Investment Wisdom for Building a Better Life: Rules Are Essential, but They Do Not Guarantee a Win
- Mar 31, 2010
Have you felt let down by an economic crisis? You might if you thought you were following all the investment rules you'd been taught. You may feel disappointed, resentful, and even angry. You are in good company if you are thinking, "I followed the rules! I should have won!" After all, doing so should entitle you to a certain reward. Doesn't following the rules protect you from losses, or at least minimize them?
Unfortunately, life doesn't work that way, and neither does the economy. Following investment rules doesn't necessarily mean you won't lose sometimes. However, using the rules as a general, meaningful guideline, even if you have to be flexible at times, is wise.
To succeed as an investor, you need to move beyond the emotional frustration of "losing" by examining your process and changing your behavior. This requires a constructive, focused, and objective mindset.
First, you have to acknowledge that there are no guarantees. But there are parameters to consider, and they are based on years of experience. Think of it this way. Picture a child running across the road between two parked cars on an active street. He makes it safely to the other side. He thinks, "Why do they tell me at school not to run between two parked cars? I did it, and nothing happened." Just because nothing happened one time doesn't mean it's a reasonable risk. One lucky win has nothing to do with the probability of future success. In fact, the probability of a win decreases with each risk taken because the odds will eventually catch up to you.
Yet sometimes this is how investors think. Either they have no investment rules, or they break their own rules and take on too much risk. When that rule-breaking strategy works, they do it again and again, thinking they are guaranteed phenomenal returns. Then they're surprised when they get run over!
The same scenario can also work the opposite way. An investor follows a rule, and it doesn't work. The investor "loses" and begins to think that following the rules doesn't matter because the rules can't guarantee safety. Think of a person who lives a healthy lifestyle, exercising and eating properly. She eats no fried food and avoids saturated fat. Can you guarantee that she won't get heart disease or cancer? No, but that doesn't mean that following the rules isn't a good idea. Although it may seem that the rules got her nowhere, the reality is they probably gained her a great deal. Could it be that her healthy eating prevented cancer from developing at an earlier date? Might she be more likely to beat heart disease because she is in great physical condition? Could it be that her quality of life before and during an illness could be improved by her healthy habits? Just as breaking the rules doesn't always lead to disaster, following the rules doesn't always lead to safety. That doesn't mean that following the rules is a bad idea.
When an economy turns south, many investors—including the ones who followed the rules—experience losses. This doesn't mean they should conclude they had poorly designed rules or that the rules don't work. Investment rules yield their effect over time. It's true that over short periods of time you might feel that you lost. You lost this one. You lost that one. But in the grand scheme of things, if you follow the rules—and we'll talk later about what those rule are—you're more likely to be on the right path.
Although you can't guarantee you'll never lose, what you can do is improve the probability of winning. That is what superior athletes do. Like the professional baseball player, all any of us can do is swing at the balls being pitched to us. And, like the baseball player, when you follow the right rules, you can increase your chances of getting a hit. You may not connect with the ball every time, but if you position your stance, practice your swing, and study the craft, the probability is that you are going to hit consistently over long periods of time. What do top players do to be in their best form? They study films, including those of the competition. They practice the skills they need until they are at the level of unconscious awareness. What looks like autopilot to us, the spectators, is really the result of years of active dedication to the sport. Top athletes are lifetime students of their game, and they learn to perform under pressure that includes less than desirable conditions. Will continual "perfect" practice always lead to a win? Is there a way to guarantee a connection with the ball? No. But practice greatly increases the chances of success. This reasoning applies to sports, investing, and anything else you value in your life.
Rules are guideposts that improve your probability, and that can make all the difference. What's the range, statistically speaking, between the minor leagues and the major leagues? For the best players, it can be very small. And yet, a ball player's life and the life of his family can be dramatically changed when he moves up to the major leagues and becomes a fixture there.
The same logic applies to the difference between mediocre and remarkable investment returns. From 1989 to early 2009, the Standard & Poor 500 stock market index return has been about 8.4% (J.P. Morgan Asset Management, Guide to the Markets, March 31, 2009). Can you guess what the average investor's rate of return has been over that period of time? About 2%. Why? Because investors, for whatever reasons, tend to buy high and sell low instead of doing the desired opposite. In any one year, the differential may not be that large. When you add all 20 years together, the cumulative effect is substantial.
Following are several ways you can improve the probability of "winning," which means increasing the potential for your investment performance.
Evaluate the Investment Rules You Followed
When you look back at the performance of your investments, ask yourself what rules you followed and how well they worked. Did you have the right rules? Were you following the rules that were appropriate for someone in your financial situation and at your stage of life? Did your situation change, and did that require revision to the rules?
This is how Rebecca describes her experience.
- Rebecca: My husband and I were on a wonderful trip, hiking in Switzerland, when he suddenly had a heart attack and instantly died. I can't even describe the shock and pain of this; I was numb for weeks. When I got home, among all my new obligations I had the responsibility of all our investments, and I had never done any of this before. I discovered that there was quite a bit of money in higher risk securities. I learned to use a computer and I took a course on investing. I wanted to handle things personally, and before I knew it, I was day trading! I guess because my husband was an active trader, I thought that's what I was supposed to be doing. I was in over my head. I felt like there were no rules, or the rules that my husband had relied on previously were no longer appropriate for me, an inexperienced widow. I realized I needed an investment strategy with boundaries and an advocate to stand by me. It was a great relief when I found an advisor who was supportive and sensitive to my needs.