Or, Why It’s Never Smart to Trust Blanket Statements, Built upon Emotional Bias, on Investing

When it comes to allocating savings (aka Investing), a surprising amount of reward will come from the decisions you don’t make. Not sure what to do? Try doing nothing.  In most instances nothing is very much something. Markets should be considered to be one of the most manipulative, conniving and destructive forces in existence – and guess what, the psychological/behavioral interference they create have a direct line to the levers you pull when making important decisions about your money. Needless to say, this is a very dangerous combination. Hence, the title of this post: Money + Emotion = Less Money.

Even the smartest participants will inevitably make wrong decisions at the absolute worst times. The best traders/investors are not immune, they’re only marginally better at containing their fallibility to Mr. Market’s brutal ways. If you think you’re set up to lose at a casino then try taking the same setup and add your entire life’s savings in chips on the table, the players seated next to you are whispering conflicting advice in each ear, the dealer is slowly stealing chips from you as you look away and, oh yeah, someone just incited panic by setting off the fire alarm. Try making the right decision under those conditions at the casino. That’s the market. The only way to survive is by sticking to your plan and sitting on your hands until the right cards present themselves.

Charlie says it best.

We are over five years into an unrelenting bull market. Five years of gains for bulls and five years of losses for those who didn’t participate has surely created plenty of behavioral bias in both groups. The winners are likely thinking very highly of themselves (overconfidence) and the losers are waiting with bated breath for the next correction so they can say they told us so (confirmation bias). Each bias is dangerous and each is guaranteed to be costly.

Taking recent results and extrapolating them far into the future is not a new concept but I’ve recently seen a few articles and blog posts regarding active management and efficient markets. The main argument against analysts/managers and for efficient markets is that stocks are now priced so accurately there is no need for individual fund managers or analysts to identify and correct any mispricing.  Sure, it’s a very defensible statement to make after a five year run where “active managers” have been trounced, but does that mean markets are really efficient? Not even close. Markets are made of people. People, especially when it comes to markets, are nowhere near sane operators – especially when there’s money on the line. Not even close. Five years is a blip on the screen when compared to a meaningful timeline. Decades are what count – we must not put too much value on recency.

I’m a huge fan of passively investing via index funds and in no way do I think individual investors should be timing the market or picking stocks for short-term gains. Individual investors should stay away from trying to do too much, but that doesn’t mean the market is efficient. Nor does it mean investors should pile into actively managed mutual funds (I would never recommend an active mutual fund). There is still a place for professional investors to actively manage portfolios for sophisticated clients in need of very specific levels of risk, return or diversification. After all, the stocks in an index have to be priced by somebody.

What happens when emotional bias gets in the way of reason?

Exhibit One: 

No comment necessary.

Exhibit Two:

Jim Cramer’s now-infamous call to pull out of the stock market for five years in October 2008.

In summary, I simply mean to say it’s typically unwise to make, or believe, very bold, blanket statements based on a small amount of data or time. Typically this is emotional bias disguised as careful analysis. Beware of phrases like “never again,” “the new normal,” “XYZ is dead” and/or “ABC is now impossible.” History is always repeating itself, or at the very least it rhymes. This is especially true with financial markets so it always pays to limit exposure to investing pundits/”gurus” and the media interests they serve. Stick to your plan, leave active trading to the pros and approach everything you see with a heavy dose of skepticism.

Possibly one in a million.

What does a picture of a sunset have to do with investing? Quite a lot, in my book, actually. I’ll quickly elaborate.

I live in a very scenic area of Seattle near Alki Beach so I find myself lucky enough to be in place to view a lot of beautiful sunsets. My phone’s full of sunset pictures. Most of them are just average, a few are pretty forgetful but then there is the picture above. It’s an absolute masterpiece. I may never again capture something so amazing. Yet, most importantly, I’ll keep trying.

This process is a lot like investing. It has parallels to a tenet I hope my clients are sick of me talking about: staying focused on the long-term. Keeping your portfolio allocated appropriately while remaining patient is going to eventually produce positive returns. It’s important to keep a process, regardless of short-term market results. If the process is sound it will produce returns over time. But only if you keep it up. Warren Buffett agrees.

With the same mindset, I’m going to keep my camera pointed toward the Olympic Mountains at sunset, hoping to one-up the above picture.

The market rewards patience. So does the Western sky.

Last week the world had its fair share of headline-grabbing events. Stocks, measured by the S&P 500 index, were down over 2.5%. Time to lighten up on your equity holdings?

Please don’t.

It’s a sad truth, but very bad things are going to continue to happen in the world. Every day, pundits will tell us there is a new threat to the global economy. They will tell us how this time it’s different in the Middle East, this time that dictator is a major threat to our livelihood and this time that virus is surely going to wipe out the population. Fear drives viewership and mouse clicks.

Sorry, pundits, but the truth is that this time is almost 100% certainly just like last time: a footnote in history. As investors and allocators of savings, we must tune out the short term noise and always focus on the bigger picture. Does a renewed conflict in Gaza materially affect the earnings outlook for US stocks? Does (unfortunately) another terrorist attack suddenly crater the value investors are willing to pay for those earnings? Probably not.

The human suffering and tragic story lines of all geopolitical events tend to resonate with certain investors who will overreact to the images they see. In turn, financial assets will fluctuate with this emotion. It is our job as investors and savers to look beyond this day-to-day drama.

Let’s look at stocks specifically. If someone wants to know why certain stocks went down on a given day, usually the true answer is, “well, some people wanted to buy and some people wanted to sell, it just turns out the price they settled on was lower today than the day before.” We rarely get that answer because it’s much sexier to attach a headline to it. The market is open five days a week. Stocks have to go somewhere and so sometimes they go up and sometimes they go down. Only when we start to attach themes will emotional overreactions begin to prevail.

At some point, a minor headline will turn into a major one and it will affect financial assets in a meaningful way. Investors must be ready to interpret that change and act accordingly. Until then, let’s stick to the plan.