Experimental Fund

One of my favorite films (easily, Top 5) is "American Beauty."  The tagline for the film was "Look closer."  It rings as a periodic reminder each time I am asked for my thoughts on a specific investment.  Whenever someone asks my thoughts, my first question is never "how much are you putting in it?"  Amounts are always relative.  My first question is "will the amount you're putting in the investment be more than 5% of your overall balance?"  If the answer is no, then I often encourage the investment with a mindful eye.

One term I learned from listening to Mo Ansari over the years is "exit strategy."  When I left my last job, I formulated my exit strategy for almost 15 months before my actual departure.  However, a job is not an investment (at least, not in these terms) and formulating an exit strategy at that point would have been heavily delayed.  The best exit strategy is formed before you invest.  And it is written.  In case you haven't noticed, a lot of this blog has been written for my own use to remember what I was thinking at the time I made specific moves.

If you invest in a fund, you should know your tolerance for its success and its failure.  "If the fund raises above 20%, immediately remove the gains."  "If the fund falls 20%, immediately sell the position."  Those are examples of flawed exit strategies.  They lack a relative basis.  The last time I added a new position to my portfolio, my exit strategy was to sell out if the fund under-performed the relative index fund for two consecutive years.  The markets could gain or lose 20% in a given year, and it is not a reflection on the investment.  Every investment has an opportunity cost, and that is the true measure for its success or failure.

For example, invest 2% of your bond index fund into a GNMA fund.  The opportunity cost is measured by the performance of that bond index fund, because this money would be doing better or worse if you had left it in that investment.  The true performance for your GNMA Fund would based on that bond index fund.

This complex mentality will block you from making three critical errors.  First, you will never move your stock funds to a bond.  The basis for comparison will be impossible to track (or more effort than it's worth).  Second, the fund will have an established second home.  If your fund is under-performing against your original expectations, then your exit strategy innately moves it to its base.  Whether you invest in another experimental fund immediately thereafter is another story, but at least you will not stay on the fence with that experiment's conclusion.  There is no agonizing over the conflicting thoughts of "it could move back up (yes, it could) but it could keep falling (also true)."  Finally, your expectations will not fluctuate like your emotions.  If you consider today what you think the market will do in 2012, but you do not write it down, then chances are your memory of today's expectations will be significantly different than what they will be when you recite them in December 2012.  This is because emotions affect our expectations.

(to be continued... ??)