Spotlight – Experience Before Theory
By Kerry O'Boyle, Aston Asset Management
"You don't need to be an Aerospace Engineer to fly airplanes"
- Common saying at the U.S. Naval Academy
Becoming a pilot is a serious endeavor involving complex machines, intricate rules, and potentially hazardous situations. In most other professions, years and years of classroom work and testing would precede any attempt to actually perform in the real world. But that's not how we train our pilots.
Training for military pilots, for example, traditionally consists of only a few weeks of ground school learning the basics of the training aircraft, navigation, and air traffic rules. Trainees are then thrown behind the controls of the plane with an instructor in back, typically a practitioner himself serving only a brief tour as an instructor away from frontline duty. After only roughly a dozen flights, trainees are required to solo—fly alone for the first time.
Why does the military take this seemingly risky approach to training pilots? To be sure, flying requires the development of physical skills, which requires hands-on training, but that could be conducted using simulators. Often overlooked is another important factor—the need for experience in a highly dynamic environment. Flying is fast-paced, involving multiple variables and constantly changing situations. Feedback, whether physical or situational, must be assessed and analyzed in the context in which it is happening. Simply put, it's an environment in which experience counts for more than mere descriptive knowledge. You learn by doing.
Buy Low, Sell High
The same might be said for investing. Descriptive knowledge tells investors to buy low and sell high, but it is experience that shows them how to do it. Developing such experience can be time consuming, which is why many investors turn to mutual funds and experienced professionals for the selection of individual securities. Security selection, however, is but one facet of the investment process. Even investors that delegate the selection of individual securities to professional money managers need to develop skills in the construction and management of their entire portfolio. Like security selection, overall portfolio management requires practice and experience derived from being engaged hands-on in the process.
Unfortunately, too many investors take a buy-and-forget approach, put their portfolios on auto-pilot via calendar-based monitoring/re-balancing schemes or employ static quantitative models and then later are left to wonder why results were disappointing. Worse yet are simplistic rules of thumb (i.e. "an equity allocation should equal 100 minus your age") that deceive investors into thinking portfolio management requires little thought at all. Markets are dynamic and investors need to be continually learning from them in order to reinforce the best investment practices. It need not become a full-time job, but it does require some work and attention. Book knowledge and academic theory is not enough absent the ability to practice it in the real world.
The dilemma for most investors, unlike pilots, is that the feedback is rarely timely, let alone immediate. It may take years to know whether an investment decision made today is ultimately a positive one for a portfolio. In addition, opportunities for mutual fund investors to "practice" and gain experience are limited by these long time horizons involved in determining outcomes. Similarly, the feedback isn't physical, though it can be emotional, often making it difficult to decipher. Mistakes will be made, but the lessons often go unlearned and the experience squandered because the context and the original decision-making rationale have been lost.
To improve outcomes, individual investors need to develop an investment process and method for tracking decision-making in order to create a meaningful feedback loop from which genuine experience can be gained. Such a process would need to instill discipline yet be flexible enough to incorporate new lessons learned and experience gained. The lack of such a disciplined investment process may explain why many investors turn to market prognosticators or academic theories—despite being largely unproven in delivering practical results — as a cheap substitute for a rigorous and experienced investment approach.
Developing such an investment process can seem a daunting task for smaller investors, but it need not be so. Practical ideas on investing can be borrowed from proven investment practitioners with experience in dynamic market environments, provided that investors test that experience out for themselves in the context of their own unique investment situation. Beginners can start at a basic level, borrowing ideas from professionals and practicing on a small scale in a building block approach towards greater understanding and experience. Theories are incorporated only after being verified through practical experience. Many investors may have a hard time experimenting in such ways—fearing mistakes—but developing a process that keeps what works and discards what doesn't based on actual investment situations provides the lasting experience required for long-term success.
An example of a meaningful place to start would be for investors to engage in more frequent re-balancing of their portfolios centered on changes in the market instead of by the calendar. Seeing the results of the regular trimming of high-flyers and additions to stragglers among individual components in a portfolio would provide more data points for feedback. It also has the additional benefit of containing risk more closely around one's designated asset allocation and providing insight as to whether that allocation is appropriate. Although somewhat counter-intuitive, more frequent activity of this kind makes each individual decision less crucial to the overall outcome, dampening potential risk and volatility. Contrast that with a buy-and-forget approach, in which the initial buy decision becomes a dominant factor as the investment is left to be buffeted by the whim of market trends and asset allocations are allowed to drift.
Data Is No Substitute
Although experience can be borrowed to some extent, investors need to be careful not to attempt to manufacture experience through backward-looking data. In the age of fast computer processing and information at our fingertips, many have become over-reliant on simple numerical data as a substitute for actual experience. While cold, hard numbers can often tell a story, whether it tells the right story depends on a full understanding of the context of those numbers and whether all variables have been accounted for or recognized. Too often, people look at data in isolation or allow someone else to interpret the data for them without having a grasp of the full picture available.
Data that is meaningful is data developed and recorded from one's own actions, experience, or interpretation, and fully understood within the context it is provided. A defined investment process should incorporate decisions based on data and other factors, and a system should be developed for recording the context of these decisions and their subsequent investment outcomes in order to build an investor's own feedback loop.
Although mutual fund investors delegate security selection to fund managers, they retain responsibility for the performance of their overall portfolios. All too often, the tendency is to blame fund managers for any failure of expectations or results—for "not being consistent" or for "not performing as they have in the past"—despite all the warnings of past performance not being a guarantee of future results. If it were that simple, investors using index mutual funds would be immune from poor results, and practical experience would lead most investors to indexing. But asset allocation, re-balancing, and the timing of buy and sell decisions at the portfolio level play key roles for all investors, making indexing less of a panacea than theory would suggest. In some ways it is akin to blaming a hammer for missing the nail. To be sure, some tools are better than others, but the user is ultimately accountable.
Whether mutual fund investors take on the role of overall portfolio manager or delegate that role to a financial advisor, practical portfolio management skills are required. Such skill doesn't come from buy-and-forget strategies or from one-size fits all academic or market theories. It comes from experience and close attention to detail gained from practice in a dynamic environment.
Pilots don't measure experience in age or years of service, but in hours—flight hours at the controls of an airplane. Only actual flight hours truly measure experience, and experience is what counts. Other professions are beginning to recognize the importance of such hours in their training as well. The trend in medicine is for medical students to see real patients earlier and earlier so as to develop experience in real world situations sooner—in other words, more hours with patients. To achieve their goals, investors need to do the same with their portfolios.
Kerry O'Boyle is an Investment Strategist with Aston Asset Management. Prior to joining Aston he wrote on a variety of investment topics as a mutual fund analyst for Morningstar, Inc. He is a graduate of the U.S. Naval Academy, and holds an M.A. in Liberal Arts from St. John's College, Annapolis, MD.
For more information about Aston Asset Management, LLC and its subadvisors, please call 800-597-9704, or visit www.astonasset.com