E + R = O, a Formula for Success – Second Quarter 2018

Some people suggest that among the characteristics that separate highly successful people from the rest of us is a focus on influencing outcomes by controlling their reactions to events, rather than the events themselves. This relationship can be described in the following formula¹:

e + r = o (Event + Response = Outcome)

Simply put, this means an outcome—either positive or negative—is the result of how you respond to an event, not just the result of the event itself. Of course, events are important and influence outcomes, but not exclusively. If this were the case, everyone would have the same outcome regardless of their response.

Let’s think about this concept in a hypothetical in

investment context. Say a major political surprise, such as Brexit, causes a market to fall (“event’). In a panicked response, potentially fueled by gloomy media speculation of the resulting uncertainty, an investor sells some or all of his or her investment (“response”). Lacking a long-term perspective and reacting to the short-term news, our investor misses out on the subsequent market recovery and suffers anxiety about when, or if, to get back in, leading to suboptimal investment returns (“outcome”).

To see the same hypothetical example from a different perspective, a surprise event causes markets to fall suddenly (“e”). Based on his or her understanding of the long-term nature of returns and the short-term nature of volatility spikes around news events, an investor is able to control his or her emotions (“r’) and maintain investment discipline, leading to a higher chance of a successful long‑term outcome (“o”).

This example reveals why having an investment philosophy is so important. By understanding how markets work and maintaining a long-term perspective on past events, investors can focus on ensuring that their responses to events are consistent with their long-term plan.

An enduring investment philosophy is built on solid principles backed by decades of empirical academic evidence. Examples of such principles might be:

-- trusting that prices are set to provide a fair expected return;

-- recognizing the difference between investing and speculating;

-- relying on the power of diversification to manage risk and increase the reliability of outcomes; and

-- benchmarking your progress against your own realistic long-term investment goals.

Combined, these principles might help us react better to market events, even when those events are globally significant or when, as some might suggest, a paradigm shift has occurred, leading to claims that “it’s different this time.” Adhering to these principles can also help investors resist the siren calls of new investment fads or worse, outright scams.

Without education and training—sometimes gained from bitter experience—it is hard for non-investment professionals to develop a cogent investment philosophy. And even the most self-aware find it hard to manage their own responses to events. This is why a financial advisor can be so valuable—by providing the foundation of an investment philosophy and acting as an experienced counselor when responding to events. 

Investing will always be both alluring and scary at times, but a view of how to approach investing combined with the guidance of a professional advisor can help people stay the course through challenging times. Advisors can provide an objective view and help investors separate emotions from investment decisions. Moreover, great advisors can educate, communicate, set realistic financial goals, and help their clients deal with their responses even to the most extreme market events.

In the spirit of the “e + r = o” formula, good advice, driven by a sound philosophy, can help increase the probability of having a successful financial outcome.²

As we head into the election season, a look back at past-market crises can serve as an important reminder for investors today. As we have discussed before, the intra-year decline of the S&P 500 Index of large U.S. stocks has averaged 14.1% since 1980. That is the decline from the market high to the market low in any given 12-month calendar year.

However, as seen in the table below, the average intra-year decline of the S&P 500 Index during midterm election years, like 2018, is much higher. In midterm election years, the intra-year decline of the S&P 500 Index has averaged 16.9% since 1950.

For many, feelings of elation or despair can go with headlines leading up to and after controversial elections. We should remember that markets can be