There is a well known story of a wealthy Australian investor who in the mid-1980s (rightly) thought shares were heading for a fall, but lost a fortune because he shorted the market too early and by the time he had to buy the shares back they had actually gone up further in value. Of course, a little while later we had the 1987 sharemarket crash. There is often a big difference between being right (ie. getting some sort of forecast right) and making money and many investors don’t realise this.
In the 1970s, a US investment professional named Charles Ellis likened sharemarket investing to playing a “loser’s game”. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis or boxing after several rounds are examples of loser’s games, where the trick is not to try to win but to avoid making stupid mistakes and thereby win by not losing! As noted in relation to Mr Market, investment markets are fickle, sometimes rational but sometimes far from it and highly seductive and thus are a classic loser’s game in which the winners win by simply not making stupid mistakes.
For many, this means the best approach to investing is to adopt and religiously follow a long-term strategy consistent with one’s objectives. However, for those who want to take a more active approach and who are prepared (or paid like myself) to put the effort in, the next few rules may be of interest.
Having a disciplined process is absolutely essential for investors who want to move away from a long-term strategy and become more actively involved in timing investments into and out of markets or stocks.
This should ideally rely on a wide range of indicators – such as valuation measures (whether markets are expensive or cheap), indicators that relate to where we are in the economic cycle, measures of liquidity (or some guide to the funds available to come into markets), technical readings based on historic price patterns for the sharemarket, exchange rate or whatever (the evidence suggests there is value in such analysis) and measures of market sentiment (the crowd is often wrong – so if everyone is bearish that is likely to be a good sign and if everyone is bullish that is likely to be a bad sign).
The key to having a disciplined process is to stick to it and let it filter all the information that swirls around financial markets so you are not distracted by the day-to-day soap opera that engulfs them. The huge flow of information often confuses rather than aids any decision making. And most of it is just noise anyway.
The problem is that having a disciplined process to actively manage investments can be costly and time consuming and well beyond what most investors are prepared to do.
Markets regularly prove even the best investors wrong. One should constantly consider contrary views and test them against your own. It is useful to have some form of ‘stop loss’. In the past I have ridden losing positions too long based on arrogant confidence I will be right (because a forecast says so). A stop loss (either in the form of a formal sell order to reduce/cut a position if the market goes through a particular level contrary to your own position or just a trigger for a review) is useful in forcing investors to consider whether they are on the right track or not.
Smart investors have an awareness of their psychological weaknesses and seek to manage them. Examples of these include overconfidence, the tendency to overreact to the current state of the world, the tendency to look for confirming evidence, and any innate bias towards optimism or pessimism. A key to successful investing is to leave your ego at the door. You can’t expect to be always better than the millions of investors who make up the market.
It is tempting to think that it is easy to outperform the sharemarket or perfectly time moves into or out of it over time. But it is never that easy. For most investors the best approach is to respect the market and have a long-term strategy and stick to it. For those who want to delve more into active management of their investments it is essential to have a disciplined process, to remain flexible and to know and control your psychological weaknesses.
Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
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