The Single Greatest Factor In Your Portfolio's Returns

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Includes: AAPL, AMZN, BRK.A, BRK.B, BYND, FB, GOOG, GOOGL, MTCH, NFLX, QQQ, SPY, VOO, WORK
by: App Economy Insights
Summary

While human emotions serve to protect us in many ways, they also can lead to poor investment decisions.

Without a clear investment framework that's sustainable and repeatable, a few bad decisions over a lifetime can annihilate all your returns.

Most investors spend an absurd amount of time picking investments, but forget to clearly identify their risk profile and strategy.

More than asset allocation or intellect, your temperament is the greatest factor in your portfolio's returns over time.

I illustrate some of the most common behavioral finance biases that can affect negatively your temperament and offer strategies to counter them.

We are all, to a certain extent, portfolio managers.

Whether you do it yourself or someone else handles it on your behalf, your portfolio of public equities is the result of thousands of decisions over a lifetime. Your returns are shaped by your time horizon, asset allocation, style, geography, size, sector, company selection and more.

But the single greatest factor that will determine your portfolio's returns is no other than your temperament.

Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.

This quote attributed to Warren Buffett sums up the importance of behavioral finance, an aspect often overlooked by investors.

We take pride in deep research or detailed valuation methods, but they can be rendered completely useless with the wrong temperament. There's no amount of reading and self help that can sufficiently address our flaws as human beings.

Even with the best intentions in mind, investors eventually make mistakes that can make their portfolio returns vanish. They come across the idea of a lifetime and decide to bet the farm on it. They anecdotally invest in companies just because a coworker mentioned it at the water cooler. They sell 50% of their stock portfolio because talking heads on CNBC suggested that a downturn is coming soon.

Make no mistake, this article is about optimizing your temperament, not about risk avoidance and capital preservation. This is Seeking Alpha after all. We are trying to beat Vanguard (VOO) and the S&P 500 (SPY) here.

Those who stay away from equities for large parts of their lives or over-diversify with portfolios filled with dozens of the latest fancy ETFs also are seeing their returns damaged dramatically by their conservative disposition. Risk-averse investors often don't realize that Warren Buffett has 65% of his equity portfolio at Berkshire Hathaway (BRK.A) (BRK.B) in his top five holdings. They think they are taking too much company risk as soon as a stock reaches 5% of their portfolio. Yet, many are willing to take a 30-year mortgage to buy a single family home with a down payment that represents the vast majority of their net worth.

How can we optimize the greatest factor in our portfolio's success?

Let's review the most common biases that mess with your temperament. And let's learn how to counter them effectively.

Temperament, portfolio, returns, stock, single greatest factor portfolio returns

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Overconfidence and the illusion of control

What is it?

Most market analysts consider themselves to have above average analytical skills. A survey conducted by James Montier found that 74% of fund managers believed that they were above average at investing. Statistically impossible, but enlightening nonetheless.

As perfectly summed up by Ray Dalio in his book Principles:

From my earlier failures, I knew that no matter how confident I was in making any one bet I could still be wrong — and that proper diversification was the key to reducing risks without reducing returns.

CNBC's Jim Cramer likes to call diversification the "only free lunch in investing." No matter how sure you are about an investment, you could still be wrong.

And don't forget that being too early can be just as bad as being wrong. Particularly if you use options or have a short-term mindset.

  • How many billions have been lost over the last 20 years by traders betting on the fact that Apple (AAPL) would go up tomorrow based on the last iPhone shipments estimates? You might as well go to the casino and bet on black or red at the roulette table.
  • How many VCs have bet on startups developing tools for Google (GOOG) (GOOGL) glass in 2014? It sure sounded like a good idea back then.
  • How many billions have been lost by short sellers betting against Netflix (NFLX) over the past decade? They were all so sure of their judgment.
  • How many investors have stayed away from technology as a sector ever since the dotcom bubble burst 20 years ago?

Dunning Kruger Effect Overconfidence portfolio returns

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How to counter overconfidence?

The best way to temper your overconfidence without compromising your long-term returns is to limit your exposure to an investment on a cost basis. For example: No more than 10% of your total funds added to a portfolio can be allocated to a single company.

If your investment moves on to become a 10 or a 20 bagger, congratulations! And if it eventually vanishes, it's not the end of the world.

As long as you clearly define what should be your maximum exposure to a single investment on a cost basis as a general framework for your portfolio, your long-term performance won't suffer from your overconfidence.

Another very important aspect is to strive for intelligent diversification by spreading your investments across uncorrelated assets.

Counter overconfidence portfolio returns

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Finally, let your portfolio concentrate for you. If your top three investments become more than 50% of your portfolio, they got there themselves, not because you blindly invested in them in an unreasonable way. Keep track of your cost basis based on all funds added to your portfolio and try to maintain the cost allocation of every single individual stock of your portfolio below a threshold that you feel comfortable with.

Let the current concentration of your portfolio be a result of its sheer performance, not a result of your firm convictions.

