by Ben Carlson, A Wealth of Common Sense
Investment strategies have a tendency to look beautiful on paper and in marketing pitch books. You get to see return numbers, risk-adjusted results and pretty looking graphs that show how great things were in the past. Iâve yet to come across a strategy that couldnât be dressed up and made to look appealing by a skilled sales team or portfolio manager.
While thereâs nothing wrong with trying to present your investment process so it stands out from the crowd, investors have to remember that the markets are never quite as easy as they look on paper or with the benefit of hindsight. Here are 15 reasons portfolios are always harder in the real world than what youâll see in a marketing pitch or back-test:
1. Your life is never going to look like a back-test. Change â in risk perception, goals, needs, family, salary, living standards and values â is a constant in life that is difficult to map out.
2. In a back-test you never have to worry about Greece, Lehman Brothers or the latest crisis du jour. Back-tests make disciplined decisions no matter what. Thatâs not so easy in the real world, in real-time.
3. No one starts off investing with a lump sum of money. Normal people are constantly investing in bits and pieces over time and slowly building up their portfolios. Plus, investing is a form of delayed gratification, so eventually people need to take distributions, as well. Markets donât always cooperate with the timing of your contributions and distributions.
4. Everyone has varying time horizons depending on different goals, wants and needs. Portfolios have to take into account a stream of different time horizons, not just a single linear path.
5. Everyoneâs desire, preference and need to take risk is going to be different and thereâs not a perfect way to balance each. There will always have to be some give and take.
6. In the real world people have to worry about the impact of taxes and costs on their investments.
7. Paper portfolios can be optimized. Thereâs no such thing as an optimal position in the real world. Perfect portfolios are a pipe dream, but everyone shares that same dream.
8. Data mining can make almost any strategy look good in the past by making a few tweaks and changes to portfolio parameters. No oneâs figured out how to data mine the future.
9. Financial markets drive the results when laying out an investment strategy on paper. In the real world, emotions are the biggest factor in anyoneâs performance numbers.
10. Making decisions regarding your life savings is never going be as easy as it looks on a spreadsheet.
11. The best investment advice for the long-term is usually the the most uncomfortable thing to do in the short-term. Poor decisions often relieve short-term anxiety, but leave you worse off in the future.
12. The majority of people are hard wired to make poor decisions. Many times itâs not your fault, but human nature that causes these poor decisions. If you arenât aware of your inherent cognitive biases youâll repeat the same mistakes over and over again.
13. Itâs easy to look at returns on a sheet of paper and tell yourself you would have been able to withstand large losses or periods of relative under-performance in regards to the markets or your peers. Envy, fear, doubt and panic are impossible to simulate.
14. Most market participants canât help but wonder if the pundit theyâre watching on TV really is their guru savior who knows exactly whatâs going to happen next or just a run-of-the-mill charlatan. The markets arenât forced to second guess themselves because they listened to the predictions of pundits. People do this all the time.
15. Portfolios can be made to look nearly flawless on paper. In the real world, things are messy and hard choices have to be made quite often.
Further Reading:
Torturing Historical Market Data
From Great to Good
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