The Best Possible Result, or the Best Result Possible?

April 18th, 2010

The British bridge expert, S. J. Simon, drew a distinction that is just as valuable to investors as it is to bridge players. Simon criticized players who sought to achieve the “best possible result” on every hand. This was too unrealistic, he contended; they should strive instead for the “best result possible” under the circumstances. Now is the season for reviewing last year’s market results and looking ahead to this year. That makes it the ideal time to recall Simon’s dictum.

 Simon’s “best possible result” (BPR) corresponds to what economists would call a global optimum. It is analogous to the highest theoretically-obtainable rate of return on investment. Some investors scan the year-end investment results filled with yearning and remorse, convinced that the distance between their returns and those of the top-ranked fund or asset is the measure of their failure. Their New Year’s resolution is to chase that highest-ranked yield until they catch it.

Simon’s logic suggests that they’ll catch it, all right – right in the portfolio. Of course, he was talking about bridge, not investments. He observed too many players making bids that may have been perfect in principle, but led to disaster when they were misunderstood by their partners. Since players could not precisely foresee the results of their own actions, they should shoot for the “best result possible” (BRP) under the circumstances by making a practical bid that avoided disaster.

Economics teaches us that most asset prices are not predictable. Price fluctuations occur randomly rather than systematically. Shooting for the BPR demands that the investor take on too much risk, creating the potential for large-scale destruction of principal value when things go wrong. The BRP is a more realistic goal, attainable via diversification and asset allocation. Buy (and hold) funds instead of individual stocks. Include small-cap, value, balanced and international funds, not just large-cap growth funds. As you age, include fixed-income assets like bonds and fixed annuities. Don’t incur transactions costs with frequent trading; instead, buy low-cost funds that earn you money through cost savings rather than higher risk.

A Cautionary Example

There are well-known mutual funds whose managers “shoot for the moon;” e.g., go all out for the highest-possible return each year. In good years, they are at or near the top of the year-end rankings. In off-years, however, this same philosophy may well produce a loss of principal. The implication is that the high-flyers’ gains more-than-offset their losses. This seems plausible, but is it true?

Consider this example. One fund racks up a 30% gain this year, but loses 10% next year. Another fund earns much smaller gains of 10% each year. The yearly results net out to about 20% in both cases. At the end of two years, do you think that the funds will be virtually equal in performance?

Starting out with $100,000, the first fund increases to $130,000, but loses $13,000 in year 2 to end up with $117,000, Meanwhile, the second fund gains $10,000 the first year and $11,000 the second year to end up at $121,000. This difference – 4% of the starting value – is not trivial. Nor is it coincidental; in close cases, avoiding the big hit of a loss levied on the entire principal value outweighs lower growth in the good year. In general, it is better to avoid both the peaks and valleys of investment performance in favor of consistent positive returns.

A Compensating Differential

Economists notice that people are willing to accept less money in return for a compensating benefit. For example, people who like quiet and solitude and loathe daily pressure often prefer libraries to sales work, even though the library pays much less. The profession of teaching is said to offer substantial recompense beyond its monetary remuneration. The label economists slap on these non-pecuniary rewards is “compensating differentials.”

Some people chase high yields less for the money than for the excitement. This is not the same thing as a higher tolerance for risk. A better comparison would be with people who play casino games in Las Vegas knowing all the while that the odds favor the house. (A risk-lover is willing to take fair gambles, but not necessarily unfair ones.) If you derive satisfaction from striving to beat the odds and are willing to bear the costs of losing, then more power to you.

Aloha, Vince Lombardi

The problem comes when people define investment success solely by rate of return. This attitude belongs on the field of athletics, not finance. The world’s greatest portfolio managers are unable to beat the market averages consistently. In investments, winning is not everything and it is not the only thing. Just earning a positive return every year – never mind its size – would be a stunning achievement.

A crushing recession works an attitude adjustment on the mindset of the average investor. The years of portfolio envy recede into the background. John and Jane Q. Public are satisfied just to emerge with their shirts intact. This is not all bad, because they are no longer chasing yield like a hound chasing a fox. Unfortunately, they are apt to retreat into their kennel and hole up in the doghouse.

The corollary to not chasing yield is to not give up the hunt when the trail goes cold. In order to earn consistently positive real returns, adjusted for inflation, you have to be in the market. Ironically, the best time to buy is when it looks like the fox has gone to ground for the duration or into hibernation for the winter. The lower asset prices fall, the more shares a given investment will purchase. Eventually, the value of those shares will soar when the good times return.

Stay the Course

The biggest obstacle toward the BRP approach is psychological. Financial reporting and analysis is geared toward yield. Consumer advocacy does a poor job of advertising the virtues of patience and disaster-avoidance. The human mind is geared toward following the herd, rather than breaking off from it. When it comes to positive reinforcement, patience comes in a poor second to a burgeoning bottom line.

In bridge, unlike investments, gratification is immediate. When each hand ends, an entry is made on the scorepad. Opportunities for redemption are plentiful. When one hand is over, it’s on to the next. An investment strategy, on the other hand, may take years to execute and decades to bear fruit. Second chances are scarce, perhaps non-existent.

Bad stock-market performance is no reason for young, growth-oriented investors to shift out of equity investments. Just the opposite, in fact; the ability to acquire shares at low prices will vastly improve long-term yield. By the same token, excellent investment results and double-digit yearly market performance are no reason for aging investors to delay changing their asset allocation towards fixed-income, conservative assets. The recent stock-market nosedive illustrates what can happen to investors who reach the threshold of retirement only to have their net worth yanked out from under them by an unexpected fall in stock prices.

The fact that different investments would have produced higher returns in any particular year doesn’t mean that actual choices were mistaken. The BRP strategy is to make reasonable choices and avoid big, costly errors.

Annuities as a BRP Investment

An excellent example of the BRP philosophy at work is the use of annuities – fixed annuities for wealth accumulation and life annuities to disburse wealth in retirement. Fixed annuities are a relatively secure, fixed-income investment that offers an option to receive guaranteed lifetime income from annuitization of principal. Life annuities trade the flexibility of control over wealth for the security of guaranteed lifetime income.

Each year, there is some asset class or instrument that achieves a high rate of return. If one could always be certain of picking this particular investment, there would be no need for annuities. Similarly, there will inevitably be some combination of retirement-investment assets that would offer a higher rate of return than a life annuity. But hoping for this BPR by continuing to chase higher yields or withdrawals in retirement is a mug’s game.

What Do Bridge and Investments Have In Common?

In both bridge and investments, a strategy of making reasonable decisions and avoiding disastrous mistakes can be a winning one. Too many variables lie beyond your control to allow for an optimal decision in every case. The use of annuities in investment is one concrete way to put this philosophy into practice.

Category: Annuities, Economic Analysis, Fixed Annuities, Indexed Annuities, Retirement Planning | Tags: , , , , , ,

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