How to be a Better Investor
The most important quality for an investors is temperament,
not intellect— Warren Buffett
According to the UN population division, there were an estimated 55.22 million deaths globally in 2014. However, one death that occurred in 2014 made international headlines. The person’s name was Ronald Read.
The Wikipedia entry that describes him starts with “philanthropist” and “investor”, and it ends with janitor and gas station attendant. Ronald Read worked as a gas station attendant for over 20 years and later swept floors at a department store. That was why when he died at age 92 with assets over US$8M, those who knew him were shocked. He never showed outlandish displays of wealth, nor did he ever speak about money. What really made the headlines were his donations of $4.8M to his favourite local hospital and $1.2M to his local library — the largest donations that either institution had ever received in history.
He did not receive a large inheritance nor did he win the first prize in the Powerball lottery, so how did he amass such a large sum of money? It turned out that he was simply a patient and systematic investor. He did not spend above his means and whatever he had left every month, he put it into the stock market. Then, after compounding for years on end, those savings grew into a multi-million dollar sum.
Philip Falcone was on the opposite end of the spectrum from Ronald Read. The Harvard-educated former professional hockey player became a vaunted hedge fund star in 2008 when his bets against the sub-prime mortgage market rocketed his fund — Harbinger Capital — to over US$36B in assets. His office in New York’s park avenue where rents averaged around US$100psf, had a treadmill and a Damien Hirst spin painting in the bathroom. He owned a treasure trove of art including Andy Warhol paintings, collected diamond, ruby and emerald jewelry, and owned two multi-million dollar properties — one was a 27-room mansion near Central Park. With his investment intellect, wealth and connections he had made, it appeared that he was destined for greatness.
In 2020 however, he declared bankruptcy after being sued by investors and creditors which included his renovation contractor and limo companies. In his greed to try to make more money in a short-span of time, he over-borrowed and bet on the wrong stocks (including private and illiquid ones) which collapsed and wiped out his hedge fund and personal wealth. It didn’t help that he lived a lavish lifestyle as well and even squandered a $2B fortune.
The contrast between these two stories could not be more stark. Ronald Read was patient and humble, whilst Phil Falcone was greedy and outlandish. However, this is a lesson more about behaviour rather than personality. All it took to bridge the massive difference in education and investment experience were a few mistakes caused by behavioural psychology.
You need to be well qualified to work in the medical industry — whether directly administering to the patient or in a background supporting role doing research and testing. And over the years, the collective wisdom and innovation in medicine has contributed to rising life expectancies around the world and better treatment regimes for the sick. Heck, a COVID-19 vaccine was developed within the first year of the pandemic, compared to the average 10 to 15 years timeframe.
In the same vein, technological advances have enabled us to construct better, taller, more robust buildings in a shorter amount of time compared to neolithic construction where homes were built out of timber, bones and clay.
A veritable who’s who of PhD’s are in the financial industry, with many of the best and brightest going on to work in the varied areas of the industry including investment management. But despite all the brainpower and discoveries, there is no evidence that it has collectively made us better investors neither has it allowed us to manage our money better. People are still as likely as to chase after the hottest performing investments (and collapse together with the bubble) in 2022 as in the 1600s; as the recent cryptocurrency implosion has shown. Barely 14 years after the collapse of the housing bubble which caused the 2008 GFC, people have over-leveraged themselves on property again. And for some reason, people still can’t prepare adequately for retirement despite it being a hot topic for decades.
The world of investing and personal finance is fascinating and mind-boggling. There is no other industry in the world where an inexperienced person is able to get a leg up on the best and brightest. You would not expect Ronald Read to be able to design load bearing structures better than a civil engineer or perform brain surgery better than the best surgeons around. Whilst technically possible, he would even be hard-pressed to be more proficient than a trained plumber who fixes leaky pipes every day. But it is possible to invest better than many other smarter, more well educated people out there. How is this possible? You could say that it was all down to luck. But the better explanation is really, financial success boils down to how you act both in good times and bad.
There is solid evidence on what drives investment returns, how to reduce risk, and building robust investment portfolios for the long run. However many investors just can’t seem to follow it. In fact even when presented and agreeing with the hard evidence, many stumble. A huge part is due to what happens in our brains. As such when it comes to money, our psyche and how we react emotionally to various events plays an extremely important differentiator to investment failure or success.
Source: Misbehaving: The Making of Behavioral Economics, Richard Thaler, W. W. Norton & Company; Reprint edition (June 14, 2016)
The discoveries on how we frame events and outcomes dealing with losses and gains are something that we need to understand and internalise in order to become better investors. For instance, the value function shown above underpins the Prospect Theory, which is one of many behavioural quirks that were studied and developed by Nobel Laureate Daniel Kahneman and other behavioural scientists.
You should be equally happy (or sad) when you receive (or lose) $100. Humans, unfortunately do not act rationally and this is why so many fail at investing.
When faced with a risky choice leading to gains, we are risk averse (hate risk).
When faced with a risky choice leading to losses, we become risk seeking (love to take risks).
Here is a simple example which explains the chart above. You have a good friend who tells you that you can choose between;
Getting a 100% guaranteed $900 from her or;
Take a chance of 90% getting $1,000 or a 10% chance of getting $0.
It is very likely you would take $900 — after all it is a sure-fire bet. Why would you want to risk possibly getting $0 with the second option?
From a mathematical perspective, both options have the same expected outcome. So why didn’t we want to choose the second option?
Now that same great friend comes back and says that you now have to choose between;
A sure-fire 100% loss of -$900 or;
Take a chance of 90% losing -$1,000 or a 10% chance of losing nothing $0.
What do you choose? A chance of losing nothing at all? Well sign us up for it as well. Why would we want to guarantee a $900 loss on the outset?
Again mathematically both decision branches have the same outcome — but we are more likely to choose the option that could give us a chance of losing nothing at all.
We love gains and making money, but we really hate losing it more. This is why we can’t sit still when markets are turbulent. When everything is crashing down around us, investors are more likely to panic and sell or adjust their portfolio at the most inopportune time. When markets are at depressed prices, we are very likely to sit on the sidelines as the fears of higher losses swirl around in our heads. The thought of the emotional pain and regret that you and your family have to go through from your failed investments is what drives your decisions. There is no rationality or logic to it.
When prices are going up it feels like the sure-fire winning bet like the first example. Everyone seems to be making money, you want to get in on the action as well. Imagine all the great things you can do with your newfound wealth! Then you tend to chase up prices even further.
How do you circumvent all the mental roadblocks you could face?
Have a plan. This cannot be emphasised enough. Getting a fiduciary advisor to create an investment plan which fits exactly what you need to invest and save up for will ensure that you understand what your long-term outcomes are and that you do not get distracted or waylaid by the numerous potholes along the way.
Having a behavioural coach. Vanguard’s study showed that having an advisor to walk together with you in your financial journey is very beneficial. However the area that had the most impact in terms of long-term returns was behavioural coaching - which made up half or more of the gains.
A study of history. For investors who are more inclined, a study of past market returns and drawdowns provides perspective on what to expect when markets react in a certain way. Knowing the long-term or maximum returns you could receive ensures that you don’t get mistakenly invest in strange assets. In addition, knowing how big market corrections can be, and how long they last gives you a good idea of how long you should be staying put - instead of panicking. This is also useful in estimating the amount of safe reserves you should put aside, so that you don’t need to touch your investments when their value is temporarily impaired.
Being a better investor boils down to controlling your emotions which overpowers your logic. Apart from our points here, you may also have some good ways on how to deal with it yourself. However, if you still need some help on how to become a better investor, come and speak with us.