If you follow this premise, you will let the few investments that are over performing take a bigger piece of your portfolio over time. Your winners will slowly overtake your portfolio.

We are all subject to "wishful thinking," where we make the mistake of believing that an outcome is more probable simply because that’s the outcome we want. By limiting your exposure to a company on a cost basis, you won't be throwing good money after bad endlessly and you won't bet the farm on something that could turn into a dumpster fire for reasons that are beyond your control.

On average, people believe they have more control than they really do. They are too optimistic about their timing, when in reality, a stock doesn't know you own it, and the market doesn't care about your feelings and needs.

Let your portfolio do the concentration job for you and keep your excitement in check with a simple cost-basis rule.

Self attribution and hindsight bias

What is it?

As investors, we all have a tendency to attribute good outcomes to our skill and bad outcomes to sheer luck.

We choose how to explain the cause of an outcome based on what makes us look best. This type of bias limits our ability to learn from our mistakes.

Maybe you thought "I knew it all along!" Maybe after the dotcom bubble of the late 1990s, when the Nasdaq 100 (QQQ) fell 78% from its high in a matter of two years. The Great Recession in 2008. We tell ourselves that we "saw things coming."

Hindsight bias can be very damaging over time since it can:

  • Prevent us from learning from experience (I did nothing wrong!).
  • Cause us to wrongly assign blame (I couldn't have known!).
  • Cause us to judge others too harshly (they only have themselves to blame!).
  • Cause us to be overconfident (perceived vs. real performance).

Image result for hindsight bias calvin hobbes

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How to counter self attribution and hindsight bias?

One of the most effective ways to offset these natural biases is documenting the reasoning behind your investment decisions and keeping score.

This will make you recognize you made a bad decision when a flaw appears in your reasoning later on. This also will empower you to sell when your bullish thesis has changed - or to hold when the thesis still looks intact.

Keeping an investment log or trading journal is the easiest way. I personally use free apps like Google Keep and Google Sheet that sync between all my devices (desktop and mobile). This can help you identify a pattern, not only with what you're doing wrong, but also with what you're doing right.

Confirmation bias

What is it?

People tend to pay close attention to information that confirms their belief and ignore information that contradicts it. We form our opinion first, and then spend the rest of the day looking for information that confirms our position.

We all like to listen to people who agree with us simply because it feels good to hear our opinions reflected back to us. We might even intentionally avoid news that may indicate a contrarian viewpoint.

Confirmation bias portfolio returns single factor

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How to counter confirmation bias?

An easy way to overcome this is to multiply your information sources. Have you found a newsletter or an analyst you love? Maybe cross-reference with another website. Read what several reliable sources you like have to say about any given investment before pulling the trigger.

Let's say a new article on Seeking Alpha is suggesting that company XYZ is a "conviction buy" and you are convinced. What about reading a short thesis from another author before you buy? Seek opinions that are the opposite of where you stand to see if your thesis still holds water.

There's no fast track to build a structured, well rounded opinion. The only viable path will often remain to read voraciously from a wide range of authors and build your own wall of knowledge one brick at a time.

The Narrative Fallacy

What is it?

Everybody loves a good story. Look at Slack Technologies (WORK), a company promising to replace email as the dominant workplace communication tool. Or Beyond Meat (BYND), a pure play in healthy food offering meat alternatives. Only time will tell if they are good or bad investments, but they are great stories. That probably explains why they had an amazing market reaction when their shares started trading.

We are all prone to be drawn toward investments that have a great story to tell. Stories are inspiring, easy to remember. They can take over our rational mind and we abandon all evidence-based research in their favor.

Narrative fallacy portfolio returns

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How to counter the narrative fallacy?

Once again, keeping an investment log will prove to be helpful here. Focus on the facts and the knowable. Do you see a trend or a pattern that confirms the story? Or is it simply window dressing? Read the quarterly (10-Q) or annual reports (10-K) of your biggest holdings, listen to the earnings calls to hear management and understand the facts for yourself.

You want to judge things as they are statistically or logically, rather than as they merely appear.

Representative Heuristics

What is it?

Heuristics are simple rules we all use when making judgments. Call them "shortcuts," to make decision-making easier.

People frequently make the mistake of believing that two events are more closely correlated than they actually are.

Let's use examples:

  • We assume that earnings beats will happen again if they did in the past.
  • We see patterns in truly random sequences of data, like a throw of dice.
  • We assume that if the product is good, we should invest in the company.

A great example is the gambler's fallacy. We mistakenly believe that, if something happens more frequently than normal during a given period, it will happen less frequently in the future (or vice versa).

As a basketball fan, I have come across the concept of the "hot hand," whereby a shooter is allegedly more likely to score if their previous attempts were successful. We believe the streak is likely to continue and has to do with something other than pure probability. Because humans are so stubborn when it comes to accepting this fact, casinos around the world make a lot of money.

Gambling fallacy portfolio returns

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How to counter the representative heuristics?

Here again, