THE STAR VS. THE SECRETARY
John Meriwether may not be a household name but he was at the center of one of the biggest financial market events in history. After making huge profits for Salomon Brothers, John started his own hedge fund. His firm utilized sophisticated models and employed a dream team of traders, PhDs, and Nobel prize winners. They felt so strongly that they not only invested their client’s assets but borrowed against that to bet even more money than they had. However, just a few years into their existence, a crisis hit. Russia’s decision to devalue its currency sent shockwaves through the markets and triggered a global sell-off. The value of their investments plummeted. They were on the brink of insolvency when the Federal Reserve Bank stepped in to prevent a total collapse. In less than a year, the firm lost roughly 94% of its capital.
By contrast, Sylvia Bloom led a less eventful life. For decades, she took the subway from her Brooklyn residence to her job as a secretary for a New York City law firm. Upon her passing in 2016 and to the shock of all who knew her, Sylvia left charitable gifts totaling over $8 million to fund education scholarships. It turns out that during all of those years at the law firm, Sylvia lived frugally, saved her money, and consistently invested those savings in stocks. What she lacked in experience she made up for in discipline. Routinely saving and investing her money regardless of the ups and downs of the markets built long term wealth.
So how is it that someone with no professional investing experience can prosper and some of the sharpest minds in the business can fail miserably? The answer lies in human nature. Successful investing takes more than studying the economy or knowing how to analyze financial statements. It takes the ability to control some natural behaviors that we are all prone to.
Below are some common traps that work against a successful investing effort. Identifying and managing our tendency to fall into these traps can be the difference between happily achieving your goals and struggling to grow your savings.
Would you accept a bet on a flip of a coin that would pay you $100 if you won but cost you $100 if you lost? Most people reject this offer. Researchers1 found that individuals typically require a gain twice as large as their potential loss given a 50/50 chance. This is since we feel the pain of losses more than the joy of gains. It may be the most damaging emotion to your investment plan. Many individuals cash out of their stocks during market sell-offs only to return when it feels safe and prices have recovered. It is a natural feeling but one with devastating effects. In 2019, JP Morgan issued a report that showed that from 1998 through 2017, the average investor earned an annualized return of just 2.6% while the S&P 500 earned 7.2% and investment-grade bonds earned 5.0%. The chart2 on the left shows the tendency of investors to take money out of stock investments while experiencing losses only to reinvest after positive returns have become evident again. While this stops the immediate pain, investors consistently earn a lower rate of return as they lock in their losses and miss out on gains.
Advisors can project the expected growth of a portfolio using historical average returns. But in reality, investors don’t experience the average return steadily over time. They earn big gains in some years and significant losses in others. The moves lower are painful and push people to abandon their plan. We prefer to run multiple projections that simulate the actual behavior of markets. During moments of stress, we suggest not only looking at returns for the current period but also at whether that lies within a normal range. Simply knowing that you have lost 20% of your savings hurts and increases the chances of a bad decision. Seeing that the current period is within expectations and that you are still on track to achieve your goals has a different feel. One that makes it easier for you to stay the course and reap the long term benefits.
In 2018, the American Auto Association released results of their survey showing 73% of people consider themselves to be an above-average driver. We know that mathematically they cannot all be right. Yet similar results are seen when individuals are asked about their intelligence or job performance. This stems from an internal bias to overestimate our own abilities. Investing is inherently risky and requires caution and discipline. Overconfidence can lead to excessive risk-taking and a financial loss beyond what an individual can afford.
Successful investing requires more than financial knowledge and analytic skills. The ability to apply those with discipline and prevent emotions from driving bad decisions is just as important if not more. If you feel the desire to bet the farm or run to the hills, take a breather. Neither one is a good strategy over time. Stick with what has been proven to work: saving, investing, and compounding returns. Rinse and repeat. Adopting a plan that recognizes our tendencies and employs tools to manage them is key to protecting and growing your net worth.
1) Source: Daniel Kahneman, Amos Tversky
2) Source: MFS white paper authored by Michael Roberge, CFA
3) Chart Data: Kwanti Analytics