Let’s begin with a lie.
To become wealthy, you must be able to pick the right stocks. To do this, you need to be good at assessing fundamentals on the balance sheet and income statement. Further, you need to be able to predict sustained competitive advantages, determine future growth rates, and find the next hot business or industry.
I once thought this type of fundamental analysis was necessary to achieve strong compounded returns. But it turns out I was wrong.
Suppression of Human Biases
It’s no wonder. Humans are imperfect and laced with emotional impulses that cause all kinds of investing errors. Tendencies that erode returns over time include overtrading, chasing high returns, panic selling and herding.
You can have the world’s best investing intellect, but it’s useless until you can first control your human biases. This requires humility, patience, discipline, and ego suppression.
Investing Is Simple, But Hard
The data and academic literature are clear on the ideal long-term investing approach. It’s dirt simple, but it is hard.
Buy and hold low-cost index funds with an asset allocation that aligns with your unique risk tolerance. The rest is icing on the cake.
The difficulty lies in controlling your human biases so that you can increase your willingness to take risk. This will allow you to take part in the beauty of compounded returns offered through ownership of global businesses.
Table of Contents
What is Risk?
Risk is the possibility of a bad outcome. Here I will use the common measure of risk as volatility – the intensity of ups and downs in price. It’s how rapidly you gain or lose money.
As an investor, you are paid in proportion to the amount of risk you are willing to take. With stocks (equity), you receive higher returns, called the equity risk premium. So, if you want high returns, you need to be emotionally ready to absorb losses that can extend for up to 10 years.
Non-Systematic risk, also called idiosyncratic risk, is localized to individual companies or to singular industries. You can diversify away non-systemic risk.
Because this non-systematic risk can be diversified away, you don’t get paid to take on non-systemic risk. Why would you get paid for taking on risk that can so easily be mitigated?
Globally diversified index funds eliminate nearly all non-systematic risk, leaving you with the risk inherent in the global equity market (systematic risk). Let’s talk about Systematic risk.
“System”atic risk is that inherent to the entire “system”. That system is the global economic system. Many factors make up the systematic risk, such as market risk, interest rate risk, exchange rate risk and inflation risk.
The Stock Market: A Complex System
The stock market is a chaotic complex system, even with global diversification. This system is subject to unpredictable Black Swan events, with short term losses ranging from 30% to 50%. It is through your ability to stomach these temporary losses that you can access the equity risk premium.
I recommend the book The Black Swan if you want to learn more about the characteristics of complex systems and human behavior. If someone tells you they can predict what will happen in the stock market over the next year – they are lying.
Investing: An Emotional Rollercoaster
The stock market is an emotional roller coaster. We get most excited and overconfident at market highs, while we are most pessimistic and fearful at market lows.
Human emotions (including mine) urge us to buy after a strong performance and to sell in the depth of crashes. These actions interrupt the compound effect at the worst possible times.
To succeed in investing, you must be aware of your psychological biases. I’ll cover what I believe to be the three most important biases to be aware of. Note that these biases feed on each other. I find the interdependencies of the biases to be interesting.
It is only once we understand human biases that we can develop methods to control these the strong emotional pulls that are built into our biology.
Herd Behavioural Bias (Bandwagon Effect)
We have a tendency to conform to what everyone else is doing. Research indicates that we have deep desires to conform for two reasons:
- We believe the group is better informed than we are; and
- We desire to fit in because we would die if we didn’t fit in before the Neolithic revolution.
The group may be better informed in some situations. Investing is not one of these cases.
You’ve heard of Warren Buffett’s saying “Be fearful when others are greedy, and be greedy when others are fearful”.
Herd Behavior and History
Herd behaviour is best displayed through history’s speculative manias. During these manias, people bid up asset prices in manic episodes where everyone seemed to be getting rich quick. In addition, we consistently overestimate the rate of adoption of new technologies.
Herding behavior can be seen when looking back in history. Examples include the Tulip Mania, the South Sea Bubble, the Dot-Com bubble, and the run-up to the 2008 U.S. housing market crash. Recently, we’ve seen herding episodes for various cryptocurrencies and meme stocks.
Good investing ignores social conformance pressure. The best historic stock pickers like Peter Lynch and Buffett even lean towards the opposite of social conformance. They advocate for boring anti-hype companies, sometimes even in declining industries.
Loss Aversion Bias
A loss hurts more than an equivalent gain is pleasurable. For example, a $100 loss is about twice as painful as a $100 gain is pleasurable. You can read into the literature here.
So market crashes hurt more than equivalent gains are pleasurable. We want to avoid pain. And this can be done by selling in market downturns to avoid further loss.
Panic Selling Example
Let’s look at Joe. In 2008, Joe has fully invested in the MSCI All Countries World Index. Joe lost over 42% of his investment value that year. Joe’s emotions were screaming “sell” in fear of further loss. Ironically, this was also the point of maximum potential gain.
Loss Aversion: Fear of Missing Out (FOMO)
Suppose you see a group of friends making money on a hot stock. You’re missing quick returns, and that hurts. To alleviate this pain, you can jump into speculative assets. Even worse, you feel social pressure from your herd of friends. When you do lose, it won’t feel so bad because everyone will be losing together. Fear of Missing Out (FOMO) is a form of loss aversion – I find this very interesting.
The stock market is a complex system, with many interdependent variables that cause chaotic, random behavior. We tend to underestimate randomness and overestimate our predictive abilities.
