July 11, 2019

In financial planning, it’s most often the ‘what’ that comes to the forefront - the return, the investments, the effective tax rates, the facts about retirement timing and income and so on. The ‘why’ is the part that tends to get lost in all of this and, in my opinion, opens the door to so many behavioral issues that advisors and behavioral psychologists have spent decades trying to correct. The problem with missing the ‘why’ – with not understanding it and believing it and internalizing it – is that when we get an unexpected ‘what’ we start to call our strategy into question. The strategy could be the plan or the investment management philosophy or the tax management approach. The ‘why’ to the strategy can be just as important as the ‘what’.

Simon Sinek has a book titled, Start with Why, and in the book he talks about the celery test. The celery test is a way to help people and organizations make decisions. He talks about a hypothetical party that a business owner attends and people keep coming up to him and saying – you know what your business needs, ________. The blank is different with every person, one says rice milk, another M&Ms, another Oreos, and another celery. The point of the story being, if you don’t know your ‘why’ – the reason you do what you do and the heartbeat of your organization – you might just go to the store and buy it all and end up surprised by the fallout when it doesn’t work. But if you were, for example, an organization focused on healthy living, the items you’d choose would be obvious – Oreos and M&Ms don’t fit your why. (I know what some of you are thinking right now – why don’t Oreos and M&Ms fit with healthy living? You’re right to question that premise.) Knowing and being unwavering about your why guides your behavior and makes decision-making and reacting to stress, easier.

Financial planning and investment management fits into this framework quite nicely. We frequently have clients come to us seeking the ‘what.’ Usually, it’s the silver bullet investment management strategy. They don’t care why it works, they just want it to work. After all, it’s our job to manage the plan and the investments, so why it works is irrelevant, right? You know this question is rhetorical, right?

The reason the ‘why’ matters so much in financial planning and investment management is that the ‘what’ has always been and will always be unpredictable. We can make educated guesses about a range of outcomes, but the exact outcome and the path it takes to get there is unknowable. What you come to realize over time is that, when you’re dealing with real human emotions, the path actually matters quite a bit.

Let’s talk about this as it relates to investment management and let’s oversimplify it. Let’s say, as an investor, you’re trying to choose between two investment strategies – buy and hold, which is self-explanatory, and trend following. Trend following can mean a lot of different things, but let’s just assume you have certain criteria that lead you to be invested in stocks when your definition of the trend is positive and not when your definition is negative. Continuing with the theme of oversimplifying, what we’ve seen is that, across many asset classes, buy and hold and trend following exhibit similar return profiles, the major difference has been that trend following has historically suffered smaller losses during major market downturns.[1]

If only it were that easy.

Let’s say I presented you with this information – almost all rational people would choose the trend following strategy. Oh, but there’s a catch. There’s always a catch. What if I went on to tell you that trend following, especially in calmer markets has tended to underperform buy and hold and frequently for long periods of time (5 years or more)? And that’s not all. As both Wes Gray and Corey Hoffstein have pointed out in their research on trend following, whipsaw is also a frequent and uncomfortable characteristic of trend following – whipsaw being defined as your rules dictating you get out of the market and then dictating you get back again later, but at a higher price.[2] Gray even showed statistics that could lead you to expect such a thing on as many as 70-90% of trades!

So why would you put yourself through this? The answer, as it turns out, is pretty simple. While you may experience multiple and frequent whipsaw losses, you can also experience whipsaw benefits and the benefits tend to be both large and infrequent and generally come in the form of losses saved during market drawdowns. The savings during these periods – historically – have tended to far outweigh the costs of negative whipsaw events. Being out of the market for a 50% loss can obviously make up for a lot of small whipsaw losses. These two historical statistics illustrate both why trend following works and why it’s so hard for investors to stick with. It’s only natural for a person to question an investment strategy that has the potential to underperform for the better part of a decade (something that buy and hold investors have also experienced several times throughout history – such as the period from 1966-1982 and more recently, 2000-2009).

Consider this from an advisor’s perspective, as well. Many investors have an easier time sympathizing with the fact that the market went down a lot and their portfolio, as a result, lost money. It’s often a lot harder to explain that the market went up a lot and they didn’t make any. That’s what I call career risk – the risk of losing clients because your advice deviates too far from client expectations – and it’s a very real consideration when allocating client assets.

All of this is to say that, when you engage with an advisor, it is ultimately the advisor’s job to be educated and give you sound advice, but you still have to live it. It’s always your prerogative, as a client, to choose to blindly follow advice without learning and believing in the ‘why’, but it’s my view that doing so makes the path considerably more difficult when you don’t find yourself performing the way you think you should. Investment management has always been about trade-offs and it’s been difficult historically to generate decent returns without feeling some level of emotional pain. What type of pain you experience and how you deal with it are choices you can make and, I believe, can be made easier if you get the ‘why’.


[1] https://alphaarchitect.com/2019/06/26/trend-following-the-epitome-of-no-pain-no-gain/

[2] https://blog.thinknewfound.com/2018/09/a-trend-equity-primer/

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. Investing involves risk including the potential for loss of principal.  Past performance is not indicative of future results.  LPL Financial is not affiliated with Simon Sinek, Wes Gray or Corey Hoffstein and does not endorse their opinions.