The Money Paradox

Barron’s

It’s easier to talk contrarian than to be contrarian.

 Studies of investor behavior tell us some surprising things about the decisions they make. Two results are particularly striking. First, 85% of sell or exchange decisions are wrong — the investor would do better by doing nothing or going the other way that 85% of the time. Simple random decision making (with no investment knowledge) would have yielded about 50% good decisions.

The second result follows from the first one: In the 20 years ended 2008, a period that included the best decade of performance ever for stocks, the average stock-fund investor averaged only a 1.9% annual return (due to consistently poor buy and sell decisions) even though the average stock mutual fund returned 8.4% annually over the same period. With compounding, the difference was about ninefold (402% vs. 46%) over 20 years. This is a compelling demonstration of the illusion of control, the mistaken belief that better results come from more-direct, detailed control and using it to make lots of decisions and transactions.

Wishful thinking and mass conformity reduce investors’ stress—and the performance of their portfolios.

Investors are not particularly stupid or ignorant people, but they did make millions of stupid investment decisions with horrible consequences. How to explain such remarkable effects? More generally, why is successful long-term investing so difficult?

The legendary Ben Graham observed that individuals’ gains were not primarily influenced by intelligence or special knowledge, but by temperament.

The economist and investor John Maynard Keynes emphasized that individual investment profits are largely determined by how investors behave at market tops and bottoms — which is where price volatility concentrates, where sudden spikes occur, where the big investment mistakes are made.

The huge losses from buying into popular asset manias near the top at high prices (with no safety margin in case of a decline) and the lost opportunities from selling temporarily unpopular but cheap assets at or near a bottom devastate long-term results because of the powerful effect of compounding, which multiplies the effect of large errors.

Moreover, investors who suffer these losses are generally hurt psychologically and are often too gun-shy for months or years after to pursue even sensible rewarding risk-taking opportunities And such losses typically demoralize the savings discipline of most losing investors, making it harder still to fully take advantage of future easier opportunities.

The combined effects — the compounding, the lost opportunities and the decline of savings discipline — multiply the effect of the initial investment mistakes.

AFTER THE STOCK MARKET SUFFERS a major decline of several trillion dollars and recovers perhaps all or most of it over several years, typically those who gain the trillions in the recovery are not the same as those who lost it in the decline. This is why most successful investors tend to be defensive (strong price discipline), habitually cluster around the middle of the risk spectrum while mostly avoiding its extremes, and follow the adage « Keep your mistakes small. »

Easy to say, hard to do: Long experience shows that people tend to make fairly rational decisions in small matters and pretty poor ones (unless they get specialized help) where much is at stake. The much larger incentive for a good result should elicit better, more rational decision making — but it doesn’t.

Psychological stress explains this paradox. Stress is always present when a great deal is at stake. It impairs cognitive skills and warps decision making. Under pressure our instincts expressed through our emotions distort our reasoning and tend to push us toward the wishful thinking and mass conformity that temporarily reduce our anxiety but not our losses.

Surprise! Investing money is like sex: « Passions makes fools of the cleverest men and can sometimes make a fool seem clever. » Investors should remember this old French aphorism in times of market stress and volatility.

Rational analysis of the business and economic fundamentals of investing is well within the understanding of very many investors, including many of those who have failed or will fail. But experience shows that the psychological issues of investing, especially under great stress when markets are so volatile at tops and bottoms, are dauntingly formidable and are almost always under-estimated or even ignored. The ignored risk is always the most deadly as it comes from the blind side, unopposed and unmitigated.

Disciplined independent analysis done under intense market pressure will inevitably be contrarian. But the usual pernicious effect of the mass media is to magnify the intensity of the destructive conformist pressure and to make effective contrarianism very difficult.

Try it — if you dare. It is easy enough to be contrarian in trivial matters but very difficult to be so in important ones when under great stress. But contrarianism is most powerful just at the moment of its greatest difficulty. This fact keeps it rare and valuable as its advantage is difficult to copy or arbitrage away.

An essential principle underlying all strategy is how best to protect the rational decision-making process, when so much is at stake, from the damaging effects of the inevitable stress. As Kipling urged, it is most important « To keep your head when others are losing theirs. »

A disciplined stoicism, or some approximation of it, is the most effective psychological posture for an investor — to care but not too much. He needs to care enough to be competently diligent but not care so much that he sabotages himself with tortured sophistry that merely rationalizes his worst wishful or fearful thinking.

MARTIN CONRAD is a longtime investor and chief investment strategist for C.I.G., a private investment group.

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