Taming Emotional Volatility - Investment Wisdom from an Investment Fool
Equity markets are volatile these days. The Dow Jones in January 2016 just had the most 1% swings in a single month since 2008.
It’s debatable if we are at the doorstep of the next crisis or not. In any case, I am fairly optimistic that this time, at least I am better prepared and would not repeat the same mistakes I did in 2008.
Traditionally I have a love-hate relationship with equity investing; I am drawn to it since my late teenage years (the film Wall Street may have played a role – damn you, Charlie Sheen) and at times was convinced I was pretty good at it. At other times, my investment activities put me through emotional roller coasters and seemed to bring the worst out in me.
I guess, in many ways, I was a typical example of an average, young, male equity investor, falling for pretty much every investment fallacy, guilty of any cognitive bias possible. (A good summary of the most common cognitive biases you can find on this Business Insider info graphic.)
Why do I emphasize young and male? My self-observation is that male overconfidence is not only causing car accidents and bar fights, it is also often a factor inhibiting investment success. Data from Openfolio, a social app to share your own investment holdings, seem to support this observation. Their recently published aggregated user data for 2015 showed that while the average user of the fairly U.S.-heavy site lost 3.09% in 2015. The losses stood in inverse proportion to the age of the investor. Investors aged below 25 lost an average 3.8%, compared to 35-49-year-olds losing only -2.74%.
Just like in 2014, female users beat the performance of male users. In 2015 females averaged -2.54%, while men lost an average 3.78%.
I started investing in stocks and warrants in the late ‘90s, when I was still a high school student in Germany. After winning two stock simulation games with my friends, we were overflowing with confidence and it worked; our paper success transferred to the real investing world. We were up, so we did everything right (typical case of outcome bias, basing judgments purely on results, not on risks taken along the way).
I continued my stock market activities with mixed success till towards the end of my university studies when I needed the funds for my exchange semester and funding my small start-up.
After my personal finances improved by taking a management position in Hong Kong, I started to invest again in autumn 2008 just in time for the financial crisis. Luckily my initial investments were small, so the losses were manageable. However, they affected me beyond the material impact. I remember exactly how I felt in winter 2008: being excited to witness history in the eye of an (for me) unprecedented economic Tsunami, feeling the incredible opportunities, and at the same time being utterly disgusted seeing my own holdings nosedive.
In the end, this emotion drove me into the typical pattern; I bought too early, then chickened out when the markets continued to fall. When I invested again, I was too selective and went into the wrong vehicles (mixed commodity ETFs) and at the end missed the largest part of the following rally.
Instead of detaching myself emotionally from the fluctuating markets, I let my feelings not only hijack my original plan of buying some solid, beaten-up blue chips and Macau casinos in a long-shot, I let it also affect my general mood and life quality.
But this is hopefully past. As mentioned in the introduction paragraph of this post, I believe that I turned a corner and matured significantly as an investor over the past two years. For the first time, I feel that swings of my Portfolio do not affect my overall, and I am actually applying investment wisdom instead of just reading it.
As so often is the case, the hardest step to improvement was actually the very first: accepting my own limits. Admitting to myself (and now to you), that I am not a born great investor, that some of my biggest investment successes might be simply attributed to luck and that I was a typical example of emotion-driven investment behavior, was hard. Yes, I was an investment fool.
Resources that helped me to rethink my investment strategy were, among others, a brilliant portfolio management course at Cornell based on the investment principles of Yale’s David F. Swensen (part of my MBA exchange semester), Tony Robbin’s book Money - Master the Game (a good foundation, even though at times terribly repetitive and painfully smug), and the always brilliant investment memos of Howard Marks.
If you want a very condensed version of the most important investment rules, take a look at the Morgan Housel’s One-Sentence Financial Rules on The Motley Fool.
My three favorites among the one-liners?
Rule 1 - Dollar-cost average for your entire life and you'll beat almost everyone who doesn't.
Rule 3 - You're twice as biased as you think you are (four times if you disagree with that statement).
Rule 13 - When in doubt, choose the investment with the lowest fee.
Changes that I introduced in the past two years, applying the above rules:
- Optimizing my accounts for tax and transaction costs: moving investments from Germany to Hong Kong and using low-cost broker Interactive Brokers for U.S. transactions (IB is really good).
- Replacing the majority of investments in single stocks by automated dollar cost averaging in index certificates, basically giving up stock-picking.
- Increasing diversification by setting targets for asset allocation across regions and introducing bond investments.
- Looking intentionally for contrary investment ideas with longer time horizon, accepting to sit out downward movements of significant proportion.
With all that applied wisdom, did I do much better in 2015 than the investors who used Openfolio? Not really - my result for 2015 was a negative 3.09%. However, given that I have significant exposure to Hong Kong (where I live) and the Hang Seng Index losing 6.88% over the course of the year, the result was not too bad. More important, the emotional costs of investing were definitely much lower than in previous years. While markets remain as volatile as ever, I at least seem to have tamed my “emotional volatility”.
There is definitely still a lot I have to learn. In 2016 I plan to introduce a bit more mathematical analysis of diversification and introduce quarterly rebalancing. I also want to take a closer look at REITS and other investment vehicles I so far avoided.
How about you? Are you a born investment guru or did you go through a similar development as me? Do you have any investment wisdom to share? How do you isolate your mood from the market volatility?