It is often said that a useful measure of happiness is the gap between reality and expectations. A similar approach can be adopted for identifying poor investment decisions. They tend to occur when our expectations of what we are capable of exceed the reality. This miscalibration leads us into activities and behaviours that we really should avoid.
Here are some of the most significant examples of what we think we can do, but probably can’t:
- Time markets: Perhaps the most grievous example of investors overestimating skill is a belief in market timing. This is not just predicting what will happen, but when it will occur. The second part of this equation is even more difficult than the first. Forecasting with any precision the behaviour of a complex, adaptive and chaotic system is just not feasible.
- Truly understand complex funds: Complex funds are alluring because they come with outlandish promises of high returns and low, differentiated risks. They also breach a cardinal rule of investing – don’t invest in things we don’t understand.
- Predict inflation (or other macro variable): Our inability to accurately forecast macro economic variables seems to have no impact on our willingness to keep doing it.
- Pick funds that consistently outperform: The greatest myth in fund investing is that any manager or strategy can consistently beat the market. Even a skilful fund manager will underperform for prolonged periods. When we fail to realise this we get trapped in a painful cycle of selling losing funds and buying yesterday’s winners.
- Withstand poor performance: Spells of weak performance are inevitable for any strategy, fund or asset class. These are easy to deal with in theory, but the lived experience is an entirely different proposition. The stress, anxiety and doubts that occur during difficult periods will lead us to make poor decisions at just the wrong time.
- Ignore a compelling story: Every bad investment comes with a beguiling story. We think that it is other people that will be taken in, but, one day, it will be us.
- Be a long-term investor: The great rewards available for long-term investing only exist because it is so difficult to do. Doing very little feels like the easiest task in the world, but the temptation to act is so often overwhelming. Every day brings a new story, a new doubt, a new opportunity. A new reason to be a short-term investor.
- Avoid dangerous extremes: Most of what we witness in financial markets is just noise, but extremes matter. When performance, sentiment and valuations are at extremes (either positive or negative) the opportunity is for investors to take the other side; unfortunately, the pressure to join the crowd will likely prove irresistible.
- Overcome terrible odds: Investors frequently make decisions where the odds of success are incredibly poor. We think that we will be the person to actually make money from a thematic fund or invest in a star fund manager who keeps producing astronomical returns. We just cannot help ignoring the base rates.
- Find the ‘one’ investment: Although investors are aware of the benefits of diversification, it is a little boring and an admission of our own limitations. We would prefer to find the ‘one’ investment that will transform our financial fortunes, whether it be a stock, theme, fund or ‘currency’. Such ambition does not tend to end well.
Throughout my career I have heard people say that ego and a level of arrogance are a pre-requisite for a successful investor because there is a requirement to ‘stand out from the crowd’. This is nonsense. These are dangerous traits, not beneficial ones.
Far more valuable is being humble about the challenges of financial markets and aware of our circle of competence.
We need to avoid being our own worst enemy.
