Investment Style: Tortoise or the Hare?

If you like the thrills that come with big-risk investing, your portfolio could pay the price for years to come.
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Slow and steady really does win the race.

That is one of the most profound lessons to emerge from the market’s historic plunge over the past month, which has caused the S&P 500 to fall by nearly 30% and the small-cap Russell 2000 index by 40%. Many advisers who have spent many years ahead of the market suddenly find themselves lagging.

By the same token, other advisers who for years have been dismissed as hopelessly conservative and old-fashioned -- worried about such antiquated notions like market valuations -- now find themselves in the lead.

Take the PAD System Report, edited by Daniel Seiver, a member of the economics faculty at Cal Poly State University in San Luis Obispo, Calif. Seiver is one of the rare advisers who has the discipline to build up cash as the market rises, in anticipation of the eventual bear market that will redeem his patience. (For the record, his newsletter is not one of those that contracts with my performance monitoring firm to audit its returns.)

At the March 2009 bear market bottom, for example, his model portfolio was fully invested in equities. As the bull market rose to higher and higher levels, he gradually reduced this portfolio’s equity allocation. At the bull market’s top in February, it was just 35% invested, with 65% in cash.

As you can imagine, Seiver’s strategy was not particularly popular for much of the 11 years prior to the past month. But guess what? His portfolio’s long-term return is now neck-and-neck with that of the S&P 500 -- on an unadjusted basis. When adjusted for its low risk, the portfolio comes out well ahead.

Seiver, in an email, pooh-poohed the idea that he did anything special. “Academic research confirms” that you can beat the market over the long-term, he wrote in an email, if you have the intestinal fortitude to buy good-quality stocks when the market is undervalued and lighten up when it is overvalued. “Not hard to do unless you worry about underperforming for long periods of time. But the next bear always shows up, maybe when you least expect it.”

Notice carefully that the discipline to which Seiver refers has two parts: Reducing equity exposure as the market rises and buying when the market becomes increasingly undervalued. And because Seiver thinks the latter condition has now at least partially been fulfilled, he has started buying -- even as almost everyone else is panicking. He has just increased his equity exposure by 10 percentage points, and plans to spread out additional purchases over the next six months.

What kind of investor are you?

Reviewing Seiver’s strategy helps you determine what kind of investor you are: Are you a hare or a tortoise? Is the thrill of being ahead of the market at bull market peaks enough to overcome the agony of being behind at bear market bottoms?

If you’re honest, and you’re like most investors, you’re more interested in the former. The prospect of being behind a market that is rising is intolerable -- even if it means incurring big losses when the market tanks.

As usual, the late British economist John Maynard Keynes captured this phenomenon perfectly: “An investor who proposes to ignore near-term market fluctuations… will in practice come in for most criticism… For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

I am reminded of a client who, years ago, subscribed to a now defunct newsletter that was far riskier than any I have monitored before or since. For example, it not infrequently allocated the bulk of its model portfolios to a call option on a single company. Most months this portfolio lost huge amounts, if for no other reason than the options’ time decay. Now and then, however, the portfolio would skyrocket hundreds of percent in just a few weeks’ time.

Why, I asked this client, did she follow this newsletter, given that its longer-term track record was so dismal? Because, she told me, she loved the thrill of those times when her portfolio skyrocketed.

At least she was honest with herself. In contrast, most of you are kidding yourselves. You tell yourself that you’re pursuing a strategy that maximizes your lifetime wealth, when in fact you’re thrill seeking.

If so, you’re now paying the price for your years of thrills. Is it worth it?