How To Develop A Scientific Investment Approach

I think people need to have an investment philosophy just like they have a personal philosophy. Now, an investment philosophy ought to be based on ideas that are empirically testable and that kind of leads to a scientific approach. So we try to base our investment philosophy on leading academic research that has been done over the last 50 years or so.

Capital markets behave in a way that we think you’d like to have them behave, the markets are where buyers and sellers come together and if a stock market is doing its job well, in an ideal stock market, both buyers and sellers are getting a fair price. That’s kind of the cornerstone of what we believe.

Now, prices fluctuate a lot so on any particular trade, either the buyer or the seller, will turn out to have gotten a better deal than the other side. But on average, over long periods of time, do both buyers and sellers get a fair price? The answer appears to be yes if you look at the numbers on the Dalbar study of 2012.

There may be other investment philosophies other than ours that work. But one philosophy that’s not going to work is to shift around all the time, try something for a while and try something else; you might experience unfavorable repercussions like paying unnecessary costs and taxes as are some of the findings in the Dalbar study points out. What you need to do is sit down and agree with the client.

Let’s create an investment philosophy that you can live with through thick and thin because about once a generation we get something like 2007, 2009, where the market drops by half. I’ve lived through it in ’73, ’74. If you’re lucky enough to live long enough, it’s going to happen again. So let’s think through how markets work and come out with an overall solution that is appropriate for you.

I think over the long haul, if you take the scientific approach, people may be more likely to be able to relax a little bit and might get the feeling that they are going to be okay. And I think that’s what the role of the adviser is, give them the opportunity for good returns, but give them a great overall experience.

Avoiding the Next ‘Madoff Situation

Bernie Madoff, we define him as a con artist and most people would. Con artists can destroy investors in two different ways. They can out right steal your money or they can speculate and gamble with it. And now once you identified Bernie Madoff or someone like him, then the idea is that you run from that person. You don’t walk, you run from that person.

There’s three steps to avoid the next Madoff and they all start with the word verify. In a presentation that I worked on, we call it ‘Verify, Verify, Verify’, and the first step is that you verify the financials of the company that you’re working with. Audited, audited financials by a third party; not some fake document they created. Remember, Bernie Madoff created and disseminated to his clients a lot of fake documents.

The second is that you verify that you have a third party custodian. See, Bernie Madoff actually held custody of assets, that made it easier for him to steal client assets. If you don’t have custody of assets, if there’s actually a third party, and you have verification through the custodian’s statements, then you know that you’ve taken a step to verify your manager doesn’t have access to your money to steal it. The third one is that you verify returns and this one is really important.

If I could give one piece of advice to an adviser out there, if something smells fishy or they think they may have run across someone like this, one is first they distance themselves from that person. And most of the time they are going to have to distance their clients from that person. And once they distance themselves from that person, then they can start to look into that person and maybe might have to call some regulators or something like that. And maybe they’ll have to look into the situation.

At Matson Money, we make every effort to avoid he fraudsters and con artists. In addition, we generally avoid these types of situations where fraudster flourish because we have a very specific investment strategy based on very specific academic tenants and we adhere to those. We have a set of core beliefs that our company was founded upon and if anything doesn’t fit within the parameters of our core beliefs or within the parameters of our academic investment strategy, it doesn’t work for us and it doesn’t work for our clients.

Well I think advisers want to provide something that’s great for their clients and sometimes they think that they need to find the next hot manager. Unfortunately, when you find the next hot manager, sometimes you neglect to do the due diligence that you need to do, in order to make sure it’s the right investment for your clients.

Inside the mind of the American investor

We’ve learned a lot about investing behavior in the last 15 or 20 years. Investors, left to their own devices, tend to trade more than they should. For some investors, this is probably due to over confidence in their ability to trade. People hold on to their losing investments and sell their winners and, to some extent, this makes emotional sense. When you sell at a loss, you feel a bad; when you sell for a gain you think ‘yeah I nailed that one.’ But, especially in taxable accounts, it’s a bad strategy. You should be delaying taxes, not accelerating them.

Another big thing that investors tend to do is chase performance. Investors buy the thing they wished they bought last year. Unfortunately, this is basically an attempt to time the market, which is generally ineffective. Investors tend to buy at peaks or near peaks and sell in troughs. This doesn’t serve them well even though it’s easy to understand why they do it.

One bias that a lot of investors have is that when it comes to buying stocks, they tend to buy things that catch their attention. They buy things that are in the news, that they read about, someone tells them about. Now if you think about it, there are thousands of stocks to choose from and investors generally can only buy a few. One of the ways that they narrow down the set is by focusing on the stocks that catch their attention, but those are not necessarily the best stocks to be buying.

The best course of action for the vast majority of individual investors is to buy a low-cost, well diversified mutual fund. Index funds or other passive investing tends to outperform active investing. Keeping your fees low is really important; that’s like money in the bank. Be sure you’re diversified and don’t spend your time trying to beat the market.

One way advisers can make use of behavioral finance is to sit down with your clients in advance, in a good calm time and talk about some common investor behaviors that can sabotage their portfolios. Especially behaviors like selling in a panic or deciding to buy that hot stock or asset class. Having the discussion before your client actually experiences it allows you to refer back to it and say ‘remember when we talked about this and I explained my investment philosophy is long run, buy and hold, don’t chase the latest performance, don’t panic when the market goes down.’ Having that discussion in advance can be really helpful.