Editor's Choice

3 Reasons You're Losing, or How Beating the Market Means Beating Yourself

Jason is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

More individual investment wealth has been lost due to emotion, whether the hubris of overconfidence or the grip of fear and uncertainty, than every recession in the past century combined. 

Yes, that's an anecdotal statement, and I don't have any evidence to prove it.  But it's likely a true one.  Take the Great Recession:

<img src="http://media.ycharts.com/charts/60492c88db003d8c12fbe899fea4f2da.png" />

^INX data by YCharts

The S&P 500 is still off of it's all-time high, but when you factor dividends in, we are back to square one.  Yet while the markets have mostly recovered, there are plenty of investors that have not.  The reason is that they simply got out at the bottom, sat on the sidelines, and missed a lot of the recovery before getting back in.  This was driven by fear and uncertainty for most. 

Let's take a look at a little longer period:

<img src="http://media.ycharts.com/charts/65497b07e0fd394e0054d63cc5cf45be.png" />

^INX data by YCharts

The chart above goes all the way back to January 2000, covering both the "Dot Com" bubble and the Great Recession.  When one factors in total return, meaning dividends are included, a long-term buy-and-hold investor would have been able to show a 23% gain over one of the toughest 12-year stretches in modern investing history, even while the market was mostly flat.  The pattern of selling and buying on emotion is repeated over and over, and plenty of investors have come through the past 12 years with nothing to show for it but being closer to retirement, yet less prepared.  

The emotional cycle happens again and again:  The market lags, investors panic and sell.  Stocks tank, driving more selling, and stocks go down further and further in a feedback-loop of activity.  Eventually, like an Ebola outbreak, it burns itself out, but not before many are left with losses that are a result of panic and overreaction- mostly as a result of their own emotional decisions to sell, and then stay on the sidelines.  Many investors create "mini recessions" in their own portfolios by making these same mistakes on a regular basis. 

If we are doomed to get caught up in it, why try to fight it?

The secret lies in learning how to beat ourselves in order to beat the market.  Let's take a look at the 3 things we have to overcome:

          1. Constant information overload

The internet has been both a boon and a pain for individual investors.  It has leveled the playing field in many ways, giving us access to data in seconds that in many cases wasn't even accessible a few years ago.  But it's the passive information that kills- the information that finds us, that has nothing to do with the fundamentals of our businesses, long-term opportunities, or anything of real investing strategy.  Yet we read it, mistake what we just did as "research," apply a catch-phrase attributed to Buffet or Peter Lynch, and call it a strategy to justify our buying and selling actions. 

           2. Overreacting to price movement

This is the height of foolish (small f) investing, and the action that causes the pain.  I review the following questions before I ever sell a share, in an attempt to limit this behavior.  It has prevented many a stupid decision: 

  1. If I didn't own this stock today, would I consider buying it at this price with the intent to hold long term?
  2. Is the investment thesis still intact?
  3. Am I selling solely based on price movement, either up or down?

Again, not a hard-and-fast rule, but it helps instill discipline, which is the nemesis of emotion. I only wish I had instituted this a decade ago!

          3. Not knowing our own limitations (or just plain refusing to see them)

The simple truth (and there's plenty of evidence if you do a little research) is that investors, especially men, tend to vastly overestimate their level of risk aversion, as well as investing acumen.  

Warren Buffett has stated that one of the biggest keys to his success, and that of Berkshire Hathaway (NYSE: BRK-B) is that he invests in businesses that have a certain level of predictability.  A good example is the insurance businesses that Berkshire owns.  The "float" from premiums, which is an easily predicted number, provides massive cash flows that are reinvested into other companies.  This predictability makes Berkshire a solid long-term investment, and a smart part of any long-term buy and hold strategy. 

Take the recent Facebook (NASDAQ: FB) or ZYNGA (NASDAQ: ZNGA) IPOs.  Zynga offers almost no way to predict the path that their business, revenues, and profits will take.  Facebook does offer a little more, based on the massive active base of nearly a billion users, and clear indication that management is focused on creating an environment where users and advertisers both benefit from the experience.  Yet that still leaves many questions, and tremendous volatility in the share price. While I think that the future looks very bright for Facebook, and Zynga is a long-term loser, neither will likely play out for many years.

The point is that Buffett's maxim about investing in businesses that are more predictable isn't perfect, but it will make us less likely to invest in things that we don't understand.  This is important, because our ignorance will make us much more likely to sell on price movement, fundamentals be-damned.  Fundamental understanding, on the other hand, will help us make our investing decisions in rational ways, price movements be-damned. 

With that in mind, set some guidelines that will help you succeed.  Here are a few that I use:

Step 1:  Disconnect from the daily noise.  Looking at your portfolio five times a day isn't research.  It isn't making you a better investor.  It's madness, and it makes us more likely to react to non-news, and sell on price movement, not fundamentals or long-term strategy.  Take the time to deep-dive into the companies that you own.  Crack open a 10-K or 10-Q.  Ignore that "hot tip" that you have to act on now

Step 2:  Gnōthi seauton (know thyself.)- Greek maxim.  Maybe you work in healthcare, and your "circle of competence" tells you that Stryker's (NYSE: SYK) orthopedic knee replacement business is really going to be challenged by Mako Surgical's (NASDAQ: MAKO) RIO surgical robot.  Mako has seen even more volatility than Facebook in the past year (high of over $45, currently around $15), but if you know the business, and can understand where the future results will come from, it's easier to ride out the storm. 

Step 3:  What's your strategy?  Not to steal the author's thunder, but as this article says, it's really about mind control- keeping ourselves in check.  And while there are a lot of very good strategies out there, there are only a few that each of us should consider.  So figure out something that works.  As Dan Caplinger wrote:

"The best investing strategy is the one that will bring you the most success. Start with one that matches your goals, but keep an open mind as you gain experience -- you might find another strategy that suits you better."

Taking the two companies above, an investor two decades from retirement may choose Mako, as time will mitigate the risk, and the upside is tremendous.  Yet a retiree-or someone close to it- would be better choosing Stryker, whose stable business, strong portfolio of patented products, and diverse revenue streams are a hedge against losses, and the small dividend a source of income today. 

My personal investing path has taken many twists and turns.  Developing skills to overcome myself has moved me down the path towards beating the market.  I hope your path leads you there as well. 

elihpaudio owns shares of Berkshire Hathaway, Facebook, and MAKO Surgical. The Motley Fool owns shares of Berkshire Hathaway, Facebook, and MAKO Surgical and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Berkshire Hathaway, Facebook, and MAKO Surgical . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus