Sure, things started off rough in 2008/9, there was the odd squall in 2011 and there have often been storm clouds on the horizon.
But, for the most part, there has been a tailwind, no turbulence and the Captain has been able to turn on the automatic pilot, enjoy the inflight meal and flirt with the cabin crew.
2014 has been another year of strong investment returns. This won’t last forever. But even when the inevitable bear market appears, if we have a robust investment process, we can keep doing the right things.
In investing you can never directly control the results – the market dictates those – you can only control your own actions. That’s why its important to have an investment process to help embed the behaviours that help us buy low, hold for the long term and (eventually) sell high.
I used to think investing was exciting. And, unfortunately, the way I did it in my twenties was exciting. I dabbled in Internet shares, mining shares, biotech shares, leveraged property shares. Many new investors go through this “lottery ticket” stock phase. If they are lucky, they get through it without losing too much money.
We all have to go through a learning period when investing. My early stockpicking experiences taught me how much I didn’t know.On the other side, lies self awareness and a knowledge of our own limitations.
The thrill of profits and, even more, the sting of losses prompted me to learn, experiment and improve my investing process. Part of my investing process is to have simple “filters” (e.g. only buy shares that pay dividends). In my active investing, I use these and other quality filters to narrow down my “investable universe” to a manageable number of shares that I can understand.
A good investment process should be steady and a bit dull, like an automatic pilot flying a jumbo jet. A jumbo jet is basically a flying bomb – a metal tube full of explosive fuel and people being propelled through the air at 600 miles an hour. There is already more than enough risk and complexity to make it interesting. The journey does not need to be livened up by the pilot looping the loop along the way.
The emotional mind set of the investor is key to good investing. The same goes for flying. Personally, I never get on a plane where I see the Captain do any of the following:
- whooping or high fiving the passengers or other crew
- crossing themselves
- sniffing white powder through a rolled up banknote
In my investing, I aim to minimise the amount of excitement and activity in my portfolio. I try to eliminate fear, hope and wishful thinking from my process and replace emotions with rationality and equanimity. When investing, you need to embrace your inner airline pilot.
Try this thought experiment. Imagine you are a passenger on a commercial airline. What does your ideal pilot look like? You can understand a lot about investment process by visualising this. They will not be very young – you want experience and wisdom. They may have hair flecked with silver. They will be sober. They will have got plenty of sleep the night before. They will speak calmly and logically in a way that indicates intelligence, composure and experience. They will make quick decisions when they have to but will try to avoid flying by the seat of their pants. Mostly they bypass problems by anticipating and avoiding them.
Most of the time the ideal airline pilot does nothing at all. They remain alert and thoughtful. They let the automatic pilot or the co-pilot fly the plane and are ready for the (very small) minority of situations where manual overide is required.
Over the years, the more I have learned about investing, the simpler it has became. Part of this is simply tuning out the noise. When I commuted into work in the City each day, I was surrounded by a cacophony of investment misinformation. From the active fund billboards at my local station to the Sky News on the TV in the office, I was surrounded by a tsunami of misinformation about how complex and scary investing is.
Living in the Prison Camp, we often get stressed by work, commuting and the background noise of consumer society. A big part of good investing is just managing to tune out the noise. It’s no accident that Warren Buffett bases himself in a quiet office in Omaha and not on a trading floor on Wall Street.
The financial media is full of the stunts, crashes and bodycounts of the investing world. Sensible investors ignore this, as do pilots. If the pilot wants to know what is going on in the world, they look out the window (direct observation) or at the instrumentation (primary sources) or they listen to air traffic control (unbiased external sources of reliable information).
Its so important not to let your investments be dictated by what you read about in the media. This will lead you to buy high and sell low. If you are human (I’m assuming that most of the readers of this site are) then resisting the pressures of the media is really, really difficult.
I think the hardest part of investing is resisting the urge to bail out of an under-performing stock (or index). Our brain processes investment losses like a snake bite: our natural reactions tell us to run away from things that have hurt us. If you see everyone else around you running away at the same time, the urge to sell regardless of price becomes almost irresistible.
If you pay attention to the financial media, you are making it even harder for yourself. The hardest thing to do is hold BP after the news of the Macondo oil spill is everywhere. In these situations, journalists are as likely to write balanced articles as a piranha is when there is blood in the water and a feeding frenzy in progress. At this point, when the share price has already tanked, sometimes the best thing to do is nothing. Keep Calm and Carry On.
Start by programming the automatic pilot with the destination. In investing terms, this includes your target asset allocation (how your portfolio is split between shares, property, bonds etc).
Your asset allocation is an aide to steering the “plane”. Market fluctuations are like turbulence in the atmosphere. They are a normal part of investing, not something to be surprised by. They can blow you off course, but an asset allocation target helps you steer back towards your investment destination.
As you proceed on your investment journey, make a series of small adjustments to stay on track just as a pilot makes gradual adjustments to direction, altitude and speed. In investing, this process of adjustment is done by redirecting new savings and periodic rebalancing. I recommend paying yourself first: use a direct debit to deduct as much as you can straight after your salary is paid and invest this consistent with your asset allocation.
Comparing your target asset allocation with your actual current asset allocation provides a guide where to invest new savings and automatically embeds a tendency to buy low and sell high. For example, when equity markets have been strong and we exceed our target % in shares, we can direct new savings to the bond element of the portfolio. Decision made automatically.
Economy of action is important to minimise costs. A good pilot flies smoothly and reduces fuel costs. Similarly a good investor avoids overtrading and reduces transaction costs. So part of my investment process is sticking to a minimum transaction size.
Over recent years I’ve reduced churn in my active portfolio. In 2012, I bought 14 new stocks, 11 in 2013 and just 3 in 2014. One of the ways I reduce activity is a rule that says never buy a share without a cooling off period – I always let 48 hours pass between completing my research on a stock and pulling the trigger. Similarly, I never buy or sell anything if I am tired, hungover or stressed.
Pilots need to know a bit about weather patterns and some basic geography. But they don’t need to be weather forecasters. They do not need to predict the rate of cloud formation, precipitation and wind currents based on the accumulation of ions in the stratosphere or whatever.
Pilots deal with the reality in front of them. If the pilot needed to successfully forecast the weather in order to get safely to the destination, then most people would (sensibly) never get on the plane. These people inherently know that long range weather forecasts are useless. So why do the same people read financial media and then invest based on forecasts of future GDP or interest rates or other macro data?
The pilot analogy even works for the active versus passive debate. A Vanguard index fund is like catching a scheduled flight on a Boeing 747 guided by autopilot – its a cost effective and rational choice. A bit boring, but you’ll get to the destination safely. Picking individual stocks is more like flying your own private jet – it looks more glamorous and can be fun but it’s probably more dangerous.