We have spent the past few weeks discussing the need to have a rules-based process in place that helps take the emotion out of investing when markets appear to disconnect from what we perceive as reality. This “perception” issue has long been studied within the field of behavioral finance and psychology. Humans are by nature risk adverse and will choose to forgo an opportunity to avoid a perceived risk. Humans also tend to perceive things to be as they think they should be. We find what we are looking for and ignore the rest. In this way, a person’s perception very much becomes their reality. These two human characteristics may have evolutionary benefits, but together they work to the detriment of many investors (professional and amateur alike).
I had a call with a client today to discuss investing more of his funds in one of our portfolios. This client is extremely smart, experienced, self-made, and wealthy. He watches the market closely and pays attention to economic data. Moreover, he has been with Cabana for some time and knows our process. By all accounts, this client has all the tools he needs to be a successful investor. There is just one problem right now. He cannot believe the market will keep going higher in the face of dire economic conditions. He “perceives” that the market is currently flawed and will inevitably collapse. He has the data to back up that perception. As we discussed his thoughts and the best way forward, it occurred to me that his perception had become more than a perception. It had become his reality. When something becomes reality for a person, it is very scary to act in opposition to that reality.
I often use the example of flying in an airplane. This is a subject that is near and dear to me. Those who know me know I don’t like to fly. I will avoid it at all costs, and it causes me days of great stress leading up to those flights that I simply must take. My perception is that flying is incredibly dangerous and something that I have no control over once I get on the plane. I perceive that traveling at more than 400 miles per hour is horrifically dangerous, not to mention doing so at 35,000 feet in the air. No one can dispute that moving at speeds of hundreds of miles an hour is exponentially more dangerous than traveling at 20 miles an hour. The same can be said of being thousands of feet off the ground. That is certainly more dangerous than keeping my feet safely planted on earth. I have carefully considered all this, and this has become my “reality”. The problem with my reality is that it only considers part of the picture. To make matters worse, it only considers the part of the picture that fits my preconceived expectations. The truth is that flying is one of the safest things that we can do. The data that I have relied on in developing my reality, is one of but a few data points that make up the much larger data set, which accurately describes the aerodynamics involved in flying. By focusing on those things that I expect to be true and that fit my narrow perception of reality, I have created my own false reality. In doing so, I have made my life more difficult than it should be. I have not enjoyed vacations to the fullest. I have forgone business opportunities. The list goes on. We can all relate to some degree to what I am describing. We all do it at various times and in various circumstances. My client is now doing it with investing. His reality is preventing him from acting objectively and continuing to invest capital into an investment process that he understands and can stick to. He knows that the key to long-term success is staying invested and compounding returns, but his new reality is in his way. He has become his own worst enemy.
This is a common problem with investors, and it is one area where a trusted advisor can help. He or she can walk through what is reality and what is perceived reality. Sometimes they overlap. It is never black and white, and that is ok. What is important is that we as advisors acknowledge what our clients are experiencing and work together to overcome it. This comes down to listening and communication. It is what separates good advisors from great advisors.
There is a very simple maxim in the investment world that perfectly summarizes the above described phenomenon and the appropriate response. The maxim is, don’t fight the tape! What that means is do not let your own perception of how things should be cause you to ignore the reality that is going on around you. Having a rules-based system does just that—and that my friends is why you must have one.
A PDF of this week’s commentary is available at the following link: