Peter Bernstein: The Importance of Staying Power

The behavioral side of investing gets a lot of attention while the personal finance side often gets less than it deserves. That’s because how defensive you are with your finances helps determine how aggressive you can be with your portfolio. Put simply, it’s easier to roll with the market’s punches when everything outside your portfolio is in financially sound shape.

Peter Bernstein dwells on the impact of being wrong on investments because the consequences can go beyond losses. The nature of investing guarantees everyone will be wrong sometimes. That means unexpected gains in some cases (being wrong isn’t all bad) and losses in others.

How quickly you can recover from losses will have a big impact on your long-term wealth. There’s an obvious psychological hurdle to recovering from losses but the state of your finances impacts your ability to recover too. Bernstein calls it “staying power.”

In planning portfolio strategies, I have always been obsessed — perhaps too much so in some instances — with a rather negative but overwhelmingly important question: What are the consequences if I am wrong? I should stress that this question need by no means lead to an excessively conservative investment philosophy, for it has led me on a number of occasions to take much bigger risks for a client than a more conventional approach would have suggested as appropriate. But I do believe that no investment decision can be rationally arrived at unless they are a logical part of a strategy based upon the answer to this question.

This question really relates to the whole problem of risk, which is an inescapable component of the investment process. We simply do not know what the future holds. This means that we are perforce going to be wrong a certain amount of the time — but we also never know which decisions it is that will be the incorrect one (we are often right, in fact, for reasons that we never anticipated: is this actually being right or being wrong?). Hence, we must move ahead always on the assumption that the next decision may be the wrong one and with the realization that we must face the consequences if it is.

The consequences of being wrong essentially involve an examination of the opportunities to recoup any losses that may be incurred. And these opportunities will be determined by two different sets of conditions.

The first and most important condition is staying power. An investor who has a substantial income or a significant amount of cash reserves that can sustain him regardless of what happens to his cash reserves can let time work in his favor in recouping losses; the greatest disasters are really limited only to those investors who are forced to liquidate at moments dictated by external events — a loan to be repaid, a job lost, a tax bill not reserved for — rather than at moments dictated by investment considerations only…

The second condition for recouping losses is the nature of the investor’s decision-making ability. Given a reasonable period of time, because markets do fluctuate, it takes an extraordinary series of poor judgments to do a really bad job of investing. You may fail to make a killing or even to run with the fastest crowd, but it is really difficult to lose money at investing if you have the staying power to carry you over the bleak periods.

I make this rather bald statement on the basis of an important fact of arithmetic: you can lose no more than 100% of the money you invest in any one security, but you can make an infinite amount on it. This apparently obvious and superficial statement tells us something that is overwhelming significant for investors: a few good guesses can far outweigh many poor ones…

Thus, the consequences of the inevitable wrong decisions can be kept to a minimum if the investor has the staying power to remain in the game until the next throw of the dice and to avoid involuntary liquidation at the wrong moment. But the consequences can also one minimized if the investor has the time and opportunity to make a few lucky decisions that can readily offset the less fortunate ones.

The greater the staying power, the greater the risks the investors can take to try to find that magic killing.

Every market downturn has its share of casualties due to the combination of investing losses and selling. The voluntary response of panic selling gets warned about incessantly. And rightly so, because it creates the problem of having to buy back into the market. Which often leads to missing out on gains when the market recovers. But the possibility still exists that the mistake of selling can be corrected sooner rather than later.

Forced selling is equally important, if not more so because it can strike at any time if your finances are in poor shape. When you’re draining your portfolio to cover basic needs, it becomes impossible to recover from losses.

A sound base — suitable emergency savings, insurance, debt, and spending habits — provides the best defense against that possibility. In turn, you can be more aggressive in your portfolio.

And, who knows, maybe knowing you’ve got the financial security to withstand drawdowns, may offer the psychological trigger to avoid voluntary panic selling, as well.

Source: Economist on Wall Street