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Wednesday, December 17, 2008

Why Investing is Hard

There are many times when I tell people that do-it-myself financial planning is really easy. In fact, as far as the math goes, it's not even as close as learning to solve differential equations, doing linear algebra, or learning to program in C++. So if the intellectual challenge behind investing just isn't that hard, why do smart, hardworking people consistently fail at it? Why did Nobel prize winner Myron Scholes sit on the board of directors of not one, but two massive hedge fund failures? (LTCM and Platinum Grove)

The answer, I think, is that the challenges that investing pose are not intellectual, but emotional. I'll provide a personal example. Last year in November when Google sat at $700 or so a share, I polled people I knew to see if they were selling. When every one said No, I knew it was time to sell. So I sold. And the stock went up to $712. So I sold some more. And then it went to $723, and I sold some more. And then it went up some more, and I sold. At this point, my hands were shaking as I pressed the sell button with my mouse. I kid you not. Despite everything I knew telling me that this was the right thing to do, it was emotionally very difficult to do it when everybody else (including the stock market) was telling me differently. My mind started constructing scenarios under which Google could be worth $1500 per share in 5 years. I started noticing articles (like this one by Henry Blodget) that were quite optimistic.

Truly, when it comes to investing, your worst enemy is yourself (well, ok, a crooked financial advisor would be even worse). Smart, hardworking people like to do stuff. Society rewards that. Your typical day job rewards that. Yet investing is precisely the opposite. Even as illustrious an investor as Warren Buffet wrote in his 1998 newsletter The portfolio actions I took in 1998 actually decreased our gain for the year. In particular, my decision to sell McDonald's was a very big mistake. Overall, you would have been better off last year if I had regularly snuck off to the movies during market hours. I remember hearing once that 95% of all positions sold to buy another stock (or mutual fund) actually decreases the performance of a portfolio, so typically, sitting on your ass is the right thing to do, but that goes against the grain of everything else society values.

Experience also teaches people that if something works, do more of it. Smart people, in particular learn that really quickly. But that's also the wrong thing to do in investing. When stocks do particularly well for a period, they tend to regress to the mean later. Which means that when your stock portfolio starts doing really well, it's really time to sell it and buy bonds. The asset allocation approach is to periodically re-balance this portfolio and that's what enforces this discipline. But usually when the time comes to re-balance, most people find it really difficult to sell their winners and buy their losers. So that works against you too.

Finally, Financial Planning success is measured in decades, which is completely counter to the way human planning scales want to work. For instance, global warming, which is a multi-decade problem falls into this category, and we have made essentially no progress in that area for the last 10 years or so, nor do I expect the human race to do so until it's too late. Fortunately, unlike international politics and policy, we as individuals can affect our destiny, but again, our evolutionary history works against us.

Financial blogs, books, etc., can help you with the intellectual underpinnings beneath financial planning and investing, but what I've found is that nobody can help you with the emotional part of investing. Heck, over the next few years there are going to be some major buying opportunities that will show up. In fact, some of them are probably already there today. But I expect that when the time comes, it's going to be just as hard for me to push the buy button as it was for me to push the sell button last year.

1 comment:

Helder Toshiro Suzuki said...

Great post!
From what I've learned humans cannot go against emotions consistently, so the right way would be to attach the emotions to the right thing: fundamentals.

The trick is no one knows the fundamentals of anything, so you must literally have faith on how much the stock is worth and your method. Warren buffet (and his teacher graham ) set a bunch of dogmas and rationales that worked for him so far.

It has been working ok for me too, but it's too soon to tell (I only started to invest in stocks 6 years ago).