How Rules-Based Investing Can Protect You From Yourself

Thanks to a rash of guest posters. I've had a really crazy summer, and I'm just getting ready for fall. Check out this post from my friend at Investment Zen about how to use rules-based investing to avoid ruining yourself financially.

Volatile markets bring out the worst in investors, who are often guilty of overreacting to good news and bad news alike.

In the face of the age old maxim to ?buy low and sell high,? many investors in fact do the opposite?getting swept up in the enthusiasm of an overheated market, or losing their cool when prices head south. Behavioral economists have a file folder full of terms to diagnose our poor decision-making, especially under uncertain conditions: outcome bias, loss aversion,?and more.

The bottom line? Our minds play tricks on us. By necessity, we make intuitive, snap judgments all the time. More often than not, those snap judgments are spot on. But in situations characterized by complexity and uncertainty, we are prone to falling into predictable pitfalls, sometimes with disastrous consequences.

Behavioral economics tells us that the answer is to impose discipline on our decision-making by taking it out of our hands entirely. Tools like checklists, algorithms, and a clearly defined process can save investors from their own worst mistakes.

They can help structure and simplify a world that all too often overwhelms the average investor.

rules based investing

Using The Humble Checklist

We?ve all seen it in the movies: a pilot and his co-pilot running through a list, calling out check, check. It might seem like a no-brainer now, but using pre-checklists to safeguard against preventable oversights was actually a breakthrough innovation at a time when experts feared that increasingly complicated systems had created ?too much airplane for one man to fly.?

In his book The Checklist Manifesto, Atul Gawande recounts his efforts to introduce checklists to modern medicine, especially in high-risk settings like surgery. Inspired by Gawande, hedge fund manager Guy Spier and others started using checklists as part of their investing decision-making process, and found this humble tool dramatically improved their results. Yet most investors are reluctant to use them. ?It somehow feels beneath us to use a checklist,? Gawande says.

It?s important to know what an investing checklist is, and what it is not. ?A checklist is not a shopping list of desirable attributes,? Spier writes in his book Education of a Value Investor. ?It?s a list of predictable errors.?

Keep this in mind as you put together your rules-based investing approach.

Auto-Pilots and Algorithms

Checklists leave decision-making in the investor?s hands while creating a sequence of speed bumps to prevent impulsive mistakes. Other tools provide even more structure, more rules. Dollar Cost Averaging (and its slightly more complicated variant, Value Averaging) put investors on a pre-set schedule. While you decide what to invest in, the plan dictates when.

In truth, you won?t always be investing at the most optimal time. But this approach prevents you from trying to time the market?which for most investors is an invitation to disaster. These ?auto-pilot? strategies also nudge you to buy when you might otherwise be reluctant to. Most of all, according to the senior editor at Money magazine, ?they give you a disciplined framework for saving.?

An algorithm is a series of calculations following a prescribed set of rules, and the algorithms used by robo-advisors like Betterment and Wealthfront take the automated approach to investing a step further.

Based on an initial questionnaire designed to gauge your risk tolerance and goals, robo-advisors recommend a portfolio typically consisting of low-cost, broadly diversified ETFs. Both the when and the what of investing are managed by the service?for a fraction of the fee charged by your average financial advisor.

For investors who want a little extra hand-holding, some services offer the option of a human element. Robo-advisors command a small but rapidly growing segment of the investment market, and established players like Charles Schwab and Vanguard have jumped into the game with their own automated services.

Robo-advisors also help you implement another key investing rule: periodic re-balancing of your portfolio. Your target allocation may, for example, be 70% stocks and 30% bonds. But if stocks surge, the equity component of your portfolio will as well, throwing your portfolio out of whack.

Re-balancing is yet another tool to protect you from the mood swings of a volatile market, prompting you to sell high and buy low instead of the other way around.

The Limits of Rules-Based Investing

Another automated approach to investing is the target-date fund (sometimes also marketed as a lifecyle fund). This is the ultimate ?set it and forget it? school of investing. Simply choose a fund with your desired retirement date, and the fund has already put together an appropriate portfolio, adjusting it as you age, and shifting your asset allocation to a more conservative mix as you approach retirement.

While an attractive, worry-free option for investing newbies, the one-size-fits-all model comes with serious limitations. You may also end up paying higher fees than you realize.

A very particular type of rules-based investing is the broad category of strategies termed ?smart beta.? Like any umbrella term, smart beta means different things to different people. Generally it refers to index funds and ETFs that depart from the cap-weighted formula of standard passive indexes, instead trying to capture the benefits of a range of risk factors and market anomalies. While proponents claim they offer the potential of superior results, critics contend that smart beta contains hidden costs and risks, marketing itself as a safe, passive strategy while being anything but.

Process, Process, Process

Behavioral economics has revolutionized finance and investing by making us aware of serious blind spots in our decision-making. A disciplined and structured approach to investing can rein in our worst impulses and save us from critical errors. It's all about rules-based investing if you want to succeed over the long haul.

While the ?out of sight, out of mind? quality of purely automated strategies might have a certain appeal, the optimal path is probably to customize a rules-based process that works best for you?one which balances structure and flexibility, and which takes advantage of the many tools available to the contemporary investor.

In the end, the most important rule is the one espoused by Warren Buffett: “Rule No. 1 – Never lose money. Rule No. 2 – Never forget Rule No. 1.”

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