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How to be optimistic and keep your investment portfolio working

Attitude counts when it comes to investing, says Bob Carlson's Retirement Watch, but so does making sure you’ve built your portfolio the right way.

These are heady days for pessimists. In markets like these, there are a lot of people who not only think the glass is half-empty, but are sure that it won’t be full again for a long time. You may be inclined to agree, however reluctantly.

But investors will always get further ahead if they remain optimistic. That’s the firm opinion of Bob Carlson’s Retirement Watch.

It’s a lot easier to be cheerful if you have built your portfolio correctly. And this is something that most investors fail to do, according to Mr. Carlson. It’s all about managing risk first, he says, and we’ll look at the specific steps he recommends in a moment.

The Civil War and the world’s end

Pessimists are always with us, says Mr. Carlson, going back to one of the darkest periods in U.S. history to make his point.

“There rarely is a shortage of pessimists in popular culture. One peak of pessimism in the U.S. was the years before and after the Civil War. A number of new religions were started during that period, and many people viewed the Civil War and other events as a signal of the world’s end.”

It isn’t that pessimists don’t know what they’re talking about, it’s just that there’s not as much to be achieved by taking a dim view of things.

“Pessimists often are smart people and make logical arguments, usually amassing a great mass of facts in their favor,” concedes the editor. “Yet, it almost always pays to be optimistic over shorter periods and always has paid to be positive over the long term.”

Opportunities for the cautious optimist

Mr. Carlson strives to practice what he preaches. “We exercise caution in our recommendations and always are on the look out for risks to avoid. We look for a margin of safety, or as Martin Whitman puts it, investments that are ‘safe and cheap.’ That enabled us to do well during the 2000-2002 market decline, and our instinct to be optimistic helped us enjoy the ensuing recovery.”

Nor is there any reason to be overwhelmed by pessimism in today’s markets.

“Even through the subprime mortgage and credit crises,” adds the editor, “things have yet to sink to the depths forecast by the pessimists. There almost always are opportunities in the markets for the cautious optimist. While we are fairly cautious right now, we are not expecting the disaster some are, and anticipate becoming more aggressive sometime in 2008 and 2009.”

In order to be profitably optimistic, of course, you have to have an investment portfolio that is built the proper way. But most investors go about it the wrong way, according to this advisory.

Lower returns with greater risk

“Most investors use a backward process when constructing their portfolios,” says Mr. Carlson bluntly. “They look first for the highest-returning investments, what they think will be the next hot stock or mutual fund.

“That is a good way to earn lower returns while taking greater risk.”

You can’t get much more backward than that. Risk is at least as important as returns, possibly more important. “Investors should focus on the trade off between risk and return instead of focusing on the return side of the equation,” urges the editor.

“The best investors are risk managers.” Mr. Carlson’s favourite fund managers are value investors. “They always are looking at the risk in different investments and choose those that seem to be selling for less than their intrinsic value.”

The proper way to manage risk is to look forward, not backwards. Investors have to determine what will happen based on the current state of the markets. Assuming that the future will repeat the past may be the biggest mistake investors can make.

Taking a wild ride

“For example, suppose in 1998 an investor reviewed long-term returns and concluded that the best risk-return trade off was to hold a portfolio with a substantial commitment to U.S. stocks,” says Mr. Carlson. “The investor also concludes that few mutual funds or investors earn a higher long-term return than a market index. The investor decides to invest primarily in index funds.”

That investor would have bought a ticket for a wild ride, plunging into a steep bear market followed by a long bull rally. In the end, that investor could have had the same or a better return from treasury bills than from index funds over the past 10 years, adds the editor. And probably a lot less anxiety.

Similarly, with interest rates on treasury bonds and other safe investments at historic lows in 2004, an investor might have sought higher yields in real estate investment trusts, higher yield bonds and the like.

The yields were not much higher than treasury bills, but high enough to be tempting. But when the credit crisis struck in 2007, these investments plummeted in value. Often, the losses wiped the additional yield they had generated over three years, and then some.

In the first case, banking on returns would have been more trouble than it was worth, in the second, quite simply a mistake.

Avoid large losses

Looking at risk first would have kept these investors safe, insists Mr. Carlson. “As long as the economy is in a positive long-term growth trend, the markets will generate positive returns. The key to capturing those returns and earning more than the market return is to avoid large losses.

“Investors swing from extremes of optimism to pessimism, and that pushes prices away from fundamental values and to unsustainable levels. Investors need to be on the right side of that swing.”

In short, if you want to make money, your first step is not to lose money.

Simple as this idea sounds, it requires discipline. Mr. Carlson suggests four ways to make that discipline work for you. These depend in part, he admits, on how much time you’re willing to spend managing your investments. If you’re prepared to do some active management yourself, here’s what you should do.

Sell high and buy low

Rebalancing your portfolio has become a pretty common piece of advice. It’s also pretty common to ignore it, according to Mr. Carlson.

As the market moves, your portfolio gets out of whack. You should reduce those investments that have gone up significantly, and increase those that have lagged.

Few investors do so, but it should be done at least once a year, and more often if extreme market moves throw the portfolio way out of balance (like now). “A disciplined rebalancing practice requires an investor to sell high and buy low.”

You should also vary the assets in your portfolio. Most investors, says the editor, own a simple mix of stocks and bonds. If you want a few clues as to how to build on that mix, look at sophisticated institutional investors like endowments and foundations. They have added assets like hedge funds (real hedge funds that protect against market drops, not the high-risk impostors created for very wealthy investors).

“These other assets give true diversification,” says Mr. Carlson, “so parts of the portfolio will rise when stocks and bonds are declining.”

Going up, not down

The third suggestion is to manage asset allocation. In effect, make sure your portfolio has investments that are on the way up, rather than on the way down. Here is how the editor does it.

“We eliminate investments that seem highly valued or about which investors are extremely optimistic. We add those that seem cheap or about which investors are pessimistic.

“This is not market timing or day trading,” he stresses. “We are looking forward one to three years and reducing our exposure to assets that appear to have the most risk over that period.”

Mr. Carlson’s final proposal is to rely on value managers. Most of his portfolios are made up of mutual funds, but the point can be equally well made with individual stocks.

These managers “engage in risk management for us. They avoid investments within their mandates that have the most risk and buy those that seem to have low risk with potential for solid returns.”

It all seems pretty simple from this advisory’s point of view. If you start out looking for high returns, you’re liable to run into a quagmire of risk. If you start out trying to avoid risk, you have a much better chance of piling up good returns.

Or, simpler still: eliminate the reasons for pessimism and you create optimism.