7 Investing Rules

Legendary investor Warren Buffett famously stated: “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

The reason temperament trumps intellect is that having the right temperament is what allows you to ignore the “noise” of the market and be a patient, disciplined investor, adhering to your well-thought-out plan through the inevitable bad times—times when even good strategies deliver poor outcomes.

What does it take to be an investor whose temperament allows you to be patient and disciplined? My almost 25 years of experience as an advisor has taught me that there are seven keys to success. The first—and most important—one is that you need to understand the nature of the risks of an investment before you commit to it.

1. Understanding the Nature of Risks Before Investing

When investment strategies are working, delivering positive returns, it’s relatively easy to stay the course. However, your ability to withstand the psychological stress that negative returns (or even relative underperformance) produces is inversely related to your level of understanding of the nature of risks of an investment.

That means you have to understand the sources of risk (what could cause returns to turn negative or be below expectations) and return for an investment. You should also understand how the risks of each investment correlate with the risks of other investments in your portfolio (whether correlations tend to rise or fall when your other portfolio assets are doing poorly).

2. Know Your Investment History

To paraphrase a noted Spanish philosopher, those who don’t know their investment history are condemned to repeat it. Before investing, you should not only have an estimate of the expected future returns (based on valuations and historical evidence, not opinions) but also the knowledge of the historical volatility of returns.

In addition, you should know how often returns have been negative for such an investment over one-, three-, five-, 10- and 20-year periods. For example, according to factor data from Ken French’s website, you should expect that U.S. stocks will underperform riskless one-month Treasuries about 10% of future 10-year periods, and about 3% of even 20-year periods. While having such knowledge won’t prevent you from being disappointed if that occurs, it should keep you from panic-selling because you were prepared for that eventuality.

Finally, you should have a strong understanding of the potential dispersion of returns: Are they expected to be normally distributed around a mean, or are there reasons to expect the distribution exhibits skewness and/or kurtosis? Skewness measures the asymmetry of a distribution. In terms of the market, the historical pattern of returns doesn’t resemble a normal distribution, and so demonstrates skewness. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from it than values to the right of (greater than) the mean.

For example, the return series of -30%, 5%, 10% and 15% has a mean of 0%. There is only one return less than zero, and three that are higher. The single negative return is much farther from zero than the positive ones, so the return series has negative skewness. Positive skewness, on the other hand, occurs when values to the right of (greater than) the mean are fewer but farther from it than values to the left of (less than) the mean.

Studies in behavioral finance have found that, in general, people like assets with positive skewness. This is evidenced by an investor’s willingness to accept low, or even negative, expected returns when an asset exhibits positive skewness. The classic example of positive skewness is a lottery ticket—the expected return is -50% (the government only pays out about 50% of the sales proceeds) and the vast majority end up worthless, but investors hope to hit the big jackpot.

Some examples of assets that exhibit both positive skewness and poor returns are IPOs, “penny stocks,” stocks in bankruptcy and small-cap growth stocks with low profitability. Alternatively, investors generally don’t like assets with negative skewness. High-risk asset classes (such as stocks) typically exhibit negative skewness.

Kurtosis measures the degree to which exceptional values, those much larger or much smaller than the average, occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a normal (bell-shaped) distribution. High kurtosis results in exceptional values that are called “fat tails.” Fat tails indicate a higher percentage of very low and very high returns than would be expected with a normal distribution. Low kurtosis results in “thin tails” and a wide middle to the curve. In other words, more values are closer to the average than would be found in a normal distribution, and tails are thinner.

An asset that exhibits both negative skewness and excess kurtosis should have high expected returns. However, it should also be expected to occasionally produce very large losses. Successfully investing in such assets requires acceptance of that risk and the ability to stay the course, rebalancing, and thus buying more after those large losses—just when it’s hardest psychologically to do so.

