The psychology of successful investing

In this article I'd like to focus on some of the psychological facets of investing and inquire into what it takes for somebody to be a successful long-term investor.

I think there's an interesting analogy between the way people drive and the way they invest money. Good driving schools teach "defensive driving" techniques. If you know what to look out for on the highway, you greatly improve your chances for reaching your destination in one piece. Likewise, I think a good investment newsletter ought to educate its readers about some techniques of defensive investing. If you know the pitfalls, you can guard against some of the roadblocks that sabotage most investors.

Impatient drivers in traffic jams often pay lots of attention to what lane they are in and how the other traffic lanes are doing compared to theirs. If the other lane looks like it is moving faster, they often will swerve over to cut in front of somebody else. Some people do this repeatedly, taking every opening they can find to get any slight advantage for themselves. Those drivers may indeed gain a few seconds. But in the process, they escalate the levels of danger and annoyance to them and everybody around them. In investment terms, they take on much more risk in return for uncertain (and possibly elusive) gains.

I think one of the greatest roadblocks to successful long-term investing is impatience, and this applies equally to buy-and-hold investors as well as those who use market timing.

Impatient investors watch the market from day to day like a hawk. But except for market timing purposes, their time would be much better spent studying what's happening in society and the world, looking for investment opportunities over the next five to 10 years. Impatient investors are easy prey. They can be lured to change lanes, and change lanes again. In their zeal to always be "on top," these people rarely give any investment or strategy enough time to perform adequately. And they end up as road kill, often retreating to the sidelines with money market funds and Treasury bills while their more patient counterparts build their wealth in the slower lanes.

Patient investors who make investments and stick with them for years or decades, with or without market timing, aren't likely to have exciting anecdotes to share at parties. But they are more likely to retire comfortably. And they are more likely to sleep well along the way and be able to devote their attention to other things in life. These people may seem unexciting, but I think they can be dubbed "Road Warriors Along The Investment Superhighway."

WHAT'S YOUR STYLE?

Whether you realize it or not, whenever you take the wheel of your car, you have a driving style that's all your own. There's a certain amount of risk you are willing to tolerate and a certain amount of frustration you are willing to tolerate. You may or may not have much patience for other drivers who don't behave as you think they should. These are all emotional factors. They have nothing to do with how you choose your destination and your route to get there. They are all descriptions of how you respond and react to external conditions, most of which you cannot control.

Likewise, you have your own style of investing. You can tolerate some level of risk, but you probably get quite nervous once you get past the boundaries of your personal comfort zone. How do you handle mistakes? Do you welcome them as an opportunity to learn more about yourself and about investing? Or, do you feel compelled to find somebody or something else to blame when something goes wrong? How quickly will you abandon the route you have chosen in search of something better? Some drivers will leave a clogged freeway in the hope they can find any alternative with less frustration, even if they can't actually see such an alternative route. Likewise, you may be quick to abandon an investment if it isn't performing up to snuff after a few years or even a few months or weeks. Perhaps you'll throw your money elsewhere purely to relieve your frustration. (This is what we call the "I Can't Stand It Anymore" method of market timing.)

INVESTING LOOKS CUT AND DRIED

On one level, investing is a rational, mechanical process that starts with some basic decisions like:

How much time do I have before retirement (or some other investment goal)?

What is my savings rate and my level of commitment to it?

How much money do I have now, and how much will I need to have at retirement?

What assumptions do I make about the rate of inflation before and after I retire?

From these, I can figure out the rate of return I will need to get from where I am to where I'm going. Then I can determine what type of asset will produce the return I need. All of this is pretty cut and dried. The calculations could be made by a computer.

BUT IT'S REALLY EMOTIONAL

But the next logical question is psychological: Can I tolerate the risks involved in the asset class that will take me where I am going? If the only way to achieve your goals is to speculate on commodities or "bet the farm" on your ability to sell stocks short just before the market goes down, you'd better have an awfully strong stomach and a Plan B for your retirement.

