We make poor decisions when presented with financial data, because the subsconscious mind is in control of our interpretation of the facts. • Simply saying, ‘I will not be affected by my subconscious mind,’ is pointless. That very statement could well be another head-fake by parts of your brain that are not apparent. Fortunately, we now have tools to make better choices.
Figure 1. Our subconscious mind is constantly making us see things that are not there, all the while reassuring us that the actions it directs are the most rational and logical steps we can take. Photo by Photographee.eu/Shutterstock.
In the previous parts of this column, we saw that baked-in “behavioral biases” make us sell securities that will do well and replace them with securities that will underperform. The mere fact that we know we do this does not make us capable of defeating these biases, since our subconscious mind controls everything our conscious mind perceives. Our invisible filters are constantly presenting us with a fun-house mirror, confirming for us our pre-existing beliefs and fears.
Without wiping out our brains, it is possible for us to invest without behavioral biases overwhelming our thinking process. This is why I’ve become a fan of mechanical investing. This style of asset allocation is neither active investing — trading based on your research and opinion — or passive investing, which involves dividing your money among various securities and never changing the percentages. Mechanical investing means choosing a computerized formula that’s been shown to achieve market-like returns or better over the long run, and then following that formula as faithfully as possible, without second-guessing it.
No formula will outperform the market every year, but it may do better over time than we humans can achieve with our fickle thoughts and emotions.
Many of my readers know that I wrote more than 1,000 columns for such high-tech publications as InfoWorld, CNET, PC World, Datamation, and eWeek from 1991 through 2003. I co-authored 11 Windows Secrets books during that period, then in 2003 launched WindowsSecrets.com and the Windows Secrets Newsletter, which grew to more than 400,000 subscribers.
When I sold the dot-com in 2010, I was faced with decisions about investing the proceeds. To my surprise, I found that popular books and white papers about investment theory had no unified message. Experts seemed to have no agreement about the best strategy for ordinary working people to make gains in the face of constant market uncertainty. Complex trading strategies that worked when the authors first backtested them failed to work after publication of a paperback or monograph about the technique. I was frustrated.
After much research, I realized that these theories lacked a meaningful definition of risk. Too many of the authorities said “risk” was a portfolio’s mere deviation from a straight line.
That’s not risk at all. All of us let routine deviation roll off our backs every day. For example, we might choose one road over another when commuting to work. Sometimes, the way we chose turns out to be more congested and slower than the alternative. We just shrug our shoulders and accept this minor loss of our time. We don’t quit going to work.
The true meaning of financial risk is the likelihood of an intolerable loss. As humans, we persist in the face of small portfolio declines, but when they grow worse than a certain point we throw in the towel.
One researcher, Charles Rotblut, showed that people’s persistant underperformance of the S&P 500 — or any benchmark — can be explained by investors liquidating their portfolios near the bottom of a bear market and then staying in cash out of fear, missing the profitable “bounce” at the beginning of the subsequent bull market. (For details, see “The 2-point behavior gap” in my one-page Muscular Portfolios summary.)
Today, we enjoy nearly commission-free trading of ultra-low-cost ETFs (exchange-traded funds). We can now construct mechanical-investing strategies that protect us against intolerable losses. This helps us remain in the market to grow our savings over time. But we won’t stay the course unless we answer the question: How much of a loss is an “intolerable loss”?
People perceive losses over 25% or 30% as intolerable
While preparing my 2018 book, Muscular Portfolios, I interviewed Ben Carlson, the director of institutional investing at Ritholtz Wealth Management. He’s worked with thousands of investors, large and small. Everyone’s risk tolerance is different, of course. But in an interview, Carlson explained to me the general progression of individuals’ stoic lack of concern changing into their ultimate capitulation:
In a 10% correction, people for the most part are OK.
At 20%, people get a little edgy.
When you get to the 30%, 40% loss range, people say, ‘Get me out. I tap out. That’s it.’
