Your Own Worst Enemy?
To be successful as investors over the long haul, we mortals must overcome some big obstacles. Some of these are obvious – the volume of news and information published daily on companies and the stock market presents a daunting challenge for anyone without the luxury of being able to study it full time, and the complexity of modern finance theory seems designed to confound anyone with less than PhD level qualifications.
The most daunting challenge we face, however, is less obvious. It is the same obstacle that has quietly stood between investors and long term success for as long as stock markets have existed: ourselves.
There are so many cognitive biases and heuristics that individual investors bring to their portfolio decisions, that an entire field of study – behavioural finance – has sprung up to document and explain them. The insights from this field of study are clear – the real enemy lies within.
One of the more damaging of our inbuilt biases is our inherent tendency towards optimism. To illustrate the effect of this, if you were to ask a class of MBA students to rate their income-earning prospects after graduation, most would indicate that they expect to earn more than the average for their class. Similarly, a group of drivers asked to rate their skill relative to others will tend to assess themselves as being significantly above average. There will be very few respondents who see themselves as average or below.
I’m not aware of a researcher having asked a group of investors to rate their investing skill relative to others, but I’m pretty sure the outcome would be similar – they would find a surplus of investors with uncanny ability.
This inherent optimism affects the way we analyse our successes and failures. Investment outcomes are always a mixture of luck and skill, and when we review those outcomes it is easy to see successes as a result of our skill, and failures as the product of bad luck, brought about by some external agency. The only way to really gauge your investing skill is to properly account for a large number of decisions over an extended period and measure performance against some objective yardstick. This is a lot of work, and I expect that very few individual investors would go to this effort.
It seems safe to assume then, that there are many investors who are subtly and inadvertently sabotaging their long term prosperity by continually making suboptimal investment decisions. When compounded over a lifetime, this can add up to a large difference in terms of retirement wealth.
So, as an enterprising investor, how can you avoid this trap and improve your prospects for a comfortable retirement? I suggest you do what the professionals do – take a sheet of paper and properly document your investment process. Identify and describe what it is that will allow you to compete effectively against all of the investors taking the opposite sides of your buy and sell decisions.
Some of the important topics to address in this document include:
What are your objectives? Think about what return you are trying to earn, and how much risk you are willing to bear to achieve it. Think carefully about this second point, and know in advance how you will respond when a bad case scenario arrives, as it probably will.
What is your edge? Clearly articulating your source of advantage and where you will apply it is perhaps the most important part of the exercise. As Warren Buffet put it in his 1996 Shareholder Letter:
“You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
If you have an interest in studying financial statements to find insights others have missed, that’s great. However, if you are relying on media commentators/brokers/casual acquaintances/taxi drivers for tips, then this topic may need more work.
How will you manage your portfolio? Position sizes should be part of a plan – they shouldn’t be defined by whatever cash you happen to have at the time. Consider how long you will hold positions and how often you need to rebalance your portfolio. Rebalancing once a year is fine. Rebalancing once a lifetime is probably not enough.
Once you’ve done all that, consider tracking your investment performance over time to see how you perform. This takes a bit of work, but doing so will help you to stay realistic on what can be achieved, and perhaps identify aspects of your plan that need improving.
This sounds like a lot of work – and it is – but there’s a lot at stake. In the long run, getting the most from your investments is well worth the effort. A word of caution, however – if you do this properly you may come to the conclusion that the best course of action is to fire yourself.
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This article first appeared in The Australian on 2 November 2013.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Joe Rich
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‘A word of caution, however – if you do this properly you may come to the conclusion that the best course of action is to fire yourself.’
An interesting comment Roger – while it makes sense that someone who focuses their time, effort, and knowledge on building investment skill should outperform, a number of studies have shown both here and in the US that over the long term, index funds overwhelmingly do better than most money managers, adjusted for fees.
There are a number of psychological biases that keep professional money managers from optimal decisions. Interestingly, you have covered these off in a number of your recent posts. Just to list a few, there’s (A) the overwhelming tendency to ‘hug’ the index, due to clients with an overly short-term focus who don’t have the stomach for long term value investing. (B) There’s also a tendency to follow the herd in terms of ‘popular’ or ‘hot’ stocks/industries. If a money manager follows the herd and gets it wrong he/she can claim that ‘nobody saw it coming’, but if they separate themselves from the pack by backing a few out-of-favor stocks, they will get punished by clients if their bet doesn’t pay off in the short term (a bias that also applies to sell-side analysts).
I believe you had a white paper last year in which you articulated these points, as well as a number of other issues affecting the fund management industry.
Roger, from following this blog for years I perceive that you’re one of the very, very few true professional ‘value investors’. And while I would gladly leave my money in your hands, I can’t say the same for the majority of your peers…
PS if there are any other readers interested in a more thorough explanation of these biases, in addition to Roger’s white paper, I would also recommend the introductory chapters of (A) ‘One up on Wall Street’ by Peter Lynch and (B)’Margin of Safety’ by Seth Klarman – they provide great insight into psychological biases of professional money managers.
Roger Montgomery
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Thanks Joe. The pool of managers that focus on small caps in Australia is often cited as evidence of consistent ability to generate Alpha. But when you look at the stocks upon which the small ords is constructed you quickly realise it should be easy to beat.
Adam Novek
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Hi Roger,
I am graduating soon and I am looking for further education to build up my skills in investment. Do you think a certified financial analyst (CFA) certificate would be more worth my time than an extra one year to my degree doing an honours research project in behavioural finance? Or do you think both are just a waste of time and money for the industry you are in?
Roger Montgomery
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If you could have both, you’d be highly employable I suspect.
Adam Novek
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Thank you. Great article by the way! I can be my own worst enemy sometimes when it comes to price fluctuations and withdrawing from a company over a negative price change ha ha.
michael castaldo
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Nice article, ive fired myself and bought ARGO shares a listed investment company, because I have a day job as an Engineer and believe a professional trained in the stock market should be able to do a better job than me. I’ve noticed not many people trained in the stockmarket dable in designing bridges with their spare time….
Roger Montgomery
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Very true. A good point and mature response.
Andrew Legget
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I found doing something similar to what you describe to have been one of the most beneficial things I have done in my investing learning journey (even found some of the guff I wrote published here as part of it). I now know a lot more than I did before sitting down and just thinking about what type of investor I am and want to be. I know what my biases are, I know what my weak points are. There for I am able to focus on my strengths.
I really encourage and investor to do the same. Be open and you never know where it will take you but it will be a better place than before.
Ok, pep talk over. I am also really interested in behavioural finance (seriously considering doing it as one of my Uni electives) and investing psychology. To me the psychology is more important than betas, efficient frontiers, variance, covariance, capms etc.
If all you learn is about market efficiency, how will you be prepared for when it gets inefficient?
Roger Montgomery
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The field is expanding and Alan Greenspan’s book has recently dealt with the subject too.