Looking to become a better investor? Well, you may want to try catching a wave or two. In a recent Time Magazine interview titled “Why Stocks Are Dead (And Bonds Are Deader),” PIMCO’s co-chief investment officer, Bill “The Bond King” Gross, CFA, likened investing to surfing:
“Investing is “dominated by the wave of either public opinion or institutional opinion, which moves prices forward. If you are negative and you refuse to believe in the wave, then you can’t surf,” said Gross. “The point is when you are surfing, you want to ride the wave, but you also want to recognize that there’s a crest and that ultimately a good surfer has to kick out.”
Fortunately for most individual investors, you don’t have to be a “bond king” or a “surfer dude” to glean uncommon wisdom from surfers. So, if you want to be better at riding Mr. Market’s waves, here are a few valuable surf lessons.
Surfers Know Which Swells to Chase and Which Swells to Ignore
In surfing lingo, there are two basic types of ocean swells — wind swells, which are generated by local winds, and ground swells, which are generated by winds blowing over longer distances. From an investor’s perspective, wind swells are similar to the market’s short-term price swings in that they are short, fickle, and difficult to ride. Conversely, ground swells are similar to the market’s long-term investment trends in that they are long and fairly predictable and require little effort to ride. Although the similarities between certain ocean swells and market trends are apparent, it seems surfers and investors pursue them very differently.
The average surfer prefers riding Mother Ocean’s predictable ground swells and doesn’t waste much energy chasing her fickle wind swells. Research shows, however, that the average investor does the opposite; overlooking Mr. Market’s predictable long-term investing trends while fruitlessly attempting to ride his flighty short-term price swings. DALBAR’s 2012 Quantitative Analysis of Investor Behavior reinforces just how frustrating this irrational behavior can be for investors.
According to DALBAR’s analysis, mutual fund investors consistently lag the market indices that reflect long-term investment trends. The data illustrate that over a 20-year period (1992–2011), the average equity fund investor lagged the S&P 500 Index by an average of 4.32% annually — earning less than half of the 7.81% annual return offered by the passive stock market index. The reason for these low returns is simple: Investors are “wiping out” when attempting to time the market’s short-term directional changes. From an investor’s perspective, it is far better to ignore Mr. Market’s short-term price volatility and ride his more predictable long-term investing trends instead.
Surfers Know How to Ride Waves More Efficiently by Rebalancing Systematically
Breaking waves ebb and flow as they move forward. For this reason, a surfer has to periodically rebalance his position on a wave in order to keep riding it. Good surfers move forward more efficiently than novice surfers by knowing when and how to rebalance their surfboards back toward a wave’s power source (or “pocket”). From an investor’s perspective, broad asset classes like stocks and bonds are similar to breaking waves in that their performance also ebbs and flows over time. Consequently, if left alone, an investor’s asset mix will eventually drift away from its power source (or “optimal weighting”).
Although it seems logical that investors would periodically rebalance their portfolios’ asset mix, researchers have found that they generally don’t. In a working paper titled “Winners and Losers: 401(k) Trading and Portfolio Performance,” the authors estimated that only about 10% of 401(k) plan participants actually rebalance their accounts. This irrational behavior is likely a result of the fact that portfolio rebalancing requires plan participants to sell recent winners and buy recent losers — a counterintuitive endeavor for most investors.
Ideal portfolio rebalancing strategies vary depending on factors like taxes and transaction costs, but there are a few simple rules of thumb individual investors can use when developing game plans. For example, a popular study by Vanguard titled “Best Practices for Portfolio Rebalancing” states that “a rebalancing strategy based on reasonable monitoring frequencies (such as annual or semiannual) and reasonable allocation thresholds (variations of 5% or so) is likely to provide sufficient risk control relative to the target asset allocation for most portfolios with broadly diversified stock and bond holdings.” Similar to surfers, individual investors will ride the market’s waves of fear and greed more efficiently if they develop game plans to systematically rebalance their portfolios’ asset mix back toward the optimal weighting.
Surfers Know the Importance of Holding a Diverse Quiver
Ocean conditions can be calm one day only to be rough the next. This volatility is an important aspect of surfing because different ocean conditions call for different surfboards. Avid surfers know they are required to own a diverse collection of surfboards, allowing them to ride a variety of waves. From an investor’s perspective, market conditions are also constantly changing and, as in surfing, no single investment vehicle works well in every market condition. Thus, diversification is as imperative when investing as it is when surfing.
The average surfer seems to understand the importance of diversification, but studies have shown that most individual investors struggle with the concept. William Goetzmann and Alok Kumar found that a large portion of individual investors hold under-diversified investment portfolios, which ends up being a costly mistake for most individual investors. Investors’ failure to embrace diversification as readily as surfers is likely a result of the lack of accurate feedback in the investment world.
The wipeout that under-diversified surfers experience when attempting to ride the same surfboard in every condition is immediate and obvious; it is thus impossible for surfers to avoid handling the challenge. In contrast — perhaps because investing is more of a mind game than a physical one — investors seem to have trouble deciphering whether or not they are wiping out. For instance, a paper titled “Why Inexperienced Investors Do Not Learn: They Do Not Know Their Past Performance” notes that fewer than 5% of the investors surveyed believed they experienced negative returns while more than 25% of them actually did. It is obvious that individual investors would benefit from more-accurate feedback regarding the performance of their investments and a higher level of portfolio diversification.
Investors can learn more than a few lessons from surfers, the most important one being that both Mr. Market and Mother Ocean are complex and unruly at times. It’s not easy to tame or beat them, so you better learn to go with their flow. If you chase the right swells, rebalance systematically, seek accurate feedback, and hold a diverse quiver, you will greatly increase your odds of catching a rewarding ride.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: iSTockphoto/kycstudio