Here’s an example of a test you should take before investing in the emerging markets. In 2008, the MSCI Emerging Markets Index lost 54%. Would you have been able to not only stay the course (avoid panic-selling) but buy more to rebalance your portfolio, as emerging markets were the worst performing asset class? If the answer is no, you should not invest in them. I would note that, in 2009, the MSCI Emerging Market Index returned 75%, but only for those investors who stayed disciplined.

There’s one other important point we need to cover regarding knowing your investment history. When recent returns have been well above averages, historical results can be misleading and should not be blindly projected into the future.

Consider the following: From 1928 through 2017, a portfolio that was 60% S&P 500/40% five-year Treasuries returned 8.5%. However, from 1982 through 2017, it returned 10.4%. This “Golden Era” is not likely to be repeated, because three favorable tail winds are not likely to recur:

Equity valuations rose sharply—CAPE 10 increased from 7 to 30(as of Oct. 24, 2018).
Yield on 10-year Treasury fell from about 14% to about 3%.
Corporate after-tax profits as a percent of GNP about doubled, from 5% to 9%.

The result of the favorable tail winds is that current valuations (our best estimate of expected returns) result in the expected returns for that 60/40 portfolio of around just 5%, about half the return of the prior 36 years. Investors need to understand not only the historical returns, but that current valuations matter in projecting future returns.

3. Ignore All Guru Forecasts

Benjamin Graham, legendary investor and co-author with David Dodd of “Security Analysis,” offered this observation: “If I have noticed anything over these sixty years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

William Sherden came to the same conclusion in his excellent book “The Fortune Sellers.”

He noted: “Despite recent innovations in information technology and decades of academic research, successful stock market prediction has remained an elusive goal. In fact, the market is getting more complex and unpredictable as global trading brings in many new investors from numerous countries, computerized exchanges speed up transactions, and investors think up clever schemes to try to beat the market. Overall, we have not made progress in predicting the stock market, but this has not stopped the investment business from continuing the quest, and making $100 billion annually doing so.”

The evidence on the lack of economic and market forecasting ability led Graham and Sherden to draw their conclusions.

It’s also what led Jonathan Clements, writing at the time for the Wall Street Journal, to offer this advice: “What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the WSJ. And, as you read, laugh. We all know that the pundits can’t predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven’t got a clue.”

The problem with listening to forecasts is that not only is there no evidence of the ability to accurately forecast markets, listening to them can lead to the abandonment of well-thought-out plans.

One reason is confirmation bias. If you are concerned about an issue’s impact on the economy and the market, and a guru predicts that issue will lead to a bear market, you become much more likely to sell.

On the other hand, if another guru predicts that the same issue will be good for the market, you are likely to experience cognitive dissonance and ignore the advice. It’s hard for humans to ignore their biases. Yet successful investing requires us to do so. Remember, you are best served by following Buffett’s counsel: “Inactivity strikes us as intelligent behavior.”

4. Do Not Take More Risk Than You Have The Ability, Willingness Or Need To Take

Most battles are won in the preparation stage, not on the battlefield. If you take more risk than you have either the ability (in terms of job stability and investment horizon), willingness (ability to absorb the stomach acid and sleepless nights that bear markets can cause) and need to take, you increase the odds that the inevitable next bear market will cause you to lose your head while more disciplined investors are keeping theirs.

Losing your head leads to the stomach taking over decision-making. And I’ve yet to meet a stomach that makes good decisions. The result will likely be that your well-developed plan will end up in the trash heap of emotions.

5. Understand That Even Good Strategies Can Have Bad Outcomes

In his book, “Fooled by Randomness,” Nassim Nicholas Taleb noted: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

He also cautioned investors that “History teaches us that things that never happened before do happen.” The following is a great example of the wisdom of Taleb’s advice.

Over the 40-year period ending in 2008, both U.S. large-cap and small-cap growth stocks, as measured by the Fama-French research indices, underperformed long-term U.S. Treasury bonds. Does this mean investing in U.S. large-cap and small-cap growth stocks in 1969 instead of 20-year Treasuries was a bad strategy? Or is it that the risks of equity investing just happened to show up over that particular 40-year period?