Another emotional question that frequently arises: Can you tolerate seeing somebody else's portfolio doing better than yours? You may recall early last year we laid out a careful plan for what we call a Worldwide Balanced Portfolio by splitting your investment assets into four equal categories: domestic equities, domestic bonds, international equities and international bonds. I recall a client for whom we set up such a portfolio last year after much discussion. Although the client is a very smart guy and understood completely what we were doing with the Worldwide Balanced Portfolio, he called me a few months ago, quite upset that his investments were under-performing the Dow Jones 30. I bit my tongue, but I couldn't help wondering what he expected. With only 25 percent of his assets invested in domestic equities, he could not rationally expect that portfolio to mirror the Dow. And in fact one reason we set up his account the way we did was to make sure that it did not match the Dow. On a purely emotional level, his anxiety is easy to understand. This has been a wonderful year for domestic equities (just as 1993 was an excellent year for international ones), and the media is heavily focused, as usual, on the Dow.

To this client, it felt as if he was missing out on the action. His reaction was akin to turning on your car radio when you're stopped cold on a freeway, and getting angry when you hear that several other freeways are wide open. It's an understandable reaction, but not very rational and not very useful.

OTHER INVESTING ROADBLOCKS

Here are some other emotional and psychological roadblocks to being a successful investor:

Focusing on hope (and sometimes hype) while ignoring risks. While managing risks is at the heart of successful investing, you'll almost never find an investment salesman who wants you to focus on risks or emotional problems you may encounter. They have learned that when people confront the emotions associated with losing money, most people will flee before a salesman can make a dime in commissions. The industry doesn't want to talk in terms of preparing for the bad times. The industry just wants to make money while there's money to be made. Unfortunately, emotional problems and pressures in a significant bear market can wash out investors just as easily as it washes out their portfolios.

Making emotional decisions instead of disciplined decisions. If you don't have a discipline, your moves are likely to be made randomly, on the basis of a whim or a conversation you had with somebody on an airplane, or emotionally, depending on whatever internal and external pressures you feel at any given moment. Either way, you will almost certainly be working against your own best interests. The key to successful investing is to have a discipline, even if it's as simple as dollar-cost-averaging, and to stick to it.

Being unclear about what you believe and how you intend to invest in the face of uncertainty. For any financial topic you can think of, I could find at least two learned and qualified experts who would take opposite positions on the meaning of any particular situation. The media like to find such experts and quote their views as if they were facts instead of just interpretations. Investors are often led astray. Is the market too high? I can find plenty of experts who can make a good case that it is. Likewise I can find experts who will tell you just as convincingly that the market is relatively low and now is a great time to buy. If you don't have a strategy, you're likely to pick one of these experts to believe and follow. You'll be likely to pick an investment strategy based on somebody's personality or charm or the emotional content of a point of view. Know what your strategy is. Know what you believe. Know what is important to you. Then you'll know how to listen to the experts and evaluate what they have to say.

Focusing excessively on individual components of your portfolio instead of the whole. Recall for a moment my client who was upset because his Worldwide Balanced Portfolio under-performed the Dow Jones Average. He was looking at immediate results instead of his real goals, which are long-term. We know from decades of experience that combining U.S. and international securities lowers investment risk and raises investment returns over long periods of time. But like many people who talk about their long-term focus, my client found himself being very judgmental about short-term performance. A tradition for many investors is looking up their stocks and funds every single day. Some supposedly long-term investors even call their brokers or look up stock prices electronically several times each trading day! This added information really does long-term investors no good and it makes it much harder to stick to a long-term focus.

