The idea that successful traders overcome or eliminate their emotions is completely off-base. If that were to truly happen, the trader would behave like a brain-damaged patient. – Brett Steenbarger
The point being that there is no form of trading or investing in which emotions do not play a role. One could argue that investors are in a constant state of stress. Even automated trading systems are in the end built by humans and maybe more importantly are monitored by humans. So the idea of emotionless investing is a pipe dream. That leaves for us the problem of how emotions affect, most often negatively, our investing.
Maybe we can get a better sense for how to invest by looking at those investors who have done a good job historically. Carl Richards writing at the Bucks Blog notes this intimate connection between emotions and decision making.
I think well-behaved investors are just better equipped than the average investor over the long haul. But they’ve also done something that the rest of us can do. They have acknowledged the connection between emotion and behavior.
The question for investors is how can they recognize and acknowledge their emotions while not letting them derail their already predetermined investment plans? This of course assumes you already have a written investment plan. If you don’t please write one out now! For the vast majority of investors a simple investment plan with as few moving parts as possible is the easiest path to follow.
Anna Prior at the WSJ had a piece up this week that talked about this very topic of simplicity in asset allocation. In the article she notes how a simple three-fund portfolio make up of US equities, US bonds and international equities provides investors with a sensible easily manageable portfolio. By focusing on a relatively small number of options it avoids the temptation to jump in and out of hot asset classes.
In one very real way a simple investing approach has taken hold in the fund world. The acknowledged rise of the target date mutual fund, especially as a default option for defined contribution plans, shows that investors are interested in a one-stop solution. In a very real sense target date funds can serve as a benchmark for investors who are looking to do it on their own. Target date funds certainly have their detractors but they provide individual investors in practice with a more workable solution than trying to do it themselves.
Some would like to go even farther. Felix Salmon at Reuters in a vintage post notes his interest in an “everything bagel” fund. One that on an indexed basis invests in every investable asset class around the world. In short, a one-stop default investment. For many this would be an attractive option, a true throw up your hands default investment. We must recognize that there are some real shortcoming to a too simple approach.
James Picerno at the Capital Spectator acknowledges that a three fund solution has a certain appeal but is skeptical that it somehow absolves investors of the difficult decisions in investing. He writes:
In other words, don’t kid yourself into thinking that if you hold just three funds you’ll have an easier time of designing and managing a rebalancing strategy. Market volatility will continue to present you with challenging choices that demand steely discipline to sell when everybody else is buying, and vice versa.
Rebalancing is a big reason why a one or three-fund solution may be too simple. Additional asset classes can provide investors with the opportunity to generate returns through a disciplined rebalancing process. In addition additional degrees of freedom also makes the tax-harvesting process potentially fruitful. With increasing complexity more decisions and the risk of decision fatigue rears its ugly head. So as with most things in life we need to balance the potential gains from portfolio complexity with its obvious downsides.
It’s funny that simplicity should need a defense. However most of the time the media is chasing ephemeral trends driving us to change our portfolios in ways that in the long (and often short run) end up hurting us more than helping. That is why when we see simple advice, clearly stated we should take note.
Jason Zweig writing at MoneyBeat says all of this better than I can so I will leave you with an excerpt from a piece he wrote that in an elegant summarizes his career in investment writing and in the end touches on this topic of portfolio simplicity. He writes:
From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.
But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.
My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.
Doing nothing is hard for us as investors. A simple, but not too simple portfolio, seems almost childish in this day and age. However a simple portfolio provides investors with the framework to ephemeral trends peddled by the media. In short it helps provide us some emotional distance between what we feel and what we actually do.
Items worth noting:
The role of somatic markers in trading. (TraderFeed)
Is too much stress killing your portfolio? (Enterprising Investor)
Lessons from well-behaved investors. (Bucks Blog)
Choosing simplicity as a default. (Abnormal Returns)
A portfolio that’s as simple as one, two, three. (WSJ)
Invest like a chicken. (Rick Ferri)
Are target-date funds aging well? (Morningstar)
Less is more with simple ETF portfolios. (IndexUniverse)
In search of an everything bagel. (Felix Salmon)
Pondering simplicity in asset allocation. (Capital Spectator)
Do you suffer from decision fatigue? (NYTimes)
The Intelligent Investor: saving investors from themselves. (MoneyBeat)