I would hope that investors didn’t abandon the idea that these risky equity assets should be expected to outperform in the future just because they had experienced a long period of underperformance. From January 2009 through August 2018, the Fama-French U.S. Large Growth and Small Growth Research Indices produced total returns of 378% and 374%, respectively, while 20-year Treasuries produced a total return of 40%. The per annum returns were 17.6%, 17.5% and 3.5%, respectively.

6. Minimize The Frequency Of Checking Your Portfolio’s Value

Nobel Prize winner in economics Richard Thaler, author of the book “Misbehaving,” has found we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This tendency leads to the behavior known as “myopic loss aversion,” creating a problem for investors who check their portfolio values on a frequent basis.

Consider the following: Based on the historical evidence for the S&P 500 Index (1950–2014), investors who check their portfolios on a daily basis can expect to see losses 46% of the time and gains 54% of the time. However, while they see gains more frequently than losses, because we tend to feel the pain of loss with twice the intensity that we feel joy from an equal-sized gain, the more often we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will be -38 ([-46 x 2] + [54 x 1]).

Over the period 1927–2014, investors who resisted checking their portfolio daily, and instead moved to a monthly check, experienced losses only 38% of the time. That reduced the net pain reading from -38 to -14 ([-38 x 2] – [62 x 1]).

Over the same 1927–2014 period, losses occurred only 32% of the time on a quarterly basis. Thus, investors who reviewed their values quarterly (like many who participate in 401(k) plans and receive quarterly statements) experienced a shift from net pain to net joy of +4 ([-32 x 2] + [68 x 1]).

Investors whose patience and discipline allowed them to check values only on an annual calendar year basis experienced losses just 27% of the time. That results in a big improvement in the net reading, from +4 to +19 ([-27 x 2] + [73 x 1]).

As you would expect, the frequency of losses continues to diminish over time. Using overlapping periods from 1927 through 2014, the frequency of losses at a five-year horizon falls to just 14%. That results in a pain/joy reading of +58. At a 10-year horizon, the frequency of losses falls to just 5%. That creates a pain/joy reading of +85 and will make for a happy (and more disciplined) investor.

If you’re a masochist, the implication for you is that you should check the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are many.

First, the more frequently you check your portfolio, the less happy you are likely to be and the less able to enjoy your life. Second, all else equal, the less frequently you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid pain.

The bottom line is that if you cannot resist frequently checking your portfolio’s value, you should be more conservative because you will be feeling the pain of losses more frequently. Feel enough pain, and even the most well-thought-out investment plans can end up in the trash heap of emotions.

There’s another important message here. The less you watch and/or read the financial media and the less you pay attention to economic and market forecasts (since they can cause you to imagine pain), the more successful investor you are likely to be!

My long experience working with thousands of investors and hundreds of advisors has taught me that these six strategies are the keys to being a disciplined investor, greatly increasing the odds of achieving your goals. But I promised you seven.

The seventh comes from Meir Statman, finance professor at the University of Santa Clara: “Start keeping a diary. Write down every time you are convinced that the market is going to go up or down. After a few years, you will realize that your insights are worth nothing. Once you realize that, it becomes much easier to float on that ocean we call the market.”

Summary

Napoleon, perhaps history’s greatest general, observed: “Most battles are won or lost [in the preparation stage] long before the first shot is fired.” That advice applies to investing as well.

Now that you have the seven keys to being a patient, disciplined investor, you have the knowledge needed to prepare to win the inevitable war for control that occurs between your head and your stomach whenever bear markets occur or sound investment strategies deliver poor results. Forewarned is forearmed.

Larry Swedroe is the director of research for The BAM Alliance.

This commentary originally appeared November 16, 2018 on ETF.com.

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Past performance is no guarantee of future results. There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.