Either being an active trader or being paralyzed in the face of an overwhelming variety of choices. As investors we can choose every day from thousands of mutual funds, thousands of managers, thousands of individual stocks and thousands of other products and plans. The industry makes it easy to be an instant, frequent trader. Wake up in the middle of the night with an investment idea or fear, and you can find a broker to execute a trade for you immediately on the Tokyo or London exchanges. The industry wants you to be a trader. Every single security salesperson wants you to change something. That's how they make a living. And everyone wants your business. If you have a stockbroker, even the other brokers in that office would be happy to have your broker move to another brokerage firm so they could legally solicit your business away from your present broker! All this adds stress to investors' lives. Some people handle the stress by becoming active traders, usually at the expense of their own portfolios. Others give in to paralysis, doing nothing for fear of doing the wrong thing. Often, standing pat is the right thing to do. But when you do it for an emotional reason, you are likely to go astray.

Taking too much risk. People with relatively small amounts of money tend to take too much risk, while those with large amounts take too little risk. At one extreme, people who have few assets feel they have little to lose and often spend their money on lottery tickets, thinking that is their only ticket to financial success. Some of them think they are "investing," while they are in fact gambling against overwhelming odds. A 20-year-old playing only $3 a week on the Lotto until age 65 will most likely wind up with nothing to show for the approximately $7,000 he will spend. That same $3 a week, invested for 45 years at 9 percent, could grow to almost $100,000.

Taking too little risk. On the other hand, many investors are too risk averse, especially those with 20 or more years before retirement. The majority of money in 401(k) retirement plans is invested in guaranteed interest contracts, bonds, money market funds and similar low-risk, low-return securities. The owners of those funds are likely to realize, probably too late, that they have shortchanged themselves, forfeiting the retirement they could have in order to gain illusive short-term security. And they will have squandered their greatest asset-time. If you are investing in an IRA or a 401(k) plan, it may seem quite important to avoid having your portfolio take a beating in the market in any given year. But that risk is tiny compared with the gains you are likely to give up by avoiding the equities markets.

Being unwilling to take a loss. If you want to avoid big market losses you must sometimes sell your holdings, even when that means you have to take a loss. This is one of the hardest things for investors to do. Many people think that if they don't sell at a loss, they don't really have the loss. And they think that taking a loss, even for strategic reasons, means they are failures. As a result, people hang on to sinking securities, often with the attitude that they will wait until they can break even, then sell and be done with it. Many early investors in Fidelity's Magellan Fund never got the benefits of that fund's impressive long-term track record because a couple of losing years in the 1970s convinced them that Magellan was a dog. Yet many of them stuck with Magellan over a period of years, just waiting for their investments to reach the break-even point. When that happened, they sold with relief, probably watching with bitterness as Magellan went on to rack up its huge subsequent gains.

Failing to manage your expectations. One of the best things you can do in investing is spend some time taming your expectations. Of course you'd like a piece of the action when things are going well, and if you follow a sound investment plan you will get some of that action. But you won't get it all the time and you probably won't get it right away. If you're not careful, your emotions can distort your perception, which can lead you to unwarranted conclusions and make it easier for a fast-talking salesman to reinvest your money to suit his purposes, but not necessarily your own.

Do you expect to never have a down quarter or a down year? Do you expect you'll never have to suffer a loss? Think you'll always like what the numbers tell you at any given moment? In every case, you're setting yourself up for an upset. Some people are so competitive by nature that they can't stand to see others doing better than they do. Other people are rarely satisfied with anything, always looking over their shoulder, asking why they couldn't be doing better. These people are bound to be disappointed. And if they don't have a disciplined approach to investing, their emotional reactions will start dictating their investment moves. That's almost a surefire recipe for disaster and more disappointment.

WRAPPING IT UP

You can bet the professionals in the investment business understand these psychological hurdles, and many of them are willing and eager to take advantage of investors who don't. When it's your money at stake, you should be the one in the driver's seat, even if you take directions from someone else. The best way to keep your hands on the wheel is to have a plan that will work for you, then stick to it. Do that by understanding the difference between your financial needs and your emotional needs. A good investment plan will help you achieve the total return you need to meet your own financial goals and timetable. It will help you preserve your capital. And it will greatly improve your chances of being a "Road Warrior Along The Investment Superhighway."

Source: http://mutualfunds.about.com