Never in the history of the world has there been more information available at the stroke of a keyboard on health and fitness than now, yet we have never been more out of shape. For many reasons, the gap between knowing what to do and doing it can be challenging to traverse. The same is true in investing. Knowing what to do can be difficult to discern because there is a tremendous amount of information on investing, plenty of which is good and some of which is bad. Compounding this challenge is the fact that as human beings we are naturally hard wired to make poor decisions surrounding investments and money due to our emotional composition. Financial decisions that “feel good” often are not the courses of action that allow us to achieve our long-term financial goals.
People regularly tell me about their successful investments, but I almost never hear about the unsuccessful ones. Investing in 2020 is a funny thing, nearly anyone can open a brokerage account on their phone and buy stock in a company they know or have read about. If the stock goes up, they are a successful investor and wonder why anyone would consult a professional. Few other professions have such a low barrier to entry; after all you cannot walk in off the street and try your hand at surgery. It turns out that typically an investment professional’s experience and skill are demonstrated only at the end of a market cycle. As well known futures trader Peter Brandt has said, “it is actually easy to make money in the markets, try to keep it – that is the challenge.”
Markets have historically followed the path in the chart below based on human psychology with fear and greed dominating behavior. Ironically, everything looks the best at the top when risk is high and opportunity for return is low. Conversely, everything looks the worst at the bottom when risk is reduced, and opportunity is high. As human beings subject to our emotions, we cannot help but be greedy and self-confident near market tops and fearful near market bottoms. Additionally, it is hard to separate from the pack and see opportunity when others are fearful. So, what is an investor to do?
Source: Ritholtz Wealth Management
Process driven or systematic investing is rules-based in that it eliminates the emotional pitfalls to which we as human beings are subject. The advantage of having a set of rules or a defined process is that it can be tested and improved upon in real time as well as over historical time periods. Process driven investing should explicitly define what to buy, when to buy, how much to buy and when to sell. No matter what the future holds, your predefined rules will guide the way. Sounds simple enough, but there are pitfalls to this type of investing. First, your rules must be robust which means you will experience the inevitable periods of winning and losing as there is no magic bullet. Second, like being fit, rules are useless unless you can follow them no matter what the world throws at you. Robust rules mean that you are sometimes harnessing the bad behavior of the crowd so those same rules will sometimes not feel good and be difficult to follow.
If there is no process or structure to your investment philosophy, you are guessing and hoping for the best. Strong bull markets are forgiving in that mistakes are easily covered up as the tide raises all boats. As Warren Buffet says so well, “it’s only when the tide goes out that you see who’s been swimming naked.”