What is the Formula for Investment Success?

E+R=O: A Formula for Success.

That was the title of a recent article from Dimensional Fund Advisors ("DFA"). A formula for investment success? I'm sure everyone would love to have one. So, what exactly is this magic formula?

It's very simple. 'E' stands for 'Event', 'R' for 'Response', and 'O' for 'Outcome'. Event + Response = Outcome.

Far too often, our investment decisions have poor outcomes because we overreacted (response) to an event which only temporarily affected markets. We cannot control what events will occur, so at the end of the day, it is how investors maintain their discipline through bull and bear markets, political problems, conflicts, and economic instability that will determine their success.

DFA's article also triggered memories of a very good piece by Ben Carlson on how markets constantly tempt us to make mistakes.

Carlson shared a story about meeting a retiree who had meticulously constructed a laddered bond portfolio to fund his spending needs in his retirement years. The man took so much time and effort to do so to ensure that his portfolio could run on auto-pilot – which would be a perfect way to keep emotions out of his decision making. However, thanks to the continuing bond bull market, the value of his bonds had risen substantially and he was thinking of selling them to lock in a profit. He didn't know what to do, and wanted advice.

Most readers here may say that his possible outcome is a happy one. Who wouldn't want to sell their assets and make money out of it? But let's not forget that this man bought bonds specifically for their coupon and the cashflow they provided. Had he sold his bonds, he would then need to reinvest his money somewhere else. The fact that bond prices had gone up meant that yields were low, such that his future coupons would be much smaller and he would possibly have trouble trying to match the cashflows to his spending.

As such, every outcome, be it positive or negative, is the result of how you, as an investor, respond to an event – not how the actual event concluded. You read about long-term investing, are advised about staying invested in markets throughout all situations, and you agree.

Then you face an actual crisis: see the red ink on your investment statement and get bombarded by the television and newspapers of scary news that financial markets are collapsing.  You then respond in a disproportionate way by selling your investments at the worst possible time.  Which seems entirely plausible.

Does this sound like what you would do or have done?

Over your lifetime, you will face many decisions, prompted by events that are both within and outside your control. Without understanding the simple basics on how markets work or having a sound investment philosophy to guide your choices, you could potentially suffer unnecessary anxiety. Which leads to poor decisions and outcomes that will damage your long-term financial well-being.

When investors don’t get the investment results they desire (which occurs quite often), many of them blame things outside their control. They might point the finger at their banker, advisor, government, central banks, markets or the economy. It is unfortunate that the majority will not do the things that might be more beneficial – evaluating and reflecting on their own responses to events, and taking responsibility for their decisions.

In addition, a simple understanding of how their financial helpers are remunerated and what drives their behaviour,will help investors assess whether the advice they are receiving will set them up for long-term success.

At the end of the day, no matter how many formulas, theories or complex investment solutions are thrown at investors, none of it can guarantee long-term investment success if they do not heed the simple formula: e+r=o .