A Word From The Advisor
Controlling the Controllable

Wow! What a quarter!

The S&P 500 is up 56.4% from March lows, and up 19.4% through the end of the quarter. Oakwood’s global strategies, using our customized mix of Dimensional funds, have done substantially better year to date. Even with this 2009 strength, many Oakwood clients tell us that they remain cautious about the future. Since, as you know, we don’t pretend to know exactly what the future will bring, we devote this edition of “Word from the Advisor” to address that caution. We look at it from the perspective of behavioral biases that invariably interfere with investment decision making — if you go it alone. We believe that knowledge combined with discipline is a key differentiator in Oakwood Capital Management’s approach. We also believe that by understanding and controlling biases, we achieve a better investment outcome.

Nerves all around

Behavioral research indicates that humans are not naturally wired for prudent, long-term investment decisions. And it’s been a roller coaster ride since the bottom fell out of the equity market last year. Only a few months ago, at the market bottom, it was widely reported that many investors, fearful of further declines, resisted buying equity shares. This was viewed by many as a perfectly reasonable emotional response to the carnage. At Oakwood, however, we saw opportunities and made selective buys. Now that the market has rallied, many of those same fearful investors are afraid to buy because the market ‘feels’ elevated — an equally emotional response. Emotions can trip you up — individuals who invest without the benefit of professional management are particularly vulnerable. The same investors who sell at or close to market bottoms are equally likely to be buying at market tops. Buying high and selling low is the curse of the emotional investor. Therein lies the need for and benefit of an objective and disciplined professional investment advisor like Oakwood.

The price of market timing

Can investors time the market? According to research by the well respected Dalbar, Inc, the answer is no. Their recent study, “Quantitative Analysis of Investment Behavior 2009,” shows that from 1989 to 2008, the S&P 500 returned 8.35% per year, compared to 1.87% per year for the average equity investor. Over those twenty years, this means that the average investor’s $1.00 investment would have grown to only $1.45, much less than the $4.97 if they simply invested in an S&P 500 index fund. The lesson is that most investors tend to buy high and sell low. The point is that long-term disciplined investors, like Oakwood, can historically earn significantly better returns than those who try to time the market.

What’s the problem with emotions?

Traditional financial theory presumes that investors are rational and always act in their best interest based on available information. However, the burgeoning field of behavioral finance has convincingly debunked those assumptions. In fact, investors are subject to a slew of powerful irrational biases which lead to poor investment decisions.

At Oakwood, our seasoned managers strive to implement disciplined, well-researched, sound investment decisions that look beyond all the noise in order to counteract this effect. In making these decisions, we focus on the following questions: (i) What are the most common behavioral biases? (ii) How do these biases affect decision making? (iii) How can investors control their biases?

Have you experienced these feelings?

The following behavioral biases can impact your investments:

• Overconfidence: Surveys consistently show that investors generally expect to do better than the overall market. This is the flip side of optimistic bias, the expectation that bad things will only happen to other people.
  
  
• Hindsight: In retrospect, past events seem easy to predict. People consequently tend to believe that the future is equally easy to predict. But in fact, hindsight is not always 20/20. This creates the familiar refrain, ‘How could I have been so stupid’?
  
  
• Familiarity: Many investors concentrate their wealth in a few well-known companies with which they are familiar. Others like to hold onto “legacy” stocks. Familiarity gives the mistaken impression of control, and offers a false sense of security. But in fact, the market does not reward investors with risk premiums for “loyalty” or “familiarity.”
  
  
• Regret avoidance: Instead of acknowledging a mistake and realizing a loss, investors hope that a stock will recover. Professional investors understand that minimizing losses can contribute more to overall performance than maximizing gains. Counterfactual thoughts lead to regret. “If only I had not made the decision to buy X.” But, you did buy X, so thinking of not buying it in the past is counterfactual.
  
  
• Self attribution: People tend to take credit for good things that happen and blame others when things go wrong. They attribute success to self-possessed skills or inherent abilities, and attribute failures to externalities that they could not know or control.
  
  
• Extrapolation: Believing that the future will follow in the same direction as the past. However, the future is inherently unknowable, and consistently confounds all forecasts and predictions.
  
  
• News: News can influence or affect a decision. As professionals, we do not react to it; rather, we see past the news, calling it the “noise.”

Insulating investment decisions from emotions

Now that we’ve highlighted some of the emotional factors that hinder investors, what are we suggesting? That you remove your emotions? Not possible. So what do we do? At Oakwood, we carefully distinguish between things within our control and those beyond our control or influence. Oakwood’s disciplined approach focuses on key controllable factors which have a huge impact on investment performance. These include (i) adhering to discipline, (ii) soundness of investment choice, (iii) diversification, (iv) reducing expense, (v) minimizing taxes. We avoid getting distracted by things we cannot control, for example, the financial press.

We don’t try to time the market – as we have shown, this is futile. Instead, we focus our attention on ensuring the best risk/return profile for our clients. We use tools to blunt the effects of behavioral biases, tools like spending time with a client to properly assess their level of risk, thereby resulting in an appropriate asset allocation. In addition, we use the tool of disciplined rebalancing.

Patience and dispassion

We believe in locking in returns following a good run, and redeploying capital into other more attractive opportunities. We exercise this discipline (not to be confused with market timing) to take profits once a pre-set target price is achieved. If we find nothing that meets our standard for risk/reward, we are perfectly content to temporarily park funds in short-term fixed income instruments and wait patiently for an opportunity to arise. It’s our philosophy that free markets must compensate investors for bearing risk. We also believe that since the market is “forward looking,” that the expectation of risk is priced into the market today. The underlying principle is to make decisions based on an individual investor’s own needs and risk appetites, and avoid getting sidetracked by someone else’s opinion about what the market will do next year, next month, next week, or tomorrow.

Jason Zweig in “Your Money and Your Brain” notes that “emotion overwhelms reason,” and that “financial losses are processed in the same area of the brain that responds to mortal danger.” Uncertainty is an unavoidable and intrinsic component of investing, as well as life. But there are many things we can control. This is where Oakwood strives to add value and protect you.