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Thursday 19 July 2012

Mindless Money 4/5: Stay Resilient, Be Prepared

Every so often in an investor’s lifetime the markets will throw us a completely unexpected curve ball.  Markets will fall off a cliff or soar off into the stratosphere. 

Whether we like it or not, if we invest in the markets for long enough we will be exposed to events that we have no experience of.  How we deal with these will make a major difference to our returns over an investing lifetime.

Developing a certain resilience to this type of problem means that you have a decent understanding of stockmarket history and that you keep it in mind all the time.  Basically, if you don’t have an understanding of the problems that can occur with your investments then you don’t have the basics of a resilient approach to investing.

At the heart of this problem are our emotional responses to emotional events.  When markets soar and our closest friends are making tons of money with no other analysis than following the shoeshine boy’s tips or they’re crashing and taking our life savings with them our instinctive reactions are guided not by rational thought but by emotional reactions.

The oft-quoted truth, that most investors buy near the top and sell near the bottom of market cycles, is simply the external evidence of our emotional neurology.  It’s also a perfectly hopeless way of investing.  Emotional resilience is as much a part of a good investor’ psyche as skilful stock analysis.

Developing emotional resilience is, in part, about experience.  Nothing else prepares you for the sickening jolts of an investing career.  However, you can develop some understanding of the possible trajectories of markets by doing some careful studying of history.

This reliance on history needs to be kept in perspective.  How many times have you heard the current crisis compared to one of those of the dim and distant past, such as 1929 or 1973?  History doesn’t repeat in such simplistic ways – it’s always contingent: what happened in the past was just one possible course of events.  That’s why all those wise predictions based on false historical analogies never come true: we're still waiting for the next Great Depression.

No, the proper use of history is an understanding of what could happen, a contrafactual baseline which we can refer to when we find ourselves in one of the inevitable economic storms that will occur from time to time. These are scary, no matter how many times you go through them, and expecting that you can simply ride these out without going through the normal cycle of fear, doubt, uncertainty, greed, rage and resignation is foolish.

Your strategy may be to sit tight, on the basis that you don’t need the capital and you’ve carefully invested in stocks which will stand the test of any unexpected economic downturn.  It may be to carefully hedge your portfolio.  It could be any number of things apart from the one that most investors adopt – to sit in the headlights like a stunned rabbit, before exiting in panic near the market bottom.

We’re emotional for many good reasons to do with survival in an uncertain world; but reacting to stockmarket crises is not one of them.  Being mindful of history is the right and proper way to develop the resilience needed to deal with the swings and roundabouts of cruel investing fortune. We're all unlucky some of the time, but some of us know how to deal with it and some of us don't.

Further reading:

The issue that history is contingent, and so is the future, was covered in Investing in the Rear-View Mirror and in Darwin's Stockmarkets.   Our inability to make money because of our emotional ineptitude was addressed in Your Self-Inflicted 6% Trading Tax while the fact that personal experience isn't a good guide to investing was dealt with in Investor Decisions - Experience Is Not Enough.  The interaction between investing and emotions is covered in lots of places - see, for example, Get An Emotional Margin Of Safety and Stone Age Economics and the Affect Heuristic.

Previous >> Mindless Money 3/5: Hold the Big Picture
Next >> Mindless Money 5/5: Avoid Overspecification

1 comment:

  1. There were more similarities to the conditions that led to the great depression - such as a Fed induced credit bubble in the Roaring 20s - but there were many differences aftewards. The Smoot Hawley Tariff Act, raising the top tax rate from the 20s to the 60s; allowing companies to collude on prices to keep prices artificially high in exchange for maintaining artificially high union wages, and on and on. Long histories, across countries, with many more samples in the mold of Rogoff and Reinhart is preferable, but even isolated comparisons are useful, so long as you both compare and contrast.