Zen And The Market

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by: Eric Winig

Summary

Investors are their own worst enemies - buying high (greed!) and selling low (fear!).

Most approaches to "solve" this problem go out the window in periods of euphoria or crisis.

The best approach may be the most counterintuitive - to actively do nothing.

Zen, according to the website Zen-Buddhism, "is the experience of living from moment to moment, in the here and now." Investing, on the other hand, involves buying something today that will (hopefully!) be worth more tomorrow. Or, in the somewhat stilted language of Investopedia: investing is "the act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit."

In other words, Zen is about the present, while investing is about the future. What can one possibly have to do with the other?

As it turns out, quite a bit. In fact, I would argue the primary reason for most investors' underperformance - whether compared to the market or their own goals - is a lack of Zen. Most humans have a built-in fear of inertia, which causes them not only to act far more often than is necessary, but healthy.

According to research firm Dalbar, which has been studying investor behavior for nearly a quarter century, the average mutual fund investor has earned 4.67% a year over the past two decades, which doesn't sound too bad… until you compare it to the 8.19% annual return for the S&P 500. This is particularly shocking when you consider that everyone involved in this endeavor - from investors to analysts to portfolio managers - is, in theory at least, trying to beat the market.

But wait… it gets worse. If we assume our "average" investor had $100,000 at the beginning of 1996, he would now have $249,000. Not bad, but, due to the power of compounding, far below the $483,000 for the index. Or think of it this way: assuming an even distribution of returns (obviously not the case, but bear with me), the index was worth more after year 12… than the average investor's fund after year 20.

There are, of course, several reasons for this. Active managers charge higher fees than index funds, and tend to lag the market during strong bull markets such as we have experienced since 2009. But the biggest reason for the gap is the fact that most investors simply cannot help themselves from buying high and selling low. Much as we like to view ourselves as rational, thoughtful, profit-maximizing machines, we are more like the proverbial dog peacefully sniffing the yard until… SQUIRREL!!!

This has been especially true over the past couple of decades due to the violent swings in markets, which have made it even more difficult to take a hands-off approach. Few are those who could stay out of the late-90's bubble, buy in at the 2003 Iraq War bottom, sell during the 2006-07 real estate boom, and buy during the depths of the 2008-09 bust. Ironically (or perhaps not), platitudes such as "keep your head while all about you are losing theirs" or "buy when there's blood in the streets," or even Warren Buffett's famous "be greedy when others are fearful, and fearful when others are greedy" tend to be of little help when such scenarios actually arise.

So what can we do?

The crux of the matter is a disconnect between our "rational" brain - the person we think we are - and our so-called reptilian brain - the person we actually are. As eloquently explained by Jonathan Haidt - anticipating Daniel Kahneman's seminal book Thinking: Fast and Slow - the situation is analogous to a rider (the rational brain) on the back of an elephant (the reptilian brain). The rider feels in control, and most of the time can steer the elephant in one direction or another. But in periods of stress the elephant takes off running… and there's not much we can do.

This all sounds pretty hopeless! Still, before we throw in the towel, let's consider some potential workarounds.

One obvious approach is to invest passively (i.e. in an index fund). This is certainly the "in" thing to do, as evidenced by the massive amounts of money fleeing actively-managed funds for indexes. According to BofA Merrill Lynch, investors have pulled roughly $2 trillion from active funds over the past decade, with a similar amount going into passive funds.

However, even those who choose to index must make decisions - small-cap or large, developed markets or emerging, what about sector funds, etc. And, of course, owning an index fund doesn't solve the original problem; many indexers sold near the bottom in 2008-09, only to buy back in at higher levels.

Another method is to set up rules designed to prevent you from doing stupid things. You could, for example, only look at your brokerage statements every quarter (or even every year). Or commit to buying more stocks if the index falls some predetermined amount. Or impose a "waiting period" on any decision to see if it still seems wise a week/month/year later.

As you are likely thinking at this point (or if not… you should be!), all these strategies have a fatal flaw. Just as there are no atheists in foxholes, there are few long-term investors during a sustained market downdraft… and even fewer sellers in a bubble. So anything you commit to doing today, while the elephant is calm, is likely to go right out the window during the next stampede.

I witnessed this over and over during my 14-year career advising institutions and HNW investors. Indeed, one of the dirty little secrets of the investment world is that large investors - widely viewed as more intelligent, more thoughtful, and dare I say more "rational" than smaller individual investors - consistently make the exact same mistakes as the rest of us.

I, of course, am no different. While I am naturally predisposed to be a contrarian - e.g. when everyone is bullish, it makes me want to be bearish - this in no way lessens the hold emotions have over me. The only difference is I work hard to stay actively aware of this tendency, taking steps to mitigate it by seeking out those with different opinions, imposing mandatory waiting periods before implementing investment ideas, and forcing myself to argue the exact opposite position to the one I hold.

And, perhaps most important... actively seeking to do less.

Still, the underlying problem remains. In my next piece I will discuss more concrete methods for tackling this most thorny of investment (ahem) "conundrums"...

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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