The Secret of Investing

Written by: Jason Lawit | Northern Trust

Can you feel sad without being sad?

I have contemplated this question on several occasions in a hot yoga room filled with persons more flexible and lithe than I. I interpret the question to mean can one experience the real and meaningful feeling of sadness while remaining present.

I've extended my contemplation of this question to public capital markets and, importantly, the empirical evidence around investing in such. We know public capital markets are competitive pricing machines by virtue of their structure and volume of activity. Good, peer reviewed studies also suggest it is difficult to prospectively identify an investor who will price risk better than public capital markets (See, Fama and French, "Luck versus Skill in the Cross-Section of Mutual Fund Returns," The Journal of Finance (2010)).

So, where does that leave us in today's markets - when global public equities have dropped twenty percent from their highs of last year? How do we act in our best interest and identify our best course of action, knowing significant behavioral biases are at work against us?

An answer: by seeking to understand risks in markets - but not (necessarily) acting upon them.

Once prices have dropped, new information has been incorporated into markets. Reacting afterward is akin to closing the barn door after the horses have fled. So, rather than reacting to information that has already been incorporated into price - consider focusing on what you can control.

Are your assets and liabilities well-organized in a way that is useful to decision making?

Have you identified your goals and considered whether there are any asset-liability matching opportunities that allow you to hedge risk?

Have you identified a sound framework for making decisions around risk?

Have you contemplated whether there are any risks (concentration, regulatory or legal) for which you are not being compensated?

Is risk a preference for you? Will you have a fair expectation of being able to fund goals off into the future if you do not have risk (return) in your portfolio?

After you have considered the above questions and arrived at answers - then it is appropriate to consider the accuracy of the dynamic pricing mechanism represented by public capital markets and whether you or your hires can do better.