Driving Emotions From Your Investment Process: A 12-Step Program

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Thomas Howard has a nice article in the AAII Journal entitled, “Driving Emotions From Your Investment Process: A 12-Step Program“. Here is Howard’s 12 steps:

The 12 Steps to Driving Emotions From Your Investment Decisions

1. Hello my name is _______________ and I am an emotional investor.

2. It is OK to be wealthy.

3. I will strive to eliminate my myopic loss aversion MLA and reduce my need for social validation.

4. I believe that volatility and its close cousins the Sharpe ratio, maximum drawdown and tracking error are largely measures of emotion and should not be used in constructing and evaluating portfolios.

5. I believe that volatility and risk are not synonymous and that most references to risk are really references to emotion.

6. I believe that increased stock market volatility represents an opportunity for, rather than a risk to, my portfolio.

7. I will divide my portfolio into buckets as a way to reduce emotional sensitivity to volatility.

8. I will focus on expected and excess returns, while largely ignoring correlation and volatility, when building long-horizon portfolios.

9. I will forget the price I paid for an investment, as well as its name, to mitigate these emotional anchors.

10. I believe past performance is a poor predictor of future performance, so I will not use it when evaluating an investment manager.

11. I believe unreasonably constraining a portfolio, such as keeping a manager in a style box, hurts performance and thus will be avoided.

12. I will consistently pursue a narrowly focused investment strategy while taking only high-conviction positions when managing a portfolio.

I agree wholeheartedly with the sentiment of removing emotional reactions from your investing practices. We have a saying within the firm:

Don’t let short term volatility ruin a brilliant long term investment strategy.

And while I agree with the sentiment, here are some of the rational objective reasons to pay attention to some of the factors Howard is suggesting to ignore:

6. The rebalancing bonus increases based on on volatility being higher and the correlation between the two categories being lower. So volatility does represent an opportunity to capture the rebalancing bonus by buying the categories which have gone down and selling the categories which have gone up.

7. We use our six asset classes as buckets. Then we report on how each bucket does historically for each year individually. This means we always have something to complain about, but it is often different each year. Thus it helps support the case for diversification. Reporting each year separately is better than just reporting time periods looking backwards which encourages recency bias.

8. Having suggested that volatility is an opportunity (#6) and knowing that the rebalancing bonus is a function of volatility and correlation, there is no reason you should be ignoring them. You should want assets with a high expected return, but also look at non-correlated assets.

9. The price paid for an investment is important for tax-loss selling or for calculations about realizing capital gains. Anchoring is also an intellectual problem which keeps us from doing these tax savvy actions. mentally tricking ourselves is good. Overcoming emotions while facing them is even better.

10. Morningstar did a study recently and found that lows fees and expenses is a better indicator of future performance and their own Morningstar star system. Index funds are generally better than actively managed funds for this reason.

In Howard’s defense, the emotional reaction for all of us humans is to pay attention to these factors and move in the wrong direction. When I suggest to pay attention to these factors you will more often than not be moving against your emotions. These contrarian movements should improve your investment performance even if (and perhaps because) it goes against the grain of what your emotions would have you do.

Ignoring factors that would cause you to move in the wrong direction is good. Noticing them and being a contrarian is better.

 

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)