Investing 102

This is a continuation of a 2 part series on the principles of successful investors.  Here’s a quick recap of the first article.

1. Faith

The single most important characteristic of successful investors is faith. This includes faith in the markets, in the future, in our free enterprise system, in the ability of good companies to grow their profits, and in humanity.

Successful investors tend to have this confidence and optimism. They see how much humanity has progressed in recent history and tend to see their optimism as realism. They don’t know how things will turn out all right – they just know that they will turn out all right…

2. Patience

The most successful investor, Warren Buffett, often says: “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient.”

Successful investors tend to focus on having high quality investments and/or advice, and tend to stick with them long term. Part of their belief system is that they don’t know when it’s going to turn out all right – they just know that it’s going to turn out all right.

Struggling investors tend to change their strategy/investments/advice often based on their outlook. For this reason, we consider them to have “STD” – selection and timing disease – the delusion that anxiously searching for the best investment/sector/strategy and timing it right is the key to successful investing.

Studies, such as the Dalbar study, consistently show that the average investor makes only about 1/3 of the return of the investments they own. In other words, 60-67% of lifetime returns are lost by performance chasing, speculative euphoria at peaks, panic capitulation at market bottoms, market timing, buying investments because of recent returns and other similar investing mistakes. These mistakes result from “short term-ism” (short term viewpoint) and cost on average 600 basis points per year (6%/year).

Struggling investors, or as we call them: “investors with STD”, often focus on the cost of investments (fees and taxes), but don’t see the huge cost of their investment disease.

A great example of the problem with “short term-ism” was the markets early in 2009. Did that look like a screaming buying opportunity to you at the time? For patient investors, that was as obvious as King Kong smashing buildings in New York. In our opinion, it was definitely one of the most obvious buying opportunities of the last 70 years and likely the most obvious one during our lifetime. We did publish an article on MDJ in March about “Irrational Pessimism”.

Yet many people that somehow think they are able to time markets (obviously they can’t) missed the early 2009 screaming buying opportunity. By simply having faith, being patient and investing more whenever the market declines, you could not possibly have missed such an obvious buying opportunity.

This was the largest market decline in the last 70 years, which is why it was the best buying opportunity of the last 70 years. Period. If you just have faith and patience that the markets go up long term, you would have had no hesitation in buying more while it is low.

In contrast, investors with STD focus on short term, random market movements, news, chart formations and market timing. They were trying to predict where the market would move next (which is never obvious), so they probably missed the best buying opportunity of our lifetime.

When you compare any 2 investment strategies, you will find that nearly always, the one that results in fewer transactions is the superior strategy. We have been surprised at how often we have noticed this effect over the years.

Fewer transactions are more effective.

This is why, for example, studies consistently show that women are significantly better investors than men.

If studies are ever done, we believe they will show that investors in broad market indexes generally do well, but investors in ETFs will do poorly over time. The ETFs themselves will do fine, but because they are made for market timing and have an average hold of only 12 days, the investors in ETFs will do poorly, in our opinion.

A rather humorous example of this phenomenon happens in families where one person (usually the guy) handles all the investments for both spouses. The portfolio of the spouse (usually the wife) tends to have a higher return than the investing spouse’s portfolio. This happens because he tends to trade more actively with his own portfolio. This tendency applies to investment advisors as well, where their spouse’s account usually has a higher return than their own.

Just like amateur golf, successful investing is more about avoiding mistakes than about making that great shot. As one advisor put it, “My wife and I have almost always had the same investments, except that I’ve done more stupid things in my account.”

The key point is that successful investors are patient with their investments, choose them well and have a long term view.

3. Discipline

Discipline is the decision to keep doing the right things. It is the decision not to do something wrong.

Struggling, STD investors tend to ask: “What’s working now?”, while successful investors care about what’s always worked over time.

Discipline is part of why it is so important to have a long term financial plan and why we don’t take on clients without a financial plan. Successful investors are goal oriented, and therefore planning driven. Struggling, STD investors are market-oriented, and therefore performance driven.

When you know your “number” – the nest egg you will need to have the retirement you want – you tend to be focused on long term financial freedom. This makes you far less likely to be thrown off course by a bear market or market bubble, or the myriad of financial events that happen in the world or in your life. Fundamentally changing the portfolio when your goals have not changed is virtually always wrong, and will depress returns.

If struggling, STD investors have an advisor, they tend to think their advisor’s main job is advice on the selection and timing of investments. Successful investors, however, usually realize that the #1 job of their advisor is not investment A vs. investment B, but to modify the natural tendency of the investor to behave inappropriately.

Behavioural Finance books list many irrational behaviours that result from the logical shortcomings of the human mind. Successful investing requires the discipline to prevent these mistakes.

In short, the behaviour and the belief system of the investor are the key factors in superior lifetime investment returns. Struggling investors are usually afflicted with “Selection and timing disease” (STD), while successful investors tend to have faith, patience and discipline.

* This article is based on our personal observations over the years and the writings of Nick Murray, a retired advisor that I consider to be a mentor. Much of our investment philosophy is based on his principles.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

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