Steel resolve: A hands-off approach to investment gains


R. B. Matthews and Doug McCutcheon

In Ian McEwan’s recent novel, Machines Like Me, the main character buys an advanced robot that winds up competing with him for the affections of his girlfriend while also making a quick fortune by investing in the stock market. Yikes!

While the speed of the robot’s investment success may be unrealistic, there can be no doubt that an investor able to minimize human cognitive weaknesses will outperform over time.

Three related cognitive handicaps that we, as homo sapiens, all share are: difficulty in thinking in terms of probabilities, a tendency to focus on potential losses to the exclusion of possible gains and an overconfidence in our ability to predict the future.

Successful investing, like machine learning, is based on thinking in terms of probabilities – an activity that is not intuitive for us. Instead, we tend to think in binary, all-or-nothing terms.

In order to estimate the probability of a future outcome, you require a statistically significant sample of data. When investing, this means, at a minimum, examining the relevant facts over a long time period. Typically, we don’t do that. An oft-asked question is, “What did the stock market do today?”

Also, we allow the fear of a loss to trump the likelihood of a gain. This short-term loss aversion was helpful at earlier stages of our evolution, when loss often meant serious injury or death.

The problem is that biological evolution happens extremely slowly. Our minds are hardwired for life in a state of nature, whereas we now live in far different circumstances. In today’s world, we should understand that if someone offers us a coin toss for which a correct call would win us $100 and an incorrect call would cost us $50 (half as much), we should take the bet. Most people will not.

When someone says, “I’d rather be safe than sorry,” it strikes most of us as prudent. If we still lived on the savannah among lions, it would be. However, when it comes to investing capital over the long run, it is typically those who have chosen the perceived safety of cash or bonds who are ultimately sorry – or would be if they compared their return to that of the broad stock market.

Another of our human weaknesses is a stunning overconfidence in our ability to predict the future better than others. As the great Canadian-born economist J.K. Galbraith said, “There are two kinds of forecasters: those who don’t know and those who don’t know that they don’t know.” Most of us fall into the latter category.

When it comes to investing, this overconfidence causes otherwise intelligent people to think they can “time the market,” an activity that is guaranteed to lower your long-term return.

How do you avoid these cognitive weaknesses? Well, if you are a tax-paying individual and wish to do your own investing, here is a simple, but not necessarily easy, approach.

Set aside, in short-term cash equivalents such as GICs, a buffer account to cover your expenses for one to two years. Invest the balance of your capital in an ultralow-fee global stock index fund or ETF, one that represents all global markets, including the emerging economies.

And then leave your investments alone! As Warren Buffett has wisely said about investing, “Inactivity strikes us as intelligent behaviour.”

A combination of real economic growth, inflation and dividend payments will ensure that you will – over time – receive a safe and highly satisfactory return from global stocks. Inactivity is likely to improve your before-tax return and is extremely likely to improve your after-tax return.

However, not touching your investments will be difficult for most people.

It may assist you in staying the course to remember that the price assigned by the stock market to a group of companies will fluctuate around the growing economic value of those companies. The market price is also far more prone to short-term volatility than the economic value. So, more often than not, if the market price falls, your future percentage gain has increased.

This simple approach may not beat an advanced robot, but over time it should outperform most human investors.

Published in the Globe and Mail

 

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