What is the most important thing in investing?

Investors, Mutual fund managers and Hedge fund managers who are managing billions of dollars around the globe have only one sole purpose, that is to “beat the index”. It has been repeatedly shown in various studies that, fund managers don’t beat the index in the long run. Even if the fund manager manages to beat the index, the full benefit is not passed down to investors in the fund. We may think that it may be due to higher fund fee or any other processing fees involved in the fund but interestingly it is not the core reason, the main culprit is “Performance Gap”.

Performance Gap

When a fund after all the expenses generates the CAGR of 18% for five years, it should also mean that the investors who have invested their money should also get CAGR of 18% for five years but this rarely happens in the real-life scenario.

Reason

The reason is very simple, investors add more money to the fund when the markets are high and redeem more when the markets are low. This behavior of the investors will ensure that investors will definitely earn less than the fund performance. Moreover, investors may also lose money due to this behavior even if the fund generate high returns in the long run. Investors buy and sell wrong stocks at the wrong time. Investors themselves are the reason for performance gap.

But the main problem is that investors investing in funds are aware of this fact and they know that moving in and out will not generate enough returns but they do it always. But why so?

Psychology traits

The performance gap between funds and investors happens clearly because of investors psychology. We humans don’t make many mistakes but rather we make the same mistakes again and again. The most common emotion and biases that investor will face while investing directly in markets or through funds are,

  1. Loss aversion – fear of loss will make us sell in worst times (panic selling)

  2. Herd behavior – following what someone else is doing

Investors are always in the state of the fear state in a market because if the market moves up and if they don’t participate, we feel like stupid because investors want to catch all the opportunities. In the urge of catching all the opportunities, they buy and sell frequently and change their investments decision every now and then.

How to overcome this

Terry Smith, one of the most well-known and respected investors in a UK based company has recently released the letters for shareholders for the year 2018, where he describes his investments thought process.

His investments style is very simple.

  1. Buy quality companies
  2. Don’t overpay for them
  3. Do nothing

First two points seem to be straight forward but what one must take is the third point, that is – do nothing.

DO NOTHING

Doing nothing is deeply psychological. In real life, people seem to be very lazy to do their work but in stock markets, those people will become super hyperactive. Hyperactivity in the enemy of investors returns in stock markets.

 On doing nothing, I want to remind you of one of my favorite quotes,

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone”

Doing nothing will not only help in investing but also in life.

Most of the people confuse, do nothing with don’t do anything.

Do nothing means that we should act correctly at the right time and rest of the time we have to patiently wait for the result.

If you closely observe the three points mentioned by Terry Smith, he has included “do nothing” at last and not in the beginning.  The first two-point suggests that we act correctly at the right time and at last, do nothing, which also means that we have to wait patiently.

The Key takeaway is,

  1. Buy good companies or invest in good funds at the right time and next

  2. Do nothing.

The first point will take care that we have started our compounding engine at the right time and the second point suggests that we give sufficient fuel (time) for the compounding engine to run for a long time in our favor.

The most important thing – handling our behavior

Humans are not designed to think rationally and it is not a bug but rather it is one of our features. We should accept the fact that, we cannot always think rationally.  We may wonder then how could great investors who have accumulated tons of money through stock markets think rationally all the time.

The big secret is that they also don’t think rationally all the time but they avoid making irrational decisions.

What can we learn from great investors?

  1. On close examining of these investors, we get to know that they also have psychological biases like us but they are very much super talented in mitigating them. For example,

 Conclusion bias – investors first conclude the result and will find all the information and facts that will make the result to come true. Investors will not be able to digest if anything happens apart from their concluded result.

But great investors never ever come to any conclusion. This is strange but true. They know that if they come to any conclusion it would we very hard to change the mind if something irrelevant happens. But they act and make the best decisions with the possible facts they have in hand buy thinking probabilistically. When facts changes, they change their decisions.

They understand that uncertainty is certain in the stock market. They also know that making and taking good decisions would not guarantee any success but rather increase the chance of being successful.

  1. They keep their investments style simple. They clearly know what they are doing and evaluate the risk associated in taking decisions. It is very astonishing to see that, all great investors keep their investments style very simple because they know that, simple things work the best.

Charlie Munger once said that,

  1. They accept their failure. They learn from them and move on. They don’t have any regrets. They are learning machines. They understand the importance of lifelong learning.

In today’s world, literacy not only involves learnings things but rather literacy is the process of learning, unlearning and relearning.

This same thing is applied to investment community also, the investor is financially literate only when he keeps on learning from his investment’s mistakes, unlearn it and relearn the new method, rest of the investors who are not following this method are simply financially ill-literate.