Monday, November 15, 2010

Staying the course

On January 15, 2009, 90 seconds after lifting off from LaGuardia Airport, the now famous US Airways flight 1549 lost all engine power upon striking a flock of geese 3,200 feet above New York City. Three-and-a-half minutes later, the crippled Airbus A320 touched down in the Hudson River, and what could have been a major loss of life became a textbook lesson in crisis management.

Listening to the cockpit communications, it's quickly apparent that "The Miracle on the Hudson" was made possible by the skill, poise and careful coordination of Captain Chesley Sullenberger and First Officer Jeff Skiles. Yet the transcript also reveals the importance of a tool that for decades has helped pilots manage both the routine and unexpected during flight. That tool is the checklist.

Indeed, in the moments just before the bird-strike, Sullenberger is heard saying, "After takeoff checklist complete." Upon losing power, the first directive he gives Skiles is "Get the QRH." The QRH or Quick Reference Handbook, is a manual consisting largely of checklists to be utilized in troubleshooting various problems such as loss of cabin pressure or engine power. After the order is given, Skiles and Sullenberger can be heard working through a series of steps designed to save the flight.

As they attempted to address an emotionally fraught, seemingly impossible situation, the two pilots had a simple resource they could turn to for help.  Beyond the aviation world, checklists are used to manage a host of complex processes: from constructing skyscrapers to administering critical care in hospitals.

Of course, the decisions investors make when markets become volatile don't have life or death consequences, but they can prove vital to ong-term financial wellbeing. And given what we know about
how market volatility can transform a calm, cool and collected investor into an emotional, panicked and scattered one,having a checklist to consult during the next period of instability might mean the difference between reaching your goals and falling short of them. The next time volatility strikes, consider these six steps:

1. Take your emotional temperature.

Even with the recent market tumult still visible in the rearview mirror, it may be difficult to recall just how unsettled investors felt in 2008 and early 2009. Yet it's all but assured that a future downturn will find us back in the same emotional boat.  We shouldn't be surprised that when markets decline our moods tend to do the same, as losses can make us feel as if our financial objectives are imperiled. Yet even if we acknowledge that declines are a reality, we are still susceptible to letting the emotions that accompany those downturns drive decisions at odds with key investing goals. One way to help keep them at bay is to gain a deeper understanding of where they originate.

Consider, for example, the strong compulsion to sell when markets become erratic. At heart this urge is essentially a flight response, We seek to eliminate a source of anxiety - in this case, the possibility of monetary loss - by disengaging from it. On a practical level, that generally means converting assets into cash, which limits the possibility of loss.

Psychological studies and research in behavioral finance confirm that this aversion to loss is actually part of our neurological programming, hard-wired into us from a time when survival depended on hunting and foraging - and holding on to the fruit of those efforts meant the difference between life and death.

Viewed in that light, it's no surprise that the visceral urge to limit losses overtakes the rational part of our brain that may be telling us that selling assets into the teeth of a down market locks in losses and reduces considerably the potential to benefit from a market recovery.

Aversion to loss is but one of many tendencies that surface during volatile periods. Others include the impulse to move with the herd - a phenomenon exemplified by the late 1990s rush into tech stocks - as well as our penchant to heavily weigh the importance of recent events rather than considering them against the backdrop of market history.

According to behavioral economist Dan Ariely in his book, Predictably Irrational, it's important to understand the surprising power that emotions can exert over our choices. "Although there is nothing much we can do to get our Dr. Jekyll to fully appreciate the strength of our Mr. Hyde, perhaps just being aware that we are prone to making the wrong decisions when gripped by intense emotion may help us."

2. Turn down the volume.

When the market is rising like a rocket or sinking like a stone, the popular press seldom provides analysis that's useful to long-term investors. Instead the headlines tend to play up whatever information or trend has grabbed the momentary attention of traders and pundits. In an age of nonstop connectivity, tuning out financial news can be tough, but fixating on daily or even weekly market returns can spur us to actions that might ultimately impede our long- term success.

