A short note on the psychology of investing

Apr 12, 2016

Over the last eighteen months US equity low volatility and relative strength strategies have performed comparatively well, whereas moving average and international portfolios have generally struggled. The reality is that, regardless of whichever investment approach is adopted, there will be periods of both outperformance and underperformance. It was ever thus.

Good returns are fairly easy to handle; unless they lead to hubris, they largely take care of themselves. But there are no certainties in investing, only probabilities. 

Nothing works all the time. Even when the odds are strongly in your favor, the trade / position won’t always work out. Probabilities play out in the long-run. In the short-term, anything can happen. Accept it.

There will be periods of underperformance. When this happens it will be tempting to switch to a different approach that’s recently performed better. However, constantly searching for the 'answer' and bouncing between strategies is a great way to fail to capture the long term returns of any approach.

i.e. Chucking in the towel on a buy-and-hold portfolio in 2009 and switching to a trend following approach. Then changing strategy once again in 2015 after that took some whipsaw losses.

Having realistic expectations from the start makes it considerably more likely that you will have the necessary perseverance to stick with your chosen strategy.  This is where analyzing backtests, delving deep into the results, seeing that there have been adverse periods in the past, can be highly beneficial.

Pursuing any single investment approach requires mental fortitude.  Buy-and-hold investors need to be able to stomach the deep drawdowns that their portfolios will suffer in bear markets. Those investing tactically require the temperament to handle the frustration of inevitable whipsaws.

Diversifying at the strategy level (a la core-satellite), however, can provide an emotional hedge for those times when the market environment is particularly unfavorable to one approach or the other. It obviously also means not having to trust one’s objectives to the performance of a solitary model.

Regardless of the approach, it’s the process, rather than short-term results, that must be kept uppermost. It’s by sticking with the process that objectives are most likely to be achieved over the long run.

Some resources that might be useful: 

A Wealth of Common Sense: From Great to Good
A Wealth of Common Sense: The Psychology of Sitting in Cash
Morgan Housel: It Was a Good Bet
Meb Faber: Why Are You Outperforming? Why Are You Underperforming?
Bason Asset Management: Diversification Sucks

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