5 Minute Read
22 March 2021
By David Naylor
Investing involves committing your attention, energy or money in the hopes of achieving a positive future return. Making the decisions to invest a portion of your life savings can be an unnerving process. The degree to which this process is distressing is dependent on many factors such as your appetite for risk and your hopes or anxieties about the future. The uneasiness that comes with subjecting your finances to the volatility of the stock market can be alleviated by developing a more systematic and less intuition-based investment plan.
Successful investors understand that they will never achieve their financial goals by trading their time for money. Time is our most finite, non-renewable resource in life, therefore, effective investment strategies earn positive returns irrespective of the time allocated to them. Aikido develops tailored investment portfolios that help you to achieve your financial goals. Our commitment to a quantitatively backed approach to investing allows you to focus on what truly matters, without having to allocate all your time and energy to beat the market.
The development of a long-term investing methodology is crucial in enduring periods of market volatility. Commitment to a rules-based or systematic strategy empowers you and reduces your propensity to make qualitative decisions which are based on subjective experiences or emotions. Therefore a sound approach follows a systematic strategy.
Qualitative decisions are influenced by two dominant emotions, greed and fear. Greedy bullish investors are blind to risk and become overwhelmed by the desire for profits in the midst of rising markets. On the flip side, fearful bears act hesitantly and are more cautious in their approach. These two powerful sentiments encapsulate the motivation driving the decisions made by highly emotional investors. Greed describes an investor’s urge to profit in a rising market and causes investors to overextend themselves, making trades with no regard for the risks associated. Greed fueled decisions are executed with a sole focus on the upside and give little thought to the possibility of loss. Many studies have linked greed fueled investments to the investors’ higher levels of testosterone. This study found that investors with higher testosterone levels report increased confidence in their investment decisions. Furthermore they experience even greater t levels in response to victories. It induces the so-called ‘winner effect’, which is a positive feedback loop that promotes further risk taking amongst investors. While this might be preferential in a bull-market, it leads to less risk averse investing in downturns, and therefore greater losses.
Fear, on the other hand, is the impulse pushing investor’s who are motivated by avoidance of loss and protection of their portfolio from market downturns. Fearful investing is typically modulated by elevated cortisol, which has been associated with increased risk aversion amongst investors. Cortisol is the hormone secreted when we are anxious, making us less attentive and less mindful. Whilst the fearful investors may not suffer from losses as significant as the greedy bulls, their apprehensive trading coupled with their lack of conviction inevitably leads to underperformance. Investments made with greed or fear as their driving force rarely lead to long term results. The greedy investors eventually succumb to hefty losses as a result of their ignorance of risk. Both types of investor generally buy when the price of a stock begins to rise and panic sell when the stock begins to lose momentum. This results in losses overtime, or at best, a failure to beat the market.
Investors who put their faith in gut feeling and instinct often succumb to emotional investing, characterized by “buying high and selling low,” a straightforward way to lose money. This method of investing is rarely successful as it relies on emotionally-based judgement, which is subject to change every hour. Thinking competitively and applying a game theory based approach. The saying, “Winners anticipate, losers react” (Tony Robbins) is particularly relevant when it comes to investing. Figure 1 demonstrates how emotionally driven investing is rarely successful in the long run.
An emotional approach to investing is grounded on a desire to have control over our investments. However, this desire is counterproductive for the majority of investors and leads many to check their portfolio with worrying frequency. As investors we believe that the more we look at our portfolio, the better chance we have to react to market events. Foolishly, we think that the more familiar we are with the markets, the better equipped we are to beat the market. When investing we should keep the wise maxim of Richard Feynman in mind – “You must not fool yourself and you are the easiest person to fool”.
