You don’t know it yet, but your financial plans already have a scheduled appointment with catastrophe.
That’s if you even have a financial plan. If not, it’s probably going to be worse. Way worse.
Want to know exactly when that epic fail is going to occur? Unfortunately, I really have no idea. Suffice to say however, your plan will undoubtedly derail at the precise moment it can inflict maximum financial harm and leave you with the least amount of time to recover. That’s what makes for an epic failure. Catastrophes are born when trains jump the track and plunge wildly off the bridge into the gorge, not when they run headlong into some pillow factory.
While the consequences of your failed plan might not condemn you to a lifetime of eating ramen noodles and cat food, I’d be willing to bet you’ve never even considered just how many of those “someday” hopes and dreams you’ve been carrying around might need to be jettisoned. Considering the sunny skies that have been favoring the financial markets since 2009, maybe now is the time to do a little house cleaning. Before the storm clouds start to gather.
Every year, the institutional consulting firm Dalbar Inc. releases the results of its Quantitative Analysis of Investor Behavior (QAIB) survey updating the 20 year annualized returns actually earned by the average investor. Based on observed investor behavior using mutual fund purchases, redemptions, and exchanges, this year’s results will likely mirror the results from last year…and the year before…and the year before that. The typical investor will achieve returns less than 1/3rd of U.S. stock market, less than 1/2 of U.S. bond market, slightly less than the returns on U.S. home prices, and just barely ahead of inflation. At a time when life expectancies are lengthening and retirement funds will need to stretch out longer, the gap between simple benchmarks and investor behavior is staggering. Clearly this is evidence not only of individual plan failures but failure to plan in the aggregate.
It doesn’t have to be that way.
Somewhere back in the 1850’s, Irish physicist Lord Kelvin advanced scientific thought by refining the 2nd law of thermodynamics. In (greatly) simplified terms, Lord Kelvin postulated that left alone, the organization of a closed system decays over time and eventually descends into chaos (actually he called it thermodynamic equilibrium, but you get the picture). Translation? No matter how elegant your financial plan appears the day you first bring it home, plans almost always fail for similar reasons: entropy.
If entropy is the natural law acting against you to relentlessly corrode the effectiveness of your financial plan, then disciplined execution is the secret antidote towards keeping it vital. Make no mistake however, execution is deceptively difficult.
From our perspective, financial plan execution is the steady (and somewhat boring) discipline of periodically rebalancing diversified investments whenever they deviate from strategic targets or more importantly, when your strategic targets become altered by life’s events. Of course it all seems simple enough when the plan is first rolled out, but as they say, no battle plan ever survives first contact with the enemy. As it turns out, the enemy is us.
Time and time again we hear similar arguments from even some of our most knowledgeable clients. “I don’t want you to sell any of that position and take a gain, its on a roll and besides, I’ll just have to pay taxes” or “I certainly don’t want to sell that position and take a loss. Let’s just wait until it comes back to where it was bought”. Taken in isolation, most plans are sufficiently robust to withstand any number of small insults. Like the buildup of arterial plaque however, it’s the cumulative effect that leads to trouble.
We have a saying around here that gets used a lot: It’s just an “O” ring. For those of you too young to vividly recall NASA’s 1986 Challenger disaster, the “O” ring was the $3 part whose failure cascaded into an explosion that nearly ended the entire multi-billion dollar U.S. space shuttle program. It serves as an important reminder of two things that bear repeating over and over: Execution is hard, and it’s the small things done well that often count the most.
Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management who has held a lifelong fascination with trains and train wrecks. The opinions expressed in this article are his own.
