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Can you handle the heat?

Many investors find out too late they can't

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Rudyard Kipling's poem If is a much-beloved evocation of grace under pressure which, had it been written today, might have mentioned keeping your wits about you when markets are falling to pieces.

Having the emotional fortitude so you don't sell your investments in a panic when markets drop significantly is essential to being a successful, happy investor, says Larry Berman, a renowned Canadian money manager and host of Berman's Call on the Business News Network (BNN),

It's a message Berman, co-founder of the Independent Investor Institute, has been preaching annually when criss-crossing the nation meeting with average folks with a keen interest in their money.

"I introduced this concept called the sleep-at-night portfolio, and really, it shows you how to build a diversified portfolio using exchange-traded funds that's adjusted a couple of times a year," says Berman, co-founder of the Toronto-based money-management firm ETF Capital Management.

Exchange-traded funds (ETFs) are a godsend for the little investor, he contends. They're low-cost on annual fees compared to mutual funds. For an ETF that gives you a slice of the TSX composite index, for example, you can pay less than one-tenth the management cost of a Canadian equity mutual fund.

ETFs provide diversification, too. And over the long run, they probably will outperform most actively managed funds because a passively managed ETF emulates the performance of an index while most managers try, but often fail, to beat the index.

ETFs come in all sorts of flavours. You can invest in the U.S., Canada, emerging markets, stocks, bonds, preferred shares, commodities, etc.

Allocating capital in a diversified portfolio of ETFs can be tricky for the uninitiated, but it can be whittled down to this industry catchphrase: What allows you to sleep at night?

It's a simple question, but the answer is a little more complicated.

"It's unique for everybody," Berman says.

We all can figure out psychology plays a large part in determining the answer, but we often fail to realize the extent to which our emotions can wreak havoc on our portfolio.

Understanding the potential negative effects of our emotions is central to figuring out how to build that sleep-at-night portfolio, he says.

Berman is an experienced technical trader, having spent years poring over charts that are largely the reflection of the collective investor behaviour regarding asset prices. He is also an economist and a firm believer in the importance of behavioural economics' influence on investment decisions.

He cites the important work of two behavioural economists, Nobel Prize winners in the field -- Daniel Kahneman and Amos Tversky. They developed "prospect theory," which basically contends people don't derive a lot more happiness as returns on their money increase.

"Their happiness does not increase all that much if they're making five, 10 or 20 per cent," Berman says. "They're probably a little bit happier making the higher returns, but not substantially."

Our experience of losses is much more profound. Losing five per cent will hurt a lot less emotionally than 20 per cent if we're not prepared beforehand for that possibility.

As a result, when a substantial, unexpected loss occurs, we are prone to make mistakes.

"That's when you're going to make the emotional decision to throw the towel in so you can sleep at night," Berman says.

This notion speaks to our tolerance for risk, and Berman has been advocating for the importance of considering the risk in your portfolio as much as the return.

"People always ask about the average return, but nobody contemplates the risk you need to take to get that."

Looking at annualized returns alone can lead to distorted expectations and nasty surprises. For example, over the last decade, the global mining sector has produced the best average annual return.

That looks good, right?

Well, that depends on what you're looking for from an investment.

This sector is also very risky and not for the faint of heart. Even well-established companies in this sector are prone to wild swings in value.

"This sector has almost twice the volatility of the S&P 500, and the last two years have been quite poor, with global mining stocks down 50 per cent over that period."

If you're only looking at the long-term return, you will only fully realize the risks after a substantial loss, and that can make you do something you'll regret.

"What I've seen for years, over and over, is people are always selling -- capitulating -- when markets are down, but they're doing it at the worst time, precisely when they should be buying."

The fact is most people invest when prices are high because they fear missing out on the gain. While that is far from ideal, what's worse is they tend to sell when prices are low because they're even more worried about losing lots of money.

This doesn't mean there doesn't come a time to cut losses, Berman says. A bad investment is a bad investment, but people have a tendency to toss out the good with the bad.

Others have trouble letting go of their bad investments because they are emotionally tied to them.

"I get questions on the show like: 'I bought BlackBerry at $60. Should I buy more now?' " he says. "These people have what is called an anchor bias."

Instead of doubling down on their mistake, Berman says they need to frame their thinking differently. Rather than waiting for the faint chance a bad investment will regain its lost value, they should consider selling and buying a better investment that could more than make up for the money lost with the bad investment.

"But the problem for many of us is the emotional mind has difficulty taking that loss."

Given next month is Financial Literacy Month, Berman says investors should do their portfolio a solid and bone up on their investment know-how, and they should start by asking themselves about their tolerance for losing money.

Certainly, the goal of investing isn't to lose money, but we need to understand how we will behave when it happens, because it inevitably will.

"Once you have that awareness and you think you understand a little bit about history, how markets work and asset classes, all of a sudden you can make better-informed decisions with the rational part of your mind as opposed to the emotional decisions that you're not really aware that you're making."

That said, one can't help but think maybe Kipling would have made a good investor, since the key to successful investment has so much to do with "keeping your head when all about you are losing theirs."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition October 26, 2013 B12

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