Lessons from Lehman Brothers Part 2 – Psychology

My first post in this series looked at the returns that an investor in Australian shares would have earned over the last ten years. The analysis presented assumed that an investor bought their shares two weeks before the collapse of Lehman Brothers.

The key point was that equity risk is rewarded over the long-term. You would have still done OK; even if you were unlucky enough to have invested just before the worst of the Global Financial Crisis (“GFC”).

But it would have required patience and discipline. It would have also required realistic expectations, a plan and maybe some coaching along the way. In this post we dig a little further into the behavioural aspects of sticking to a long-term investment plan though recessions and crises.

Anxiety

You should never invest in a way that causes anxiety. Anxiety is a good indicator that there’s a mismatch between you and your investment strategy. The mismatch could be due to many causes but ultimately the result is always the same. You will make a bad decision at the worst possible time.

This is no revelation. Think about it, do you usually make good decisions when you’re stressed and anxious[1]? I don’t. And you probably don’t either.

This is not to say that you shouldn’t have any anxiety at all. Investing happens in the future. The future is uncertain because its unknowable. You have to make decisions with incomplete information.  Sometimes you won’t know the effects of your decisions for a very long time.

There is always going to be a level of anxiety. This is healthy. A total lack of anxiety could be a sign of overconfidence, which is always a dangerous trait in investing.

An illustration might help make the point clearer. I’m a parent of a sixteen-month-old boy named Leo. Sometimes I worry about his future. I wonder if he will find good friends, be good in school, or what he will do for work. A certain level of worry is healthy. It’s a sign that I love Leo very much and that I take my job as a parent seriously. It also motivates me to plan and do the things that are necessary to ensure that Leo grows up into a healthy, happy and successful adult.

But what if I were to worry constantly about Leo’s future? That would be unhealthy. I would probably make a lot of bad decisions. These decisions and their effects would interfere with my goal of raising a well-adjusted young man.

A reasonable-level of anxiety is a sign that you take investing seriously and are on guard against complacency and overconfidence. Meanwhile, too much anxiety is a sign that you’re investing in a way that just doesn’t suit you.  Which is just another way of saying that you’ve increased the risk of making bad decisions.

OK, so we should all just invest in what’s comfortable for us. Not so fast. Some investors may need to invest in shares even though it makes them uncomfortable. For example, a retiree may be comfortable with the safety of investing in a term deposit. But this exposes them to the erosion of their purchasing power due to the long-term effects of inflation. It also creates the risk that they may outlive their means.

Perception = Reality

Some investors may need to change their attitudes to risk for their own good. The good news is that this is possible. The bad news is that, like any form of behaviour modification, its hard to do.

Anxiety and stress are responses to a perceived threat.  This is an important point. When it comes to emotions, perception equals reality. Change the perception and you might be able to change the response.

Things that happen in life seem much less scary if you:

  • Understand what’s going on.
  • Prepare for what might happen.
  • Make a conscious and deliberate choice.

The actions that will help you to change your perceptions are:

  • Educate yourself on the basics so that you can at least form realistic risk and return expectations.
  • Prepare ahead of time. This means having a written investment strategy and a financial plan.
  • Get advice, coaching and support from by someone more experienced that you trust.

 Experience

Changing how we perceive events will help, but ultimately there’s no substitute for experience. And there’s only one kind of experience that really matters: you need to lose money.

There’s really no way to know how you’ll react to losing money until you’ve actually lost it. The experience effects everyone differently. One thing you don’t want to happen is to become so scared that you never invest again. As we’ve already considered, there’s a significant long-term reward available to those that can look past short-term losses.

You need to experience what it’s like to lose money in a controlled environment. It has to be real money at stake. Even if it’s only a small amount. Paper portfolios don’t generate the same emotions.

Think of an engineer building a bridge. They build a model, stress it, identify any weaknesses, refine the design and test again. Only when it works do they scale it up. Smashing multiple models is part of designing a bridge that works.

You need to think of small losses in much the same way. I call them my “tuition fee”.

I’ve paid my fair share of tuition fees over the years. But I’m a far better investor because of it. Its how I’ve learned to manage my mistakes (they are inevitable) and still achieve great results. It also means that I can look my clients in the eye and empathise with them.

Hopefully, you’ll learn a few important lessons from your mistakes. Here are some of lessons that I’ve learned:

  • Mistakes are inevitable. You’d better get used to them. In some sense they aren’t really mistakes at all. After all, nobody knows the future because it hasn’t happened yet.
  • The primary purpose of a portfolio (i.e. diversification) is to ensure that you survive your mistakes.
  • Portfolio math works like this: there will be inevitable losers, a lot of average performers and a handful of really big winners. Limiting/managing your losses is what matters, not avoiding them entirely. One or two big winners can more than make up for a lot of small losers.
  • What matters most isn’t whether your right or wrong about a particular investment. What matters is what you do when you’re right or wrong.

Most of what I’ve written here runs contrary to what many financial planners or wealth managers will tell you. They’re built their businesses around promising to make the pain go away (trust us, we’re experts) and providing comfort (for a fee).

Unfortunately, this is largely an illusion. Nobody can take the uncertainty of the future away. But that doesn’t mean that you can’t plan and be ready for it. And it certainly doesn’t mean that you can’t invest profitably. This is the true value of financial planning and wealth management.

The first step in planning is knowing yourself. This will be the topic of the next post in this series.

 

[1] This is also when the parts of your brain responsible for processing fear and threat detection are working overtime.

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