When the market gets crazy, you’re itching to trade your portfolio, or just want to act on the latest breaking news, the decisions you weigh matter in the long run.

Of course, not all portfolio decisions are equal. Sometimes it’s the decisions you don’t make that matter most. 

In fact, Charley Ellis made this case two decades ago. He broke down portfolio decisions into five categories:

In making investment decisions, there are five separate levels of decisions for each investor to make individually:

• Level One: Asset mix — The optimal proportion of, e.g., equities, bonds, private equity, for the policy normal of the investor’s portfolio. This is where investment counseling usually concentrates.
• Level Two: Equity mix — Policy normal proportions in various types of stocks: e.g., growth versus value; large-cap versus small-cap; domestic versus international.
• Level Three: Active versus passive management — Deciding on the appropriate method of implementation for the policy normal mix of investments.
• Level Four: Specific manager selection (where most investors and most investment committees concentrate their time and effort) — Deciding which firms will manage each component of the overall portfolio, firing the most disappointing, and hiring the most promising.
• Level Five: Active portfolio management — Changing portfolio strategy, security selection, and trading.

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Quote for the Week

How does one identify risk tolerance? Our thinking on this was that the issue is not so much tolerance for risk as it is tolerance for losses. Tolerance for losses means that you have to know — the individual investor has to know and certainly the advisor has to try to know — how much loss the person will be able to tolerate before he changes his mind about what he is doing. Clearly, changing course by and large is not a good idea, and selling low and buying high is not a good idea… If people are very prone to regret, then you have to help them devise a plan that will minimize their regret. For the very wealthy, emotion is clearly important in determining what policy is appropriate…

The main question that I have found useful to ask when someone is very wealthy is how much loss is the individual willing to tolerate? That is, what fraction of their wealth are they actually willing to lose? It turns out that fraction is usually not very large. That’s a very important parameter… Then you have to take steps so that they won’t lose more than they are willing to lose. That’s in effect stop-loss policy…

Also, people have to become aware of the fact that by stopping their losses, they are giving up some potential upside. Looking at the trade-off between the upside and the downside gives you a sense of their attitude toward losses and what you should encourage them to do. — Daniel Kahneman (source)

Quote for the Week

In the last analysis, it was the public which was chiefly responsible for its own undoing. The stock-market boom was a classic example of the madness of crowds. History records some of the most notorious of these mass movements — the Mississippi Bubble, the South Sea Bubble, the Tulip Mania — and the madness of the ’20’s must certainly be added to the list. The prehistoric tribal eruptions from Central Asia, the Crusades, the medieval dance craze, all these — right down to the Florida boom and the 1929 market madness — were phenomena of mass action under impulses which no science has explored. Such impulses have power to affect any static condition or so-called normal trend. For that reason they deserve consideration by students of economic affairs.

Although there is no scientific cure for these madnesses, there may be potent incantations. I have always thought that much of the evil might have been averted if, in the lamentable era of the New Economics culminating in 1929, even in the very presence of dizzily rising prices, we had all continuously repeated that “two and two still make four.” And I think it would be a salutary thing in the present situation, which in many respects so resembles the ’20’s, if we reminded ourselves of the fact. — Bernard Baruch (source)

Quote for the Week

In every bank and brokerage house, in business places, on street corners and in elevators and restaurants — wherever people met — one could hear talk of ”the tip I got on the market.” Token margin requirements enabled anybody to test his luck. Taxi drivers told you what stocks to buy. The shoeshine boy could give you a summary of the day’s financial news. An old beggar, who regularly patrolled the street in front of my office, now gave me market tips — and, I suppose, spent in the market the money I gave him. My cook had a brokerage account and followed the stock ticker closely. Her paper profits were quickly blown away in the gale of 1929, and she had to be rescued from being sold out entirely.

Whenever some cool, calm voice like Sen. Carter Glass’s was raised against this madness, it was jeered. Whenever the market fell back — and there were some sharp setbacks on occasion — assurances that all was well would come from every quarter. Unfailingly the prophets of the New Economics in government and finance promoted the boom and nourished public confidence in it. From the White House itself came President Coolidge’s soothing statement about the mounting loans on stock exchange collateral, that ”five billion isn’t very much.” In those days it was…

There were some who believed that prices would never descend and others who thought that, if they did, it would still be possible to get out in time. But of those who realized that the boom had to end, none knew when the expected break would come. — Bernard Baruch (source)