This tendency is strongest after long runs of returns. We also attribute higher predictability to outcomes when looking back at history – the well-known hindsight bias.
Overconfidence can cause over-trading and the acceptance of excess risk to satisfy get-rick-quick urges.
An interesting example of the over-confidence bias is when dealing with your friends. You’ll only hear about the “wins” and they likely won’t tell you about their losses. This is particularly common with options traders. Be careful when listening to the success stories put forward by others.
Some Books on Human Biases
How to Cope with Risk
Risk Tolerance: How Much Risk Can I Take?
The amount of investment risk you should take is unique to you. It depends on two factors:
- Your ability to take on risk; and
- Your willingness to take on risk.
Both dimensions of risk are described well in this article. I also discuss both aspects of risk in a post about How a Military Career can Increase Expected Investment Returns.
You have a high ability to take risks if you are young with a long time horizon and lots of earning power ahead of you. But you can’t take on this risk until you assess your willingness to take risk.
This is where control of human bias comes into play. If you panic sell after a sharp downturn, or if you can’t sleep at night because your portfolio is down 40%, you do not have the willingness to take risk.
Take on too much risk, and you may ruin your financial goals. But if you fail to take enough risk, you will sacrifice future wealth for yourself and your children.
Proper Asset Allocation
One way to protect yourself from yourself is to engineer your portfolio risk by changing the mix between stocks, bonds, and cash. This called “asset allocation”. It can make your portfolio less choppy, at the expense of lower long-run expected returns.
Or you can make it more choppy (100% stocks) while increasing long run expected returns. You can estimate your rough asset allocation using Vanguard’s Investor Questionnaire.
Yes, bonds barely beat inflation and look to be a poor investment when looking strictly at the numbers. But bonds can add value by adding an emotional buffer that improves the likelihood of holding out stock market crashes. In this case, they contribute to higher returns through their positive psychological influence.
Eliminate Non-Systemic Risk
Globally diversified indexed funds minimize non-systematic risk. This gives you the highest returns with the lowest possible volatility. Burton Malkiel calls global index investing the closest thing to a free lunch in his book A Random Walk Down Wall Street.
Behavioural Tips For Investing
Keep it Simple, and Boring
Simple portfolios require less tinkering, allowing you to spend more time on things that matter. And less tinkering means you are less likely to become emotionally attached to your portfolio.
Global index investing is so boring that you’ll have limited desire to check and tinker with your portfolio. This will help you better detach emotionally. I gain my excitement in life from other sources – not investing.Boring one-fund solutions like or XEQT make access to global stocks as simple and cheap as possible for Canadians. Similarly, VT makes it easy and cheap for Americans. For those who have a bond allocation, check out the Canadian Couch Potato Model Portfolios.
Don’t Check Your Portfolio Often
I have a hard time with this one – it’s exciting to see the value of your portfolio change from day to day.
But daily fluctuations in portfolio value are irrelevant and all they do is increase the emotional response the stock market, and makes it harder to detach emotionally. You’re investing for a time horizon of decades, not weeks.
Understand Your Investments and Where Returns Come From
Understanding the basics of where stock returns come from helps you keep calm in the face of volatility. It can even help you view a downturn as an opportunity because you know that you are paying less for future cash flows of the businesses you own.
The price of a stock is based on the future earnings power of the business. As an owner of the company, you get to share in the earnings via dividends or share buybacks.
By owning a basket of stocks with an indexed fund, you share in the aggregate earnings growth and dividends of all the businesses. This, in short, is where returns come from.
Avoid Stock Market News
Stock market news is terrible. No one can predict what will happen in the market, including the experts. I don’t understand how these folks retain confidence after routinely failing in their predictions.
Further, news is primarily negative and is likely to trigger loss aversion that makes it harder to hold through downturns.
Build Strong Systems - Invest Consistently Over Time
Systems and habits remove reliance on willpower and reduce the influence of your human biases. This is why pilots use checklists, and it’s why aircraft technicians have someone conduct an independent review of their work. The book Atomic Habits stresses the importance of solid systems and habits over goals.
Let’s go through some examples of systems. This is important.
Investment System - Example 1 - Jake's System
I’ll share my system with you.
Every 2 months, I invest my accumulated savings into 6 specific index funds that provide geographic exposure to thousands of stocks. My portfolio structure is pre-set, with specific allocations to different geographic regions. I follow the portfolio regardless of what is going on in the markets.
Every two months, I strengthen my habit of continuously investing in accordance with my system. This rids parasitic attempts to time the market, and improves my odds at sticking with my system for the long term. I’ll naturally catch the highs and the lows of the market – a nice emotional buffer.
Investment System - Example 2 - Automoation
Even better, you can automate your investments to have a set amount pulled out of your chequing account, moved to a brokerage account, and invested in an index fund immediately. This is called forced savings (with automated investing).
The coolest thing about forced savings + automated investing is that one simple decision can set you up for long-term financial success. It allows anyone to statistically beat the returns of most (professional) investors while erasing the effects of your emotional biases.
- Humans have behavioral biases that result in poor long-term performance if left uncontrolled.
- If you want higher returns you need to take on more risk. Greater emotional control is needed to ride out the ups and downs associated with greater risk.
- You can limit emotional decision-making by understanding human biases, global index investing, proper asset allocation, and discipline.
- There are other non-behavioral factors that affect your risk tolerance such as your human capital and time horizon.