Leave your emotions at the door

Emotions have a place in many areas of your life. They shouldn’t have a role in your investment activities. When you start investing, try leaving emotions and feelings at the door. Just like in sports, poker, meditation, surgery — you need to be able to control your emotions to perform well. You know the saying “master of yourself, master of the world.” Investing should be a calm and passive activity, with a clear goal — an investment mandate. Your online broker/bank account is not where you go to vent out your anger, to boost your ego, or to seek vengeance on the world.

In particular, try to always resist fear and greed. Never panic. It never helps. If markets are falling and all your portfolio is red (financial color for falling prices), do not panic. Assess the situation calmly, remember you are in this game for the next 15–50 years, and figure out what, if anything, you want to do.

On the other side, also resist greed. Every other day there is a fad in finance — as I am writing this, yesterday the US Senate held the hearing on GameStop, Reddit, and RobinHood. And bitcoin is at 50.000+, so my whatsapp is full of messages from friends asking me “do you think it will keep going up? Should I buy?”, and all media have at least an article about “the commodity supercycle.” As you see bitcoin rise from 5000 to 50000, as bankers and economists talk of a commodity supercycle and commodity prices have increase, as you hear of armies of retail traders making money on GameStop and other stocks, part of you naturally wonders if you shouldn’t jump in too and make an easy buck. Resist these urges. What assets you trade, and how you trade them, should always be part of your long term investment strategy. If you believe there is a commodity supercycle indeed for example, then research it, form a view, and dip your toes with caution. Remember the same people talking to you about a commodity supercycle today will probably explain to you next year why commodities are at “all time lows.”

Your first step to mastering your emotions?

Ignore noise:

If you are an investor, all the short term is noise. What happened today on the stock market, what happened this week, and even this month, is just noise. There is an entire industry of financial journalists, economists, fund managers, traders — every day is exceptional for them, every day something that wasn’t supposed to happen happened, and they always know exactly why. Let them be. Here are three tips to help you ignore noise, and control your emotions:

1. The best way to avoid noise is to not follow financial news. Sign up to a financial newsletter, Investopedia’s is great for example, and check the titles only — read more only if you see something relevant/interesting. Maybe flip through financial titles in your local newspaper, or the WSJ, or the Financial Times. It’s good to be financially literate. But this is a cherry on the cake action, not something investors need to do. This is just a high level filter for you to see if anything really crazy has happened, if one of your companies is in the news in a very good or very bad way etc. It’s just a sanity check to tell you if you need to look more closely into things or stay on autopilot.

2. Don’t check your portfolio more often than you need to. When you invest, you are in for the long term. The short term doesn’t matter to you. Neither in terms of what markets did, nor in terms of what your portfolio did. It doesn’t matter that 3 stocks are 2% up today in your portfolio and 5 stocks are 1% down, and tomorrow 4 will be up and 4 will be down. I don’t check my investment portfolio more often than monthly, but probably l don’t check it in average for longer than that. This will also avoid you from fear and greed, the downfall of many an investor.

3. Avoid or resist gamification. Use whatever app or website you like best for investing. But if you use one of these apps full of gamification tricks — balloons on your screen when you do a trade for example — do your best to ignore, to block them out from your mind. These gimmicks are there to play on, and with, your emotions. The balloons really celebrate the app making money off you, not you making money. You can be happy for your app owners — founders and venture capitalists — but you’re investing for yourself. The balloons for you come later.

Are you ready to step it up though, and build a system that makes sure your investments will be driven by reason not emotion? This is perhaps one of my favorite parts of this entire program. Here we go.

Rules based investment

Quite simply, rules based investing is any rules-based investment system. These rules can be created by you in a Word document or an Excel, by mathematicians / statisticians, or by machines themselves (all are equally good — it is the principle that matters. What is important is simply that such a system follows clear rules, no matter how simple or complicated. These rules can change over time, but in a clear way. And when you change your rules based investment system, you change the rules it follows, rather than interfering with the decisions of the system: you change the input, in a conscious decision, and not mess around with the system’s outputs. You can change what goes into the system (the rules that create it), but not what comes out of the system (the result of those rules). The rules in our investment systems are there to protect us from ourselves, from our human nature. Let me tell you why this is important.