That’s my back-of-the-envelope personal experience of the pain point.
Carlson’s perception confirms Rothblut’s observations and my own. Given a bit of investor education, most people can learn to tolerate drawdowns of 10%, 20%, even 25% in their life savings. But beyond that, individuals soon reach a point where the pain is simply too great (the “behavioral pain point”). Unfortunately, switching to cash near the bottom of a bear market is the most profit-destroying action people can take.
And yet book after book — and white paper after white paper — recommends strategies that are known to cause losses of 40%, 50%, or more. The S&P 500, adjusted for dividends and inflation, crashes 30% or more every 10 years, and collapses 40% or more every 18 years. An author recommending a high-risk, 100% equity portfolio — or any strategy that has intolerable losses — simply guarantees that most of the followers will capitulate near the bottom, regardless of what their book may say.
The underlying theory of investing
Hard sciences, such as physics, have something called first principles. These are rock-bottom statements that cannot be deduced from other principles. Scientists build solid, working models on these foundations.
During my research, I had to constantly ask, “Where are the first principles of investing?” In the 21st century, asset allocation is almost cost-free and ETFs track virtually every asset class. And yet I found no agreement on how individual investors should proceed. There was no consensus on the best course of action in a world where anything can happen and nothing can be predicted with certainty.
I had to lay out a new set of principles, drawing on the work of Rotblut, Carlson, and many other experts. The following 12 points from my book are called Strategy Sanity — the minimum standards that investors should demand from any investing plan:
- Market-like returns. It’s possible with highly liquid index ETFs to capture 99% of an asset classes’s gains.
- No month-end losses over 25%. Advances in portfolio design keep drawdowns tolerable.
- Absolutely no math. Most people will never crunch spreadsheets or compute their own statistics.
- Less than 15 minutes per month. Busy adults don’t want to be glued to computer screens every day.
- No more than monthly changes. Excessive trading hurts performance and makes saving a chore.
- Fully disclosed. The book Muscular Portfolios and its website are examples of the new free, open strategies.
- Free picks updated continuously. The website refreshes its listings every 10 minutes during market hours.
- No registration required. Submitting an email address or purchasing tutorials is not mandatory.
- Years of use by actual people. Users have access to a longtime newsletter or online forum.
- Unlikely to become overgrazed. Muscular Portfolios take discipline that many investors don’t have.
- Same formula at all times. Identical rules in bear and bull phases, which cannot be predicted.
- No shorting or borrowing. Going short and taking on debt heighten your risk of loss.
Fortunately for me — and anyone who wants growth without periodic heart attacks — I was able to find experts whose strategies met all of the above criteria, including being publicly documented (not a black box):
- The mechanical formulas of experts such as Mebane Faber (co-author of The Ivy Portfolio) and Steve LeCompte (CEO of the CXO Advisory Group) have shown market-like returns for decades but never lose more than 20% or 25%, even in the worst 50% market crashes.
- The ultra-simple two-asset portfolio recommended by the late Jack Bogel (founder of the Vanguard Group) suffers losses larger than 25%, but in return the investor must make changes no more than once a year, for those who literally have no free time.
- A wealth-preservation portfolio — based on the well-known 20% stocks/80% bonds model — keeps losses below 14%, which would hardly ruffle high-net-worth individuals who rarely bother to check the exact balances of their cash hoards.
Mechanical investing can be a lifesaver, not to mention a saver of your savings.
For the millions of people who own 401(k) plans — virtually all of which prohibit the purchase of individual stocks and allow changes no more than once or twice a month — complex strategies are literally impossible to execute. For them, mechanical investing is a godsend. But even people who own self-managed IRAs and ordinary taxable accounts can benefit from the peace of mind that a proven formula gives you.
Rather than me re-hashing all of the details here, you can start freeing your nest egg from behavioral biases by reading the short Muscular Portfolios summary on a separate page at StockCharts.com.
Here’s to your investing!
With great knowledge comes great responsibility.
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