Safety drills aren’t about how to react to expected events: they are about controlling reactions to unexpected events.

Selective memory is a valuable human trait when it keeps us moving forward, refusing to be encumbered by painful experiences in the past. However, it can make us feel a little too comfortable in the midst of good times.

The markets have rewarded investors handsomely for the past five years.  After such a long stretch of positive returns, it’s easy to get complacent and forget that risk is an intrinsic part of investing. That risk has to be carefully evaluated and managed, in good times and in bad. The temptation when markets are roaring ahead is to take on more risk than you would in times of modest growth or negative returns.

One technique for managing your tendency to assume more risk than you should in great markets – or overreact and sell out in bad ones – is an adaptation of safety systems and procedures. For example, building managers clearly mark fire exits, regularly test fire containment and warning systems, and drill people on how to safely evacuate burning buildings. Just because these systems and procedures are in place doesn’t mean that the building managers are expecting a fire; it’s simply prudent to make sure that everyone is prepared if disaster strikes. People are drilled in procedures so that habit and forethought will prevail over panic and chaos.

An investor’s safety procedures include regularly reviewing the investment parameters you established when your portfolio was constructed: as discussed in our last column, making sure you are rebalancing on a cost and tax efficient basis to keep within your asset allocations. It also includes communicating any material changes in your financial situation to your investment advisor, so that your long-term financial plan can be updated.

The least reliable part of the safety process

"The investor's chief problem - and even his worst enemy - is likely to be himself."

- Benjamin Graham, The Intelligent Investor  

Once you have your goals established and a portfolio strategy designed to achieve them, your work is to stick to your plan over the long haul, in spite of near-term distractions in the markets. Here comes the most difficult part of the drill, because that is much easier said than done.

For an analogy better suited to the complex investment environment, one might look to how you might prepare for a fire at sea. You can physically go through a drill showing you how to exit various parts of the ship and where the lifeboats are, but much of your drill beyond that would have to be conceptual. After all, how do you rehearse hurling yourself into a raging sea in a lifeboat? You could educate yourself about the safety features of the lifeboat and surviving at sea, but only an act of imagination could prepare you for being tossed around on stormy seas for an extended period of time. One thing is certain: you wouldn’t want to abandon your lifeboat!

As an investor, let’s say your portfolio is your lifeboat. Your portfolio should be constructed with deliberation and care, using investment concepts that are based on scientific research to withstand market volatility and earn you the sustained rate of return required to meet your needs. It’s important that you have a clear understanding of the reasoning that went into constructing your portfolio, because you won’t be able to conquer fear in a volatile market or greed in a rising market if you do not have confidence in the long term viability of your portfolio.

The next part of your drill in stormy markets is to imagine as vividly as you can how you will react to a negative event. Your investment advisor should discuss potential outcomes with you, to temper your expectations in good years and bad. If you have $2 million and your portfolio goes through a particularly difficult year and drops to $1.75 million, how will you react? Imagine how you will feel when you finally summon the courage to open your statement and see that number. What if this period of negative returns lasts for 18-24 months? How will you react? The mental drill is to stay put in your lifeboat, because market history shows that the storm will pass and you will be fine. Your portfolio was built to withstand the battering.  Like the disciplined investors who stayed the course in 2008, you’re going to be okay.

When the real event happens – as it will – you will have gone through a mental rehearsal that should help you avoid destructive behaviour. You can remind yourself that you knew this was going to happen and this is how you decided to react, when you were calm and rational . . .  and focused on the far horizon.

This article by Daryn Form was published in the October 2014 edition of Business Advisor.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.