In the late 1960s, psychologists from the University of Washington in the United States, conducted studies with medical radiologists from the University of UCLA in Los Angeles (both are major academic centers in the United States). The study consisted of computer programs reading X-ray images following extremely simple rules, which were taught (coded) by the doctors themselves, and comparing the results with the readings made by the specialist doctors themselves. At the end of the study, the psychologists were shocked to find that their simple system, based on rules taught by the doctors themselves, performed better than the specialist doctors. It didn’t make sense, the doctors themselves having “taught” the system they were being compared to. The psychologists therefore redid the study, but this time they introduced changes, such as giving the same image twice to the specialist doctors. Once again, the simple rules-based system outperformed the doctors. However, this time the psychologists also found that doctors contradicted themselves and their own past readings, when presented with the same image twice, and sometimes drastically.

And this has been the most important lesson of this study. Rules-based systems were not “smarter” than men / women. On the contrary, they had been “taught” by these. They were just perfectly consistent through their “work”, whereas humans were not, and never will be.

In 2012, the famous German magazine Der Spiegel interviewed Daniel Kahneman. Daniel Kahneman received a Nobel Prize in economics, being the first person to receive it for advances in behavioral economics. His Nobel Prize was therefore a recognition of the importance of behavioral psychology in economics and finance. Der Spiegel asked him a question on the topic of rules based models versus experts. Here was Kahneman’s response:

“In financial markets, the predictions of experts are virtually worthless.”

We saw in a previous post why investment forecasting is difficult, and therefore why expertise in this area should be taken with a pinch of salt. However, there is another problem facing investors. And this is not related to the nature of markets, but to human nature. I’m talking about one of the favorite themes that Kahneman and his longtime collaborator Amos Tversky studied: human biases of course. However, although Tversky and Kahneman have studied financial experts in detail (compared to rules based models, once again), I will defer here to James Montier. Montier is an expert in behavioral economics specifically, and he has spent most of his career working in finance. For many years now, he has worked with GMO, one of the largest asset management firms in the world. And, having studied behavioral psychology in relation to investing all his life, he wrote a book that I highly recommend. He refers to more than a dozen biases in the human brain, which we all exhibit, and which influence our investments in a negative way. Insofar as investing is concerned, humans exhibit the following biases/problems:

hard wired for the short term

hard wired to herd

self control is a limited resource

hot cold empathy gaps

anchoring

endowment effect

personal experience

overoptimism

overconfidence

illusion of knowledge

illusion of control Groupthink

Whether you are a professional or an individual, these biases are linked to the human brain and we all have them. Do you want to know what this actually leads to? I’ll give you a one-sentence answer: over a 30-year period to 2016, the average US equity investor gained 4% per year, while the US stock market (S&P 500) gained 10% on average. Dunbar, the consulting firm that has been doing this annual survey for more than 25 years now, attributes this poor performance by stock investors versus the stock market itself, primarily to human psychology. Human behavioral psychology. We humans are hard wired to be bad investors. The following steps are meant to help us establish a rules based system, in order to become good at something at which we are naturally bad, and to accomplish our investing objectives.

How to establish a rules based system

Have a goal

There are two ways to set an objective:

1. Top down: this is where you start from the top, in this case your end goal, and you work your way to the bottom, or all the small actions needed to get there. You work your way from the top of the pyramid to the bottom effectively. For example this could be “I intend to retire at 65. I have a state pension of 1500USD per month. And I want to complement this with a pool of savings that will allow me to have another 1000USD per month, so that my income in retirement is 2500USD per month.” This then allows you to walk backwards and calculate how much you need to save/invest each month in order to be able to achieve your objectives.

2. Bottom up: this type of analysis is more simple. You start from the bottom up, so from the small actions today, and you work your way towards what this will allow you to achieve. This is what I advise you to start with today. Here we are most of all trying to start, to not find excuses. No paralysis by analysis as it’s called. So we’ll take the most simple route. What do I mean? Easy. How much can you/do you want to? 100USD per month? 15% of your family’s income? You tell me what it is. There is no too little here — all that matters is that you start.

Implement an investment mandate towards that goal

Every professional fund manager has an investment mandate. This is a well defined, explicit, document, that defines what the fund manager is allowed to do (and implicitly what he/she is not allowed to do). For example it will stipulate that this fund manager can only invest in US stocks, or only in Japanese bonds, or only in oil and natural gas. It will stipulate this fund manager is not allowed to invest in anything outside of this asset class (equities or bonds or commodities), and this geography (North America, Europe, India).

