From the May 2004 issue of Investment Advisor • Subscribe!

Disciples of Discipline

There's a price to be paid by investors who cannot stick to their investing disciplines

As an advisor, one of the most important responsibilities you have--maybe the most important--is to ensure that your clients avoid making mistakes that will devastate their wealth. Of all the mistakes that investors make, the most egregious is the failure to maintain discipline.

The precise amount of potential wealth lost by investors due to lack of discipline is difficult to measure. However, it is intuitively obvious that moving in and out of the equity markets at the wrong time can destroy your potential gains from the capital markets. I was struck by a recent Forbes article ("Your Own Worst Enemy," December 22, 2003) that estimated that investors who broke their discipline by jumping in and out of stocks have lost a whopping $1 trillion over the past decade. By contrast, damage to investors from the mutual fund scandals total around $10 million, Forbes estimates.

Don't get me wrong. Fund managers who commit illegal acts should be held accountable. My point is that in the wake of all these scandals, it's easy to forget that investors' worst enemies are often themselves. That's why one of your top priorities must be to teach clients what it means to be disciplined investors, and in the process keep them on the right path through thick and thin. By showing your clients how to become disciples of discipline, they'll end up happier, wealthier, and very gratified with the value you provide--helping you to build a very successful business.

What Is Discipline?

Many clients are unsure of what it means to be disciplined, so it's important for you to begin by helping them understand the characteristics of a disciplined investor.

For start-ers, a disciplined investor knows that inves- ting in the equity markets is long term by definition, and that the only way to reach your goals is to stick with a long-term game plan. Once a client has a diversified investment portfolio that reflects his or her personal profile--age, risk tolerance, financial situation, number of children, and so on--the only reason that portfolio should change is if the client's profile changes.

Of course, most of your clients will agree that this approach makes sense, but often will find it tough to follow. The reason is simple. As humans, we feel the need to take action as events occur, thinking that we know how markets will react to those events. That's why, for example, many investors cashed out of stocks following 9/11, or why I'm sure some of your clients are considering what moves to make depending on whether Bush or Kerry wins the election. It's these types of changes prompted by external events that are responsible for investors losing $1 trillion in the past 10 years.

Disciplined investors, however, don't make these mistakes. They never let events, market moves, or forecasts cause them to change their long-term investment strategy by moving in and out of the markets. They understand that the key is to stay invested at all times so they'll always be there when the market return is positive. Like Woody Allen said, 80% of success is just showing up. Your clients need to know that all they must do to succeed in the capital markets is to "show up."

When you explain discipline to clients in this way, it begins to look very appealing. So often the term "discipline" has a negative connotation because you must deny yourself something that you desire and enjoy--Atkins dieters need the discipline to avoid their favorite pastries and pastas, for example. Disciplined investing is different. The discipline that comes with being a long-term investor can be very satisfying, and not just when you achieve your goals: Relieving the daily anxiety and stress of the equity markets has it rewards as well. Disciplined investors don't deny themselves anything that they would want to experience. Instead, they feel liberated by the fact that they no longer have to take action when the world at large changes. They get to focus their time and energy on what is truly important in their lives.

If you can find anything painful about that type of experience, let me know.

Stay in the Game

So how can you drive home the importance of discipline to your clients? Quantitative data can certainly help. You have all seen what happens to investors' returns if they miss the market's best performing days. For example, the chart at right shows the returns for the S&P 500 from 1991 through the end of last year. By simply staying invested in the market during that time, an investor would have gained 11.9% annually. That return plummets to 2.1% if he or she was out of the market for just the best 30 days. Of course, a quick review of that period--which included the September 11 attacks, the Russian debt crisis, and the Clinton-Lewinsky scandal--shows that there were plenty of opportunities for investors to break their discipline and damage their returns. This is what you must guard against on behalf of your clients.

You also can use common sense or analogies to drive the message home. For example, I was reminded of the need to keep clients disciplined when I went to a hockey game earlier this year. Hockey is one of those games where the action is continuous. When I arrived, I decided I would stop by the snack bar for a little popcorn and soda. As luck would have it, as I was waiting in line I heard "Goal!" and the roar of the crowd. I had missed the first score. Before I finished paying, I once again heard "Goal!" Now I was really frustrated. In that game, a total of six goals were scored, but by getting out of my seat for part of the game, I missed a significant portion of the highlights I was hoping to experience when I bought my ticket.

This experience reminded me of stock market investing. You have no idea when the market is going to soar, so in order to reap the benefits of being an equity investor you need to be there for the entire game. In fact, it's even more relevant for investors to stay in their seats for the entire game than it is for hockey fans. At least the hockey fans have instant replay. There is no TiVo for investors.

There is no better example of this than last year's market. 2003 was the best year for large-cap stocks in five years, the best year for large international stocks in 17 years, and the best year for micro-cap stocks in 36 years. But how many of us could have predicted a year like 2003--with events like the war in Iraq, worldwide SARS outbreaks, and the mutual fund scandals involving some of the most prominent fund sponsors? Those events led many investors--and perhaps some of you--to conclude that 2003 would be a good year to "wait and see" about the market. For example, in one week last March, investors redeemed $3.7 billion in stock funds. Then roughly one week later, the Dow hit its low for the year and began its way up. Meanwhile, the prognosticators were forecasting a fourth consecutive negative year for stocks and even an economic recession. But as we now know, 2003 was not a good year to be at the refreshment stand.

The point is that no one--not even the smartest minds--can be sure of what the future holds. That's why it's called the future. If you compare the experts' expectations for 2003 to what actually occurred, your clients can't possibly miss the importance of simply staying in the game.

Fresh reminders

That said, your clients will always feel pressure to break their discipline, especially during those stressful market environments when emotions like fear and greed run high. So how can you keep your clients on track year in and year out? I suggest three tactics:

o Revisit their profile. For each of your clients, you should have developed an investor profile that spells out their goals and unique financial and personal situation. When the next big earth-shattering event occurs, remind them of all the data you considered and the discussions you had when creating their investor profile. Then ask them if this event has fundamentally changed who they are as a person and as an investor. The answer will always be "no." Then simply remind them of the deal you made with them: They can change their plan--but only when their profile tells them the time is right.

o Pull the plug and cancel the subscriptions. If you have a weight problem, you don't eat dinner at a buffet. Likewise, if you want to be a disciplined investor, don't put yourself in a position to be tempted. Remind clients that CNBC and the popular financial media peddles investment pornography that's designed to titillate, not educate. There's no value in any of it. Their whole pitch is aimed at playing on your emotions and encouraging you to break your discipline with stories like "Found: The Next Microsoft" and "Sell Stocks Now." Why? Because disciplined investing stories don't attract advertisers the way sexy investing stories do.

o Send 'em to school. When I was an advisor, I got all of my clients together twice a year to educate them about investing intelligently. Those meetings also served a second powerful purpose: My clients were able to see that they were among a lot of other people also having a successful investment experience. They realized they were members of a select group of investors who were doing it right--we called it "the smart people's club."

Of course, there will be times when clients feel tempted to break their discipline and put pressure on you to comply with their desires. You have to decide at these moments whether you are simply a facilitator or truly an advisor. If you are an advisor, this is when you really earn your fee and ensure your clients will be forever grateful for helping them to achieve their most important goals.

As I like to say, do your job and the numbers will take care of themselves.

Dan Wheeler is director of global financial advisor services at Dimensional Fund Advisors in Santa Monica, California. He can be reached at dan.wheeler@dfafunds.com.

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