Daniel Kahneman on why people make irrational decisions: “Because the long term is not where life is lived.”
— Ben Carlson (@awealthofcs) October 13, 2014
The past couple of weeks of market volatility help underline the challenges investors have focusing on the long term. This is in part due to the fact that the long term is made up of a series of ‘short terms.’ As Daniel Kahneman says above the long term is not where life is lived.
In a great post Morgan Housel at Motley Fool looks at research into the ‘history illusion.’ The idea being that we think things will change very little over time despite knowledge of past changes. There is a big gap between what our youngest selves think our goals will be versus what our actual goals turn out to be. In this light planning for the future seems like an impossible task. He writes:
I don’t know what the answer to this problem is. None of psychology literature I read on this topic offered a solution. Maybe it’s balance, and avoiding extreme goals in either direction. Maybe it’s flexibility, and the ability to quickly change your goals when you realize you’ve changed as a person. But I think the first step is realizing and accepting that whatever your goals are today, you’ll wish for something different in the future.
Knowing that we really don’t know how the future, or our reaction to it, will play out what are investors to do? One approach is to avoid doing stupid stuff. Shane Parrish at Farnam Street is fond of this Charlie Munger quote where he talks about avoiding ‘consistent stupidity.’ Munger writes:
Wesco continues to try more to profit from always remembering the obvious than from grasping the esoteric. … It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying, ‘It’s the strong swimmers who drown.’
That why it is important to make some fundamental decisions about your investment process and automate them to the greatest extent possible. If you have to constantly rethink every decision it give you more opportunities to do ‘stupid stuff.’ Carl Richards at the Bucks Blog writes about how market volatility works to knock us off track:
With all of this noise comes hundreds of opportunities to rethink the good financial decisions we’ve already made. It’s so tempting to latch on to these predictions and believe they mean something. But unless something fundamental has changed in our lives, these so-called opportunities actually represent a huge cognitive drain and present a danger to our financial health.
One way we can combat an uncertain future is to save (and invest) more. It sounds horribly cliched but building a personal ‘margin of safety‘ is important. Bill Sharpe in a recent AAII interview with Charles Rotblut gave the following answer when asked about advice for investors:
Save more. Just save more; if you’re still working, you probably need to save more because you almost certainly aren’t saving enough. If you do the calculations based on having X when you get to retirement, you can begin to understand what X can do for you given all the uncertainties that come with later life. I’ll bet most investors would say, “I wish I had saved more, even though I had to give something up.” I just suspect that’s the case. So my guess is that you can pretty well predict somebody will wish they’d saved more.
That saving has to go somewhere. Absent Warren Buffett-like investing skills it is probably best to focus on those simple things you can control. Patrick O’Shaughnessy author of Millennial Money: How Young Investors Can Build a Fortune wrote:
Investing success is incredibly simple: spend less than you earn, make consistent investments in the global market, and wait. If you do these three things, you cannot help but get rich as compounding works for you over time. But simple doesn’t mean easy. That last step (“wait”) is incredibly hard to do in practice. We always want to do something with our portfolios, and usually at exactly the wrong time. As Nick Murray says, “You can’t, as we’ve seen, build and hold wealth without equities. But the converse is even more importantly true: equities can’t do it without you.” Controlling your behavior matters more than anything.
O’Shaughnessy is right that none of this is easy. We are by and large fragile creatures who are easily knocked off track by what life and the markets throw at us. That is why putting in place some rules to combat our worst tendencies is important. Robert Seawright at ThinkAdvisor wrote about how we can combat the planning fallacy, that is our inability to accurately predict how things will turn out. Seawright notes three ways we can do this:
- Be humble.
- Avoid errors. Errors cost more than good decisions help.
- Plan for the worst even as we hope for the best.
Formulating for ourselves simple rules we can follow over the short run will hopefully help us get to our (ever changing) long term goals. There are of course no guarantees. No one knows what the future brings, especially stock market pundits. All you can do is focus on building up some personal margin of safety over time. As Seawright notes:
Things rarely turn out the way we expect. We never have everything covered. Life happens. Act accordingly. You have been warned.