October 30, 2013
By Mark Joseph, CFP®, CPA, PFS, ChFC, CLU
Filed under Investing
You have probably heard the tale of the tortoise and the hare, but I am guessing that you are not as familiar with the story of the T-Rex and the cockroach. The mighty T-Rex is celebrated in museums and movies as the biggest and most dominant and terrifying carnivore of all time. The cockroach, on the other hand, is small, ugly and perhaps the most reviled of insects. For investors, the important moral of the T-Rex and the cockroach story is that the lowly cockroach is still thriving and multiplying around the globe, while the once dominant and mighty T-Rex is long extinct.
In his outstanding investment book, A Demon of Our Own Design, Richard Bookstaber praises the lowly cockroach as a survivor that has withstood “many unforeseeable changes – jungles turning to deserts, flatland giving way to urban habitat and predators of all types coming and going.” In Bookstaber’s opinion, it is the fundamental design of the cockroach that has allowed it to survive and thus thrive and multiply over time. The T-Rex, in contrast, would fit better into a category that Bookstaber describes as “a species that is prolific and successful during a short period of time, but then dies out after an unanticipated event.” He further describes this category of species as “well designed for the known risks of one environment but not for dealing with unforeseeable changes.”
As an investor, it is critical to determine whether you are pursuing an investment strategy that is designed more like a T-Rex or a cockroach. This is important because just as the T-Rex and the cockroach faced countless “unanticipated events and unforeseeable changes,” so too do investors. The people who were most badly hurt in the 2008 (subprime mortgage crisis induced) market decline and the tech bubble that burst in 2000 were following a T-Rex-like investment strategy. Their strategy worked incredibly well for a short period of time (dominating most other investment strategies), but then suddenly and “unexpectedly” came apart. How can you help to avoid this obviously undesirable outcome? You need to acknowledge the reality that you cannot predict the future and then try to adopt a cockroach-like investment strategy that acknowledges uncertainty and is prepared to deal with it head on.
What would a cockroach-like investment strategy look like that is designed to help your portfolio survive “unanticipated events and unforeseeable changes?” Among other things, it would be highly diversified and made up of mostly market-based investments. History has shown that, properly designed, this type of portfolio has withstood “unanticipated events and unforeseeable changes.” In fact, its design can actually cause it to benefit from these events and changes over time.
Take the example of the S&P 500, which is probably the best-known market-based investment. Companies are added to, and removed from, the S&P 500 every year (as we discussed in a prior post). Therefore, as changes occur, as new technologies are discovered, as new ways of doing business are employed, and as old companies die and new ones emerge, the S&P 500 automatically adapts to these changes. If you own the S&P 500, you may not be the T-Rex, headline-grabbing leader of the investing pack, but you are also not at risk of extinction. As one of my favorite financial writers, Nick Murray, likes to say, “Discipline and diversification assure that you will never make a killing, but they also assure that you will never be killed.” This is not meant to imply that a highly diversified, market-based portfolio will never temporarily decline in value. Using the S&P 500 example, there have been many temporary declines in the S&P 500, but there has never been a permanent, extinction-causing decline in the S&P 500.
By surviving all the “unanticipated events and unforeseeable changes” that history has produced, a cockroach-like portfolio has benefited from two of the most powerful tools in investing – time and compounding. How you diversify and what market-based investments you use, and in what proportions, are critical elements in the design of an enduring, cockroach-like investment strategy. But we will save that conversation for another day. I’m sure that you’ve had more than your fill of cockroach talk for the day!