It's interesting to consider that the temptation to monitor stock and bond investments on a daily or even hourly basis stems mostly from the fact that there is always new data available, as trading creates regular re-pricing. To remain focused on long-term goals, it may be helpful to take the same approach with your investment portfolio that you do with assets that don't get re-priced with similar frequency. For example, short-term fluctuations in the value of your home or car don't prompt you to immediately put them up for sale.

Another strategy for curbing the emotional impact of market volatility is to review the value of your investments only at regularly scheduled times. Many investors elect to do so quarterly upon receiving account or brokerage statements. This diminishes the likelihood that they will feel it necessary to make constant changes in response to day-to-day market swings.

3. Find the broader context.

Ask the average investor how many 20% market declines they'd expect to experience over a 25-year period and chances are the answer will fall short of the number suggested by history. The figure, based on the unmanaged Dow Jones Industrial Average dating back to 1900, is about seven. That's right, roughly once every three-and-a-half years (assuming 50% recovery of lost value between declines), the Dow has lost at least one-fifth its value.

Yet each time such a downturn occurs, it understandably upsets investors. Moreover, the sharper drops often elicit claims that this time the selloff is different or worse than those that have come before. As previously noted, maintaining perspective while watching an account balance shrink is not easy. but remembering that downturns are a fairly normal occurrence can help place short-term market events in a broader historical context.

Having that historical perspective can strengthen your resolve to stay invested, which can be a key to long-term success. After all, pulling out of the market at a high point and buying back in at the boltom is almost impossible to do once, let alone more than a half dozen times during your life as an investor.

4. Recognize the potential harm of sudden movements.

A recent survey by financial research firm Dalbar determined that over the 20 yearsended December 31, 2009, the average stock investor's return trailed that of the broader market by nearly 5% per year.  Put another way, if the market gained 10% annually, the average investor's portfolio realized only a 5% gain.

Much of this differential stems from investors who, for the reasons discussed previously, sold at the boltom of the market and, if they bought back in, did so once the market had already begun to recover. Market turnarounds often happen suddenly and unpredictably; being on the sidelines when a reversal occurs can rob investors of significant return.

In fact, a hypothetical investor in the unrnanaged Standard & Poor's 500 Composite Index who wasn't invested on the index's five best days during the lO-year period ended December 31, 2009, would have realized an annual return nearly 4% lower than someone who remained invested the entire time. Of course, past results are not predictive of results in future periods.

5. Think like a contrarian.

Warren Buffett once offered the following bit of investing advice: "When others are greedy, be fearful; when others are fearful, be greedy." A more delicate rephrasing might be: Amid adversity, there is often opportunity. Volatility of the kind that marked 2008 and early 2009 often punishes good and bad investments alike, as some investors succumb to the stress and opt out of the market entirely.

Though coetinuing to invest when markets are declining can be difficult, if you believe that stock and bond funds are a good way of meeting long-term financial objectives - which has been the case historically - then making purchases during a downturn is often like buying investments at prices below their longterm average. That's because as markets become less emotionally driven, stocks and bonds generally return to something closer to their long-term average, and investors who "bought on the dip" can benefit. While regular investing doesn't ensure you'll make money, staying the course through thick and thin can help increase your share balance, which can increase your portfolio's ability to provide income.

6. Check in with your financial adviser.

No one would set out on a Himalayan trek without enlisting a guide who knew how to navigate the most perilous stretches. So it goes with investing.

Your financial adviser can be a steadying presence when market conditions get tough. Whether reviewing your investment plan, providing perspective on what's happening in the market or placing current conditions in a larger context, your adviser is an important ally and sounding board.  Maintaining open lines of communication can prevent you from taking steps that could undermine your long-term goals.

Indeed, you might think of an adviser as a kind of co-pilot. Much like Sullenberger and Skiles, you can manage the crisis more effectively together - by systematically working through your checklist with the goal of achieving a belter outcome.

The preceding article appeared in the Investor Magazine provided to shareholders of American Funds, a mutual fund company whose various funds are used by Jersey Benefits Advisors and John Kaighn to assist clients in meeting their investment objectives.