for the long-term are much more likely to be rewarded than those trying to jump in and out of the financial markets. A portfolio manager recently shared with us that, “Oftentimes the best investment is the hardest one to make at the time.” It is critical to have a disciplined strategy that will be an objective guidepost when facing volatile markets.

10. Never Employ an Investment Strategy that Cannot be Understood

Over the last decade the number of highly complicated strategies increased at an exponential rate. Many of these strategies employ quantitative models that are opaque and difficult to understand for the average investor. Moreover, portfolio transparency is often poor because of a manager’s unwillingness to divulge proprietary data. Many investors became unaware of implicit portfolio risks in these complex strategies.

For instance, various quantitative models select securities on the basis of historical market patterns and price momentum. While these types of strategies do well when markets exhibit relatively stable and consistent trends, they often fail to capture volatile periods or inflection points in the market. Many model-driven investment products performed poorly during the market crisis and its subsequent recovery in 2009.

In the years leading up to 2008, many core bond managers touted their strong investment records generated in part through their use of high-performing securitized residential mortgage-backed securities. Strong investment returns, however, did not match up with what was marketed as a low-risk strategy. Only during the financial crisis of 2008 did owners of these products discover their excessive exposure to sub-prime mortgage loans, which collapsed in value as housing prices declined and teaser rates reset. Long-term investors are more likely to be successful if they look for hidden risks when examining managers’ track records and use strategies that can be easily understood.

Conclusion

While the lessons learned from 2008 and 2009 are easy to identify in hindsight, we believe that recalling and acting on these principles should be beneficial to long-term investors. It is likely that the financial markets will continue to be volatile, presenting new challenges and investment opportunities. Over time, a prudent, thorough, and ongoing investment review process will remain indispensible for meeting financial objectives.