(As published in Lifestyles 55+ 2012 November)
“I can calculate the motion of the heavenly bodies, but not the madness of people” said Sir Isaac Newton, after losing a fortune in the South Sea Bubble of 1720. Most people believe that investing is a matter of rigorous discipline and stringent analysis. But there is always a certain amount of uncertainty, and with that comes variability. The most sophisticated econometric model will never include all of the complex and interacting factors that cause the peaks and valleys of the business cycle and the volatility of individual stocks, never mind getting the direction and magnitude of their impact right all of the time. But the bigger problem is people, and the frailties of human behaviour. We may think we are rational beings but much of our behaviour, especially as a herd, is most irrational. That is when the importance of psychology comes into the art of successful investing.
Besides you and Warren Buffett, how many saw the crash of 2008 as a wonderful opportunity to buy, because many blue chip companies were “on sale” compared to their intrinsic long term value. The madness was exhibited in the thousands who saw their retirement portfolios lose 30% of more of their (nominal) value and sold out for whatever they could get, to sock it away in guaranteed investment certificates – with after tax returns that do not even cover inflation.
A recent column by Tom Bradley (Steadyhand Investment Funds) in the Globe and Mail, compared playing the stock market to playing golf. Several perfectly human approaches show up in both, the unpredictability of when we will hit a good game, or fuzzy honesty with ourselves, never mind the scorecard. Human nature misdirects effort even when we know better, practicing driving versus putting, or buying new clubs in lieu of practicing at all! Local bias is a factor that also narrows vision. A Canadian thinks the TSX index is diversified but with 45% resources and 30% financial services, the TSX would be considered an aggressive, specialty portfolio in most places. Bradley concludes by pointing out the: “biggest mistakes are not related to IQ, but rather EQ (emotional intelligence). For both golf and investing, temperament is the key.”
Some of the most common self-defeating behaviours are: panicking when stocks fall; chasing the hot stock tips; trading too much; paying fees that are excessive to the value of what you are getting; buying things you don’t understand, or just plain being greedy. Joel Schlesinger in the Winnipeg Free Press recently devoted a column to the “Thrill of the game”, how the same basic drives are involved in gambling or investing.
So what to do? Take your time – even a 5% return becomes a lot of money when compounded long enough. Diversify across risks, and not just normal cycle volatility but for risks like interest rate swings, credit tightening with poor liquidity, not to mention the risk of losing your capital. Make a plan, based on your real needs and risks, starting with clearly defined your goals. Then you can choose the right strategic asset mix, along with setting out the process for measuring progress and rebalancing as circumstances change. Keep working to that long term plan, avoiding jumping irrationally to short term shocks. You must keep the right temperament and discipline to make decisions, the patience to see how they turn out and the fortitude to stick to your plan. Finally, get help. To quote an aviation adage: “Learn from the mistakes of others, you will not live long enough to make them all yourself”. You may be the captain of your ship but a navigator can help you get to where you want to go.
My favourite advise for dealing with the psychology of investing came form Norman Rothery of Stingyinvestor.com, again in the Globe: “How to be a better, happier investor? Ignore your portfolio”. The studies of behavioural finance have shown that in the psychology of investing we will feel twice as badly about losses as we feel pleasure from gains. Even after you have invested all that effort in the analysis and planning, with the best advisors you can find, “your portfolio will see a great many bad days even if your long term results are good”. He goes on: “mental discomfort is the price you pay to obtain good returns”. “If you were scared out of the markets near the lows of 2001 and 2009 then investing in stocks is probably not for you.” “Even those with stronger stomachs should resist the urge to look at their portfolios every day. It’s a recipe for unhappiness.”
Much of the day-to-day fluctuations of the market is due to “the madness of people”. Like Warren Buffet, construct a solid portfolio suited to your destination and goals, using the best advice you can find. Review its performance annually, at most quarterly, against the criteria set out in your plan, and rebalance where necessary to keep on track. You will sleep better.