Keeping emotion out of investing

The level of noise surrounding the financial markets can interfere with sound decision-making

Nov 26, 2014 @ 12:01 am

By Matthew P. Erickson

Excerpted from "Asset Rotation: The Demise of Modern Portfolio Theory and the Birth of an Investment Renaissance," by Matthew P. Erickson (Wiley, 2014)

Before we can begin to dissect all of the nuances as to why what has worked in the past may no longer work in the future, we must first start with a “30,000-foot view,” putting into perspective both the realities of the individual investor's disposition and historical performance, as well as our current economic landscape. Once we have a general understanding of the challenges at hand, we can examine these issues more intimately and ultimately provide practical solutions as to how investors can more efficiently navigate this tumultuous environment (while inherently reducing the impact of outsized risks).

It has often been said that when you are in the thick of things, you simply cannot “see the forest for the trees.” Because of all of the obstacles that surround us (some real, others imagined), our vision is impaired and it is easy for even the most astute observer to become overwhelmed — so much so that they can no longer see the path which lies ahead, nor the bigger picture at hand.

MARKET-MOVING HEADLINES

If we apply this analogy to the investment markets and the daily influx of market-moving headlines, prognostications and so on, it is easy to see how one might get lost in the directional noise. After all, CNBC, Bloomberg and the like need to drive ratings, and there is nothing better than sensationalizing a trivial nonevent for this purpose. For that matter, we must admit we find the circus to be mildly entertaining. In one segment, you'll hear from some expert why the market is going up, and in the next you will hear from another why it is going down. It's painful to think how many people get their investment ideas (particularly stocks) from watching this drama play out.

In the past, we have had the good fortune of sitting in on a handful of small-group presentations by renowned economist Dr. Bob Froehlich. Reiterating our previous point, the one thing we heard Dr. Bob say that has stuck with us over the years was, “If you see someone on TV telling you to buy a stock, it is because they own it and they need to get out at a higher price.”

The reality is that we live in a world that is dialed into the investment markets 24/7, in the United States and abroad. Whether through TV, radio, the Internet, or a litany of industry-related publications, in-vestors today are flooded with a plethora of information. They are inundated with commentary from very smart people weaving well-crafted messages to convey their views. These experts are backed by industry-related pedigrees, impressive educational backgrounds and fancy initials after their name — all of which leads us to believe they are qualified to know what is coming next, whether for the state of an individual company or the economy at large. But despite all of these superficial pearls of wisdom, more often than not, they are wrong. It's not their fault. They are simply purveyors of an ego-driven industry in which individuals believe they can know more than the markets.

OCKHAM'S RAZOR

“Pluralitas non est ponenda sine necessitate” (“Entities should not be multiplied unnecessarily”) — William of Ockham, a 14th-century Franciscan monk, born in the small village of Ockham in Surrey, England.

While many of us may not be familiar with the name, historians today regard William as one of the central figures of Renaissance thought, at the epicenter of the major intellectual and political controversies of his time. William is most highly regarded for his contributions to the principles of parsimony. This later came to be known in academic circles as “Ockham's Razor” and centuries later continues to provide one of life's most important guiding principles.

Ockham's Razor essentially states that one should always opt for an explanation in terms of the fewest possible causes, factors, or variables. Today, we know this as the KISS principle — Keep It Simple, Stupid.

When you look out into the landscape of the financial markets, you can see that we certainly don't do a very good job of this. Click on CNBC, pick up your Wall Street Journal or turn on your Bloomberg radio, and this much should be blatantly obvious. There is a whole army of financial wizards trying to decipher the behavior of the investment markets and sharing with us their opinion of what's to come.

The irony is that more often than not, their visions fail to come to fruition. And yet we as investors are encouraged to base our investment decisions on their collective wisdom.

Perhaps this is where William of Ockham comes in. Rather than attempt to predict the future price of a stock or the future state of our economy, encompassing a mountain of data and incalculable variables, rather than attempt the impossible by looking forward, wouldn't it just be easier to look back?

The price movement of a security will tell you more than any analyst or economist ever could. In the spirit of Ockham's Razor, price momentum is the one true metric we have that provides clarity to the psychological underpinnings that move the markets. These psychological forces drive both short- and long-term trends.

In the investment world, we like to make things more complex than they need to be. Our industry is famous for as much, and the investment vehicles or methods used today have grown increasingly complex. Whether by virtue of some sort of masochistic, egomaniacal pursuit of proving one can consistently outsmart the markets or the result of simply adhering to the rules that have been laid out before us (attempting the impossible by predicting the future), the results remain the same. Investors have a long history of underperformance.

According to the 2013 Quantitative Analysis of Investor Behavior, conducted by Dalbar Inc., over the past 20 years (1993–2012) the average rate of return for retail equity investors in the United States has significantly lagged that of the S&P 500. The average annual return for individual investors in the United States has been 4.25%; the S&P 500's average annual return 8.21%.

Pulling out our financial calculators and computing a few simple time-value-of-money calculations, this would imply that:

• An investor starting with $100,000, with a 20-year compounded average annual return of 4.25%, would have seen their savings grow to $229,890.63 by the end of 2012.

• Conversely, an investor in the S&P 500 starting with $100,000, with a 20-year compounded average annual return of 8.21%, would have seen their investment savings grow to $484,560.42.

Surely this does not paint the individual investor in the most favorable light. Daily headlines, rumors, and stock market gossip invoke emotive responses out of investors. News that should be regarded as nothing but noise serves as a catalyst for action, either to buy or to sell.

Successful investors are wise not to listen. In one of the great literary works of all time, “The Intelligent Investor,” Benjamin Graham, the father of value investing (and mentor to the iconic Warren Buffett), opined, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” On this point we wholeheartedly agree, as the psyche of the human condition is not wired to endure such gut-wrenching events as watching one's net worth decline by more than 50%. Suffice it to say this is easier said than done.

Mr. Buffett once said, “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the market.” On this point, we may find some common ground. We agree that investors simply can't take watching their investments lose significant amounts of money; they fear they will never get it back. They also fear that things will get worse. Such fears begin to consume them and they simply pull the eject lever and get out, potentially locking in a permanent impairment of capital from which they may never recover.

Consider that if an investor is down 50%, they will need to go up 100% just to get back to even. If you have $100,000 and you lose 50%, you are left with $50,000. Even if you go up 50%, you still only have $75,000. After losing 50%, at a respectable rate of return of 8% it will take nine years to get back to even. Worse yet, if an investor makes the impulsive move into an even more risk-averse security averaging a 4% annual rate of return, it will take an astonishing 17.7 years to get back to even.

But who can stomach losing 50%? Who's to say you have not just bought the proverbial “falling knife” (as “value” investing can so often lead one to do)? Does this mean one should not invest? Do all investments bear such risk? We all know stocks do, and we also know that most people can't handle seeing them go down precipitously. It only makes sense that any sound portfolio management process should provide a discipline for reducing participation in prolonged declines in the investment markets.

Investing based on emotion will never work, but admittedly in a world where we are continually peppered with bombastic news intended to stoke feelings of fear and greed, we are playing in a game we can't win. That is, if you care to listen.

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