As the graph above depicts, the emotional approach to investing is far from optimal. In addition to reduced returns, the time needed to follow this strategy far exceeds that needed to follow any quantitative approach. Several studies have exposed the shortcomings from such strategies, in terms of returns and even the investors quality of life. One such study, conducted by renowned economist Richard Thaler coined the term ‘Myopic Loss Aversion’, describing the tendency of investors to evaluate their portfolios too frequently. Thaler’s study showed that investors who committed to a detached approach, moving to a monthly check of their portfolio experienced losses only 38% of the time whilst investors who checked their portfolios on a daily basis were expected to see losses 46% of the time. [ Shiomo Benartzi and Richard H. Thaler (May 1993) ]. In addition to their increased losses, these investors are more likely to suffer from the emotional distress that comes with seeing market volatility. The study describes a pain/joy meter, which is an indication of the distress caused by losses when compared with the joys of seeing positive returns. The paper finds that the average investor tends to feel the pain of a loss with twice the intensity that joy is felt from an equal-sized gain. Therefore, the more often investors check the value of their portfolios, the more net pain is felt and the lower their quality of life.
Loss aversion is the phenomenon whereby investor’s unconsciously perceive losses as twice as powerful, psychologically, as gains. This accounts for investors’ constant desire to limit losses, driving regular checking of portfolios. Whilst these emotional decisions help us in the short run, emotional decision making does not lead to long term results. A portfolio-diminishing spiral of investing can be onset through seeing losses, driving further emotional decision making, leading to further losses. To achieve long term results, a long-term approach is needed, as Warren Buffet observed, “Outstanding long-term results are produced by avoiding dumb decisions, rather than making brilliant ones”.
When it comes to investing, poor decision making is synonymous with reacting to emotion, which is very difficult for any investor who is consistently examining their portfolio’s performance. Studies emphasize the need for a detachment from one’s portfolio, which is achievable when one is committed to a reliable-quantitative strategy.
To become an effective investor, one whose portfolio earns while he/she sleeps, the investor must learn how to detach from their investments. Detaching means becoming less emotionally connected to your investment portfolio. Understandably, becoming disengaged with your life savings is not a simple process. However, for the majority of us, we are limited by time and the best investments are those that yield a positive ROI with as little involvement as possible.
One method to becoming a more detached, less emotional investor is becoming a more mindful investor. Mindfulness in isolation, is focusing one’s awareness on the present moment and calmly acknowledging one’s feelings, thoughts and emotions. Combining these principles with investing leads to the essential ingredients for long term results – both detachment and less emotional investing. Investing mindfully is not following the crowd and reacting to the market. Very often, the mindful investor acts in spite of market trends. It is with a mindful approach that you will be able to “Be greedy when others are fearful and fearful when others are greedy” (Warren Buffet). This process of observing your emotions, rather than allowing them to be the driving force for your investments is an effective technique that maximises both gains and quality of life. Mindful investing has empowered many successful investors including Ray Dalio, founder of Bridgewater Associates, the largest hedge fund in the world with over $160 billion in assets under management. Dalio attributed any significant success he has achieved in his career to his daily meditation practise, where he developed the ‘ability to go above himself and look down at oneself with a clarity and an objectivity’. The centeredness and objectivity that meditation granted Dalio is evidence that a detached approach trumps an emotional approach in the world of investing. Dalio describes the feeling of being like a ninja in a street fight after regular practise, enabling him to manage a successful hedge fund while maintaining a high quality of life.
The attainment of your investment goals are best achieved through the development of a mindful approach. Mindfulness allows the practitioner to observe the nature of their emotional state. After practicing, you should notice that emotions have a fleeting half life and are inherently short lived. Understanding the nature of these sensations allow you to cope with changes in both your portfolio, and the market. The emotional toll of gains or losses are short-lived. With your sensitivity in the passenger seat, you will be less inclined to react to volatility and will be enabled to make effective investing decisions, which are quantitatively backed. Whilst it is human nature to want to have total control over our finances, the most significant gains are often made when we relinquish our attachment to our investments, putting faith in the numbers rather than emotions. At Aikido, we are committed to an emotionless, quantifiable approach to investing. Our systematic investing strategies are not subject to the fallibility of human nature, they separate the wheat from the chaff allowing you to detach from your investments with the confidence that your savings are appreciating while you sleep.