The human side of investing is easily overlooked because nobody goes in believing they’ll act like a basket case at any point in the process. Instead, the focus is finding on the right strategy or allocation or fund or stock. And it makes sense…then something wild happens because it always does.
In the latest edition of The Most Important Thing, Howard Marks points to four central themes in the book. The riskiest things were one but mastering behavior was the critical theme:
The ‘human side of investing’ is the critical side. It’s certainly an area in which superior investors must excel, since financial analysis won’t guarantee superior performance if your reactions to developments are skewed by psychology just like those of others.
In other words, the best strategy is made worse in the hands of a basket case. Successful investing involves managing yourself and your money. To that end, Marks made six comments on the importance of controlling emotion and ego.
My third key theme relates to control over emotion and ego. Accomplishing this is quite difficult, since everything in the investing environment conspires to make investors do the wrong thing at the wrong time. We’re all only human, so the challenge is to perform better than other investors even though we start with the same wiring.
Charlie Ellis once broke down the three ways investors can earn superior results. Most people try to outsmart or outwork everyone else. But the third way is to behave better than everyone else over the long term.
None are easy. The first two require massive intelligence, dedication, and focus on a single cause. Even then, there’s no guarantee they outsmart or outwork anyone.
The last one, however, doesn’t require a big brain or 20 hours a day of focus. It’s accessible to anyone willing to try.
Psychological influences have great power over investors. Most succumb, permitting investor psychology to determine the swings of the market. When those forces push markets to extremes of bubble or crash, they create opportunities for superior investors to augment their results by refusing to hold at the highs and by insisting on buying at the lows. Resisting the inimical forces is an absolute requirement.
Investor misbehavior — the cycle of fear and greed — is the only constant through centuries of market history. Human nature is the underlying force in factor anomalies today.
Better behavior is required to arbitrage misbehavior. But it also requires an understanding of the interplay between psychology, market cycles, and history.
A lot of the drive in investing is competitive. High returns can be unsatisfying if others do better, while low returns are often enough if others do worse. The tendency to compare results is one of the most invidious. The emphasis on relative returns over absolute returns shows how psychology can distort the process.
Greed may be bad but envy is a worse trait in investing. When everyone is growing richer, envy makes it hard to stand by and watch.
Combine envy with a short-term mindset, and the game devolves into who can get richer faster. Pretty soon, risk is tossed aside and leverage is taken on, all for the goal of biggest returns.
Unfortunately, seeking the biggest returns carries massive downside. The race to be the richest can quickly turn into a race to the poor house.
Investing — especially poor investing — is a world full of ego. Since risk bearing is rewarded in rising markets, ego can make investors behave aggressively in order to stand out through the achievement of lofty results. But the best investors I know seek stellar risk-adjusted returns…not celebrity. In my view, the road to investment success is usually marked by humility, not ego.
Every great investor is humble and few wear their performance record on their chest.
One of the best accounts of this I’ve come across is Walter Schloss. During an interview, the interviewee rehashed Schloss’s performance over the past 30 years. He bested the S&P 500 by a factor of two.
Schloss’s reply, “Was it really 2.2 times? I’m really surprised it’s 2.2 times the S&P 500. I knew we were better, but I didn’t know it was that much better. I’m very impressed by that.” Schloss had no clue.
Most swings toward the extreme of bubble and crash are based on a seed of truth, usually subjected to reasonable analysis…at least at first. But psychological forces cause conclusions to incorporate error, and market to go too far in incorporating those conclusions. the gravest market losses have their genesis in psychological errors, not analytical miscues.
Every bubble starts with a seed of truth, then gets distorted by emotions. Everything Marks described above — envy, ego, FOMO, quick riches — play a role that leads to widespread panic as prices rise.
Historically, housing prices rise over time. The internet will change the world. There is nothing incorrect about either of those statements. And yet, somehow, both were distorted into a housing bubble and internet bubble, respectively, that ended in a crash.
The idea that investors learn from past mistakes, has been proven wrong by those two massive events less than eight years apart. And that says nothing of all the minor bubbles that have popped up since.
It seems every generation gets at least one chance to repeat the mistakes of the past with their own niche of stocks inflated by a captivating story.
Refusing to join in the errors of the herd — like so much else in investing — requires control over psyche and ego. It’s the hardest thing, but the payoff can be enormous. Mastery over the human side of investing isn’t sufficient for success, but combining it with analytical proficiency can lead to great results.
It’s difficult, but not impossible.
Related Reading:
How to Stop Being Your Own Worst Enemy (in Investing)
Lessons from a Very Old Book on Market Psychology