Investing By Process, Not By Emotion

What process do you use to manage your investments? 

Research shows that investors who follow a process do significantly better than those who make decisions based on emotion or other subjective criteria.

 

Every year Standard and Poor’s (S&P) studies the performance of investment managers. Consistently, very few investment managers do better than the market index. Only 19.6% of Canadian equity funds outperformed the index over past 5 years, while only 5.1% of US equity funds outperformed the index over the same period. Most people’s investments are underperforming.

 

Even more surprising is that the average investor underperforms the investment funds they own by a significant margin. Yes, they actually do worse than the funds they own because of emotional investing decisions such as buying and selling at the wrong times. According to Morningstar Research, investment funds in the US delivered on average 7.30% annualized over the 10-year period ending Dec 31, 2013. Over the same 10 years, individual fund investors experienced a 4.81% annualized return (see chart below). 

This means that investors experienced a return that was 2.5% per year below the average fund. Over 10 years, this adds up to a 42.3% difference between the returns of investors and investment funds.  

Here are two common examples of investors making poor decisions based on emotion, rather than a defined process. 

 

Example 1: Selling When the Market is Down

In 2008 and 2009, investors could have seen their portfolios fall 50% or more. History shows that many investors sold out at or near the bottom of the market, likely because they could not handle the emotional challenge of the losses they were experiencing. While a portfolio should have good downside protection measures in place, there will always be times when your portfolio goes the opposite direction you want it to. These times, provided you hold quality investments, are not the time to sell. This is the time to hold your nerve, and perhaps even put more money into your investments. Those who held their nerve in 2009 saw the Canadian stock market (TSX) rise by 93.3% and the US market (S&P500) rise by 204.3% from the low of March 2009 to the end of 2014 (source: Quotestream Professional).  

Example 2: Over-Allocating to “Hot” Investments

While the first example is a decision based on fear, the second example is based on greed. When individuals see an investment doing well, or the promise of a particular investment to excel, they are tempted to allocate too much of their portfolio to it (and often at the wrong times). In the 1990s technology stocks were flying high. Many individual investors allocated too much of their portfolios to this sector, and many borrowed money to put into the market. This emotional decision led to disastrous results for many individuals and families when the tech bubble burst in 2000. Decide on an asset allocation that makes sense for you and your goals, and then stick with your strategy. Resist temptation to over-allocate to high-growth investments. 

Follow a Disciplined Process

 
 

At Tycuda Group we believe in the importance of following a disciplined process. We do not select investments based on gut feel, what is popular or what has the most marketing dollars behind it.

 

Instead, we rigorously analyze every security in the marketplace according to specific criteria. We look for an investment or investment manager’s ability to generate higher returns, with a lower amount of risk, and with shorter recovery cycles. If an investment does not meet our strict criteria, it is not included in our strategies.  Ultimately, the investments that do make it into our portfolios are ones we have very high conviction in.

 

Once we understand our clients’ goals and circumstances, we often combine a blend of our strategies into an overall portfolio for each client. This is based on meeting each client’s goals, with the most appropriate amount of risk. If a client requires a specific level of returns to reach their retirement goals, we do not need to assume unnecessary risk by aiming for higher returns. Once again, we based this on process and discipline, not on emotion.

Stick With the Process

 
 

Once we embark on the journey of investing, there are opportunities to stick with the process or give in to emotions. When markets pullback, as long as the investment is sound and appropriate for a client’s goals, we will advise strongly to stay the course. In many cases we’d recommend clients add more money to the investment. Sticking with the plan in these times is what keeps investors from underperforming their own investments and sets them up for greater success.

 

Do you have a defined process for managing your investments? There is no time like today to take the necessary steps to ensure you have one in place.

 

Feel free to reach out to us at www.tycuda.com to chat about our investment process, or any subject raised in this blog.