Technical know-how is the biggest factor for long-term investing success? Picking the right stocks requires assessing price-to-earnings ratios, predicting competitive moves, determining future growth rates, and finding the next hot company or industry.
What if I told you this was wrong? The largest investing mistakes are attributed to human behavior. Speculating, and market timing to minimize loss results in the average investor performing worse than the broad market.
The data and academic literature are clear on the ideal long-term investing approach. It’s dirt simple – buy and hold low-cost index funds that align with your unique asset allocation. Although the reasoning to prove that is Understanding tax sheltered accounts and achieving tax efficiency are icing on the cake.
But most professional fund managers underperform the market, and DIY investors do even worse. The failures of the average DIY investor come from behavioral mistakes. You are a human and you have biases. If you disagree – that’s the overconfidence bias.
You can have the world’s best investing intellect, but it won’t help your investing if you can’t control and understand your biases.
This is why joining the military at age 16 was the most beneficial event for my long-run investing returns. My time in the military taught me self-control. The second most helpful experience was making mistakes in my early 20’s – holding onto losers due to loss aversion, avoiding index funds due to overconfidence, and selling early due to lack of patience. Finally, at the bottom of the importance hierarchy, comes the knowledge gained through degrees, courses, books and podcasts.
What is Risk?
Risk is the possibility of a bad outcome, and it’s measured as volatility – the severity and duration of ups and downs in price. It’s how rapidly you gain and loose money.
As an investor, you are paid in proportion to the amount of risk you are willing to take. With stocks, this is called the equity risk premium. So, if you want high returns, you need to be emotionally ready to absorb temporary losses, sometimes for 5+ years.
Non-Systematic risk is localized to individual companies or to singular industries. You can diversify away non-systemic risk. And you don’t get paid for taking on risk that can easily be avoided. So, you don’t get paid for taking on additional non-systemic risk. Therefore, globally diversified index funds eliminate nearly all non-systematic risk, leaving you with the risk inherent in the global equity market (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 is a chaotic complex system, even with global diversification. This system is subject to unpredictable Black Swan events, with losses ranging from 30% to 50%. 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.
The Importance of Emotions
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 strong performance and to sell when at the depth of crashes. These actions kill the compound effect and reduce long-term wealth.
We need to first understand these human susceptibilities. Then we can develop methods to improve self-control over these responses that are built into our biology
Awareness of your psychological biases is critical to investing. I’ll cover what I believe to be the three most important biases. Take note of the interdependencies of the biases – they feed on each other.
Herd Behavioural Bias (Bandwagon Effect)
We have a tendency to conform to what everyone else is doing. Research indicates that we do so for two reasons:
- We believe the group is better informed than we are; and
- We desire to fit in. Before the neolithic revolution, we would die if we didn’t fit in.
The group may be better informed in some situations – investing is not one of them. You’ve heard of Warren Buffett’s saying “Be fearful when others are greedy, and be greedy when others are fearful”.
Herd behaviour is best displayed through history’s speculative manias. During these manias, humans bid up asset prices far above intrinsic value and overestimated the rate of adoption of new technologies.
We can see such behaviour by looking back at the Tulip Mania, the South Sea Bubble, the Dot-Com bubble, and the run-up to the 2008 U.S. housing market crash. Currently we saw this with TSLA, Cryptocurrencies, meme stocks and ARKK.
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.
Market crashes hurt, more than equivalent gains. The pain of loss makes us want to sell to avoid further loss. So, we are most likely to sell at the point of maximum expected future returns.
Let’s look at Joe. In 2008, Joe has fully invested in the MSCI All Countries World Index, and he 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 is also at work when stocks are doing well. I think this is cool. Fear of Missing Out (FOMO) triggers loss aversion – I find this very interesting. 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.
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 especially pronounced after long runs of strong 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 interest effect 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.
How to Cope with Risk
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”, and 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 are well worth the returns.
Eliminate Non-Systemic Risk
A 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 the Random Walk Down Wall Street.
Keep it Simple, and Boring
Simple portfolios are requiring less tinkering, allowing you to spend more time on things that matter. You are less likely to become emotionally attached if you are less involved with your portfolio.
Boring one-fund solutions like or XEQT make access to global stock markets 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.
Global index investing is so boring that you’ll have limited desire to check your portfolio. This will help you better detach emotionally. I gain my excitement in life can from other sources – not investing.
Avoid Stock Market News
Stock market news is terrible. No one can predict what will happen, including the experts. I don’t understand how these folks retain confidence after routinely failing in their predictions.
News is primarily negative and is likely to trigger loss aversion that makes it harder to hold through downturns.
Keep Investing Consistently Over Time
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Investing consistently in a globally diversified index fund builds a strong habit of continuously investing immediately as you get paid. This rids you of parasitic attempts to time the market. You’ll naturally hit the highs and the lows of the market – a nice emotional buffer.
Even better, you can automate your investments to have money pulled off your paycheck, moved to a brokerage account, and invested in an index fund immediately. This is forced saving.. It allows anyone to statistically beat most (professional) investors with one easy decision.
- Humans have behavioral biases that result in poor investing 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.