In The Pruning Effect we looked at actual results generated by a strategy designed to deliver a lopsided relationship between the size of gains relative to the size of losses. This asymmetry of returns results in a statistical advantage over time which is the key in separating investing from gambling.
Possession of a statistical edge is a vitally important factor in sustaining performance over an investing life that can span many decades. Luck can help you out here and there, but luck is unreliable. A good plan is one with rules that can be measured and replicated. A good plan is a prerequisite for long term results but it is just that – a prerequisite. People with good plans fail all the time, not because of their plan, but because they are people that suffer from human nature. Here are three ways we traditionally blow our edge and sabotage a perfectly good plan:
- Impatience. Every investment strategy comes with ebbs and flows. A well tested plan should be able to give you some idea of what to expect during an off period – for example, whether or not a current drawdown falls within a normal range. Abandoning a plan that is operating within the range of expectation is an investor failure. Statistical edges accrue over time, an investor that changes course before the edge has time to appear was probably not well suited to that plan in the first place.
- Unrealistic expectations. Impatience is usually a direct result of unreasonably rosy expectations. People often adopt strategies based on long term charts and tables that show average results over many years and sometimes lose perspective of what off-periods can feel like. A year or two of lackluster performance looks insignificant on a twenty year chart, but feels endless when you’re in the thick of it.
- Changing rules on the fly. A good plan sometimes forces us to do things that feel wrong. If we override those rules based on a gut feeling or because of something we just heard on CNBC, they aren’t really rules and it wasn’t really a plan.
The investor’s worst enemy is not high frequency trading or the government or crooked CEOs or any other outside force. It’s our own human nature. Our wiring works against us in a hundred different ways as demonstrated by the unending cycle of booms and busts throughout the entire history of markets. An overextended Orange County house flipper in 2007 was driven by exactly the same impulse as a Dutch tulip bulb speculator in 1630.
A plan that works is a theoretically valuable ally. A plan that allows growth while providing a robust approach to managing risk is an asset with tremendous potential. Designing, testing and implementing a strategy that does these things isn’t simple, but it’s not rocket science either. The hard part, the monumental task, is combating thoughts and instincts forged by 50,000 years of human evolution.