Each one of us should have such an investment mandate for ourselves. For most of us it will be a mix of stocks in our home market (whichever country you live in), major developed markets stocks (US, Europe…), bonds, and maybe commodities.

Here is my own example:

I invest mostly in equities, almost all public with a bit of private companies too.

I invest in large caps (large companies) in the US and Europe, Japan, Hong Kong and Australia.

I invest through passive, low cost, stock ETFs.

I invest in options on US and European equities.

I invest in commodities like gold and oil.

I don’t invest in small and medium companies at the moment, and don’t invest in many emerging markets as I don’t have the expertise for it (Pakistan, Vietnam — interesting markets but I don’t know much about them).

In the private assets space I make direct investments (angel investments in private companies).

I don’t invest in active funds such as private equity firms, hedge funds, VC firms — I don’t have the capital nor the access to invest personally in the best ones.

I don’t invest in currencies/FX.

You could start with “I will invest in low cost, diversified, developed stock markets ETFs, maybe a few companies I follow like Apple and Microsoft, and safe, government bonds from the most solid governments/countries on the planet.”

Stick to your mandate

Now that you have an investment mandate, comes the hard part: sticking to your investment mandate. The reason the investment mandate is so important in investment management is because it allows you to make sure the fund managers you invest in/with, stick to what they know, are good at, and you contracted them to do. The same should apply to ourselves: we are investing in ourselves, we are investing our own money, so we should make sure we will stick to what we know, are good at, and what we set ourselves to do.

Let’s say here that retired you, is now contracting young you, to make his/her life better, and he/she wants to make sure you wont fuck it up for him/her.

Why am I emphasizing this? Because you will start investing. And in your first week you will read in the news that “bitcoin is reaching all time highs.” Or that “due to Robinhood traders option volume is at an all time high.” Or that “a genius 16 year old girl in Los Angeles tripled her money last year.” And of course, plenty of people on Youtube will try to show you their Forex trading system. The reason you have an investment mandate is to help you avoid the syrens of all the things that you’re not good at or decided not to do.

Can you change your investment mandate? Of course. But with care and caution, and in a reasoned manner. You think about it, you make a decision, you update your investment mandate, and then you jump in. Not before and not randomly because of what you read in the news or hear from friends.

Risk management

Just like every investment manager has an investment mandate, he also has a risk management policy. Most firms have a risk manager, or team, whose job is to monitor the implementation and respect of this risk management policy.

What is a risk management policy? Simple, it is a small document where you codify your risk limits. Within your investment mandate, how far can you go basically. For you it will be quite simple, probably a maximal position size as a percentage of your portfolio, and a maximal loss per position.

For example:

No single position in my portfolio will represent more than 15% of my total portfolio. It doesn’t matter how much I like a company, or how bullish I am on the American stock market, I will not take the risk of having a single position be too important in my total portfolio. This way if a position goes really bad, it will not take down my entire portfolio.

The most important risk management rule you will ever learn as an investor

Nassim Taleb is one of the smartest investors/traders, and professors of statistics, in the world. And in his wonderful writings about investing and life, he preaches a cardinal rule that applies as much in investing as in life: never risk more than you can afford to lose. Take calculated risks, with what you know you can lose if the worst possible scenario happens to your investments. Never take terminal risk, where if the worst outcome realizes, you are done for good.

You know how you read of tragic stories, in which people lost all their life savings on one very risky investment, or maybe a poor youngster took his own life after trading some very risky instrument (an option or futures or a crypto currency typically), and ending up owing hundreds of thousands of dollars or even millions in debt? This what I mean by risking more than you can afford to lose. Whatever happens in your investment portfolio, the worst possible scenario, all your investments go to 0 –it shouldn’t be a loss than you cannot afford. It is ok if it’s a big loss, you will bounce back. But it shouldn’t be so important that it wipes you out forever (personal bankruptcy, unbearable indebtness to pay back your losses etc.)

As a little side note, this is what happened to Chris Sacca, one of the most famous investors in Silicon Valley, best known for the cowboy outfits he likes wearing. Chris managed what many think is the most successful venture capital firm ever created lowercase capital, and was an early investor in Twitter, Uber and Instagram. However what most people don’t know is that Chris was an avid trader in college, trading on margin (he was borrowing money from his broker for his trading activities). When the dotcom crash happened, he ended up 4 million US dollars in debt, as a student. It took him most of his 20s to pay back this debt. And while he got back on his feet, many others never bounce back. As Chris himself lectures all around the world, this is the type of risk you should not take.