The profitable virtues of patience

The average investor’s returns from a managed fund tend to be less than the overall return of the fund in which they invest.

Think about that for a moment. How can a group of investors that each invest, say, $50,000 in a managed fund on July 1 of a given financial year produce a combined return on June 30 a year later that is less than what the fund itself has delivered, after fees?

The only thing each would need to do achieve the returns of the fund is precisely…nothing. And that, of course, is the point. In investing, doing nothing is hard.

The research shows that an investor is more likely to withdraw from or add to a fund at the worst possible time. When common sense suggests that each investor should aim to buy cheaply and sell when things are expensive, Dalbar’s findings indicate investors tend to do the opposite.

The withdrawals take place after the fund suffers losses, which is to say those losses are crystalised. And when fund performance is strong after prices have risen, investors become over-confident and add to their investment.

This behaviour isn’t an expression of fundamental analysis of a company, or an economic analysis of the macroeconomic environment. Instead, it’s purely a psychological expression of raw human emotion, typically fear and greed, as represented in the image below:

It’s tempting to believe that investing is primarily an analytical exercise in understanding how a company makes money and whether it shares offer good value or not. There is some truth to this. Unfortunately, this truth is often overwhelmed by the natural emotions that define each stage of the market cycle.

In an analyst profile, Intelligent Investor founder, John Addis, was asked what he thought the source of most investors mistakes was. His answer wasn’t choosing bad investments:

“I suspect the source of most of our errors are a result of innate psychological… The fight against error is a constant battle with the evolutionary programming of our brains. We can only hope to mitigate its impact.”

This kind of thinking was first enunciated in Benjamin Graham’s famous 1949 book, The Intelligent Investor, where he introduced the character of Mr Market, who swings from obsessive optimism one day to paralysing pessimism the next.

In a sense, we are all our own versions of Mr Market, the aggregated emotions of which are show in the cycle of market emotions above.

The cycle explains why investors in a fund often fail to get the return of that fund and why bubbles inflate and then pop. It is also why people like Warren Buffett, who was taught by Ben Graham, became incredibly rich.

Whilst Graham and Buffett mastered the cycle of market emotions and turned it to their advantage, most investors still fall victim to it. Once you understand market psychology and lean to master your own impulses, you can profit from acting when others are too scared to do so, and do nothing when everyone else is jumping.

There are two traits that will serve you in reaching this elevated position above the crowd. The first is patience. Knowing when to do nothing, which is most of the time, will help you overcome the urge to act at precisely the wrong time.

The second – adopting a long term view – reinforces the first. Most investors measure their investment times frames in weeks and months, sometimes even days, when it should be years and years.

Measuring yours in years helps you look past the current chaos and will help you focus on the business in which you invest. Together, these traits can assist you in achieving greater returns then the crowd.