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Fuzzy Thinking and the Stock Market

fuzzy.jpgThe recent media attention to the ups and downs of the stock market reminded me of a piece of advice I heard a few years ago. John Muhlenkamp, manager of the Muhlenkamp Fund, was one of the speakers at the Financial Planning Association Retreat in 2004. He suggested a simple way to reduce the overall volatility of any portfolio: Don’t price it so often.

Over the past few weeks, a good many investors have opened their account statements to find that their retirement nest eggs were worth less than they had been the month before. This is not an enjoyable experience. Those who could read the numbers and still maintain their serenity were probably practicing a useful strategy for investors—fuzzy thinking.

Fuzziness about finances doesn’t seem like an approach a numbers guy like myself should promote. Investment advisors and financial planners are always urging clients to accept the reality of the income, expenses, and other financial facts that define their assets and liabilities. After all, financial statements deliver cold, hard facts. Those numbers at the bottom represent reality.

Well, yes and no. True, the number at the bottom of a monthly statement shows the precise value of that account on a given day. At the same time, though, it’s important to understand that the number represents just one point on a scale that constantly fluctuates at least slightly.

This is why planners keep reminding clients about “standard deviation.” It’s one of those terms that financial advisors use as a matter of course. It’s also a term that can instantly make clients’ eyes glaze over, especially those who have less than fond memories of algebra, calculus, or statistics.standard-deviation.jpg

Standard deviation describes the amount that the value of an investment can be reasonably expected to fluctuate over time. It does have a precise mathematical formula, which for most investors is completely beside the point. Instead, it’s probably helpful to think about standard deviation in a more right-brained way. It simply means “more or less.”

Let’s say your investment portfolio showed a balance last month of $1,045,382. This month’s balance was $998,764. When you read the statement, you naturally are going to focus on the fact that you have “lost” $46,618. Yet both those numbers are comfortably within the range of standard deviation for a diversified portfolio. Each of them can—and should—be read as “one million dollars, more or less.”

This is where fuzzy thinking can be useful. Your net worth is not a fixed, precise number. It is an approximation that fluctuates over time, within a range that can be wider or narrower depending on how much risk you take with your investments. This is why a chart showing the value of a portfolio over time isn’t a straight line, but zigzags up and down.

If a portfolio is well managed, of course, those zigzagging lines will also gradually climb. The investments will increase in value from their starting point, despite the ups and downs along the way. If you want to compare this month’s statement amount, then, it’s better to compare it to the statement from a year ago, or two years, or three. Comparing your account balance to what you started with rather than what you had last month gives you a more accurate snapshot of its value.

sleeping-bear.jpgOr, even better, take John Muhlenkamp’s advice and don’t focus too much on this month’s bottom line. When you consider your net worth, just remember to add the phrase “more or less.” Not only will you demonstrate your understanding of standard deviation, but you’ll probably sleep better as well.

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