14 Oct 2011 “A Foolish Consistency is the Hobgoblin of Little Minds” Ralph Waldo Emerson

Psychologists have uncovered a fascinating phenomenon about people at the racetrack. The moment after placing their bet on a horse they become much more confident of their horse’s chances of winning than they were immediately before placing their bet. Is it possible that the very same thing happens the moment we invest in a stock or a mutual fund? 

In his book entitled Influence, Robert Cialdini says that the need for consistency “lies deep within us directing our actions with quiet power.” It is quite simply our nearly obsessive desire to be (and to appear) consistent with what we have already done. Once we have made a choice and taken a stand we will encounter personal and interpersonal pressures to behave consistently with that commitment.”

In this increasingly busy, networked world, information could easily overwhelm us if not for automated responses. They offer us “shortcuts through the density of modern life” according to Cialdini. “Once we have made up our minds about an issue, stubborn consistency allows us a very appealing luxury: We really don’t have to think hard about the issue anymore. . . . We need only believe, say, or do whatever is consistent with our earlier decision.” Sir Joshua Reynolds put it this way, “There is no expedient to which man will not resort to avoid the real labor of thinking.”

But even more troubling according to Dr. Cialdini is the second and more perverse attraction to mechanical consistency. “Sometimes it is the cursedly clear and unwelcome set of answers provided by straight thinking that makes us mental slackers. There are certain disturbing things we simply would rather not realize.” He goes on to say that preprogrammed, mindless automatic consistency can effectively barricade us from the sieges of reason and reality we don’t want to face.

Last Sunday there was a fascinating article in the Wall Street Journal on a phenomenon which occurs among stocks that could be explained by the theory of automatic consistency. The article by Russell Pearlman, entitled Dead Stocks Walking illustrates the surprisingly large number of large company stocks that have provided no returns (or losses) for their investors over a full decade despite fundamentally good earnings performance. Blue-chip companies like WalMart, Cisco, General Electric, Pfizer, Merck, Amgen, Medtronic, Intel, Microsoft, Ford, Dell, and Time Warner. These are industry-leading companies long held by widows and orphans and hundreds of mutual funds. Pearlman adds up the market capitalizations of the 30 worst performers to find that a staggering $2 trillion has gone nowhere in a decade.

Pearlman attempts to explain why individuals and professional portfolio managers alike would tolerate such lousy performance for such a long time. One reason he thinks is the old buy-and-hold strategy, proven effective by experience. From 1980 to 2000, the average annual return for the 100 biggest U.S. stocks was 62%. Pearlman says “that wasn’t a fluke of the calendar, either. Indeed, during any 20-year period from 1970 to 2010, investors saw large-cap stocks’ average annual return rise 13%. Managers interviewed by Pearlman said they have no intention of changing their buy-and-hold strategy. They say “investors get into trouble when they change their stripes or discipline.”

Wall Street analysts consistently like the big guys too. Pearlman notes that as many as “13 pros had buy ratings on [WalMart] in 2004, and a near-equal enthusiasm can be found among securities analysts in virtually every quarter since. (Only one of them, during this stretch, has slapped a SELL on the stock, according to Zacks Investment Research, and even then, the rating lasted a mere two months.”

Another reason cited by Pearlman is that the large-cap category of managers “have no choice but to buy these stocks: There are only so many large-cap equities. Adding smaller names carries a risk, managers say: having their fund no longer classified as a ‘large cap’ fund by Morningstar, Lipper or another ratings firm. These classifications might not matter to individual investors, but they do to financial planners and pension plan administrators looking for a particular type of asset mix.” Hear Mr. Emerson whispering ‘foolish consistency’ yet?

Still another reason cited by Pearlman is intellectual discipline. Value investors want to buy stocks that seem undervalued relative to its growing earnings and shrinking stock price. As the stock keeps falling they simply buy more (automatically and consistently).

Take Abbott Labs for instance. Since 2001, Abbott has more than doubled its annual profits, yet its stock price, while outpacing the broad market since then, has essentially remained flat. Rather than being disgusted, though, Robert Zagunis of Portland, Ore. actually likes that he can continually buy the stock. ‘Investors would love to be able to buy a private company that was increasing profits like that,’ he says. But since Abbott is public, ‘you get a weekly, daily, even hourly reminder of what other people think,’ which makes the task of sticking to one’s guns ‘more difficult.’

Whether one justifies behavior with ‘buy-and-hold,’ ‘analyst favorite,’ ‘large-cap allocation,’ or ‘value’ the outcome for the last eleven years has been inarguably painful. Automatic consistency has quite literally stolen wealth, and lifestyle from a huge majority of investors for nearly one fifth of their investing lifetime.

What’s the alternative?

Change the focus and energy of your life from selecting (or endlessly holding) stocks, mutual funds, and active managers to setting goals and continually evaluating your confidence of reaching and exceeding them. You know your goals and dreams, we can help you marshal your resources (including, but not just your investments) to confidently achieve those dreams.

Using sophisticated probability analysis, we continually stress test plans to determine, based on the latest information, whether they are properly, under- or over-funded to meet their objectives. While we can quantify goals and their timing, we cannot know with certainty what impact the capital markets will have on our assets as we plan to save and spend over our lifetimes. But we can measure the uncertainty and manage it to an acceptable level of confidence, enough for comfort and not so much that you sacrifice today for future wealth you have said you will not need in your lifetime.

We use exchange traded funds which efficiently and effectively capture the broad and diverse capital markets. We allocate stocks and bonds appropriately for each client’s plan to provide sufficient future wealth, with no more risk than is required to maintain sufficient confidence of meeting or exceeding their goals. Our portfolios virtually eliminate the risk of underperforming markets as did the ‘dead stocks walking.’ We also eliminate the risks added by active managers who make outsized bets on under-diversified selections.

Active managers increase uncertainty in your portfolio, which quite simply translates into reduced lifestyle; working longer, saving more, taking more risk, or enjoying fewer financial rewards in your future. Why risk your future trying to improve on the already sufficient returns of the capital markets? Over the last decade the allocation we use for our Growth model has returned 3.9% per year, while our most conservative portfolio has yielded 5.23% annually, comparing favorably to the ten-year average for the S&P of 2.9%.

We generally value and approve of consistency. But no one wants to consistently do the wrong thing, or even wonder consistently if they are doing the right thing. We help our clients consistently re-evaluate where they are relative to their goals and objectives by controlling what we can in costs and underperformance and by quantifying and managing uncertainty through sophisticated planning.

Consistency by any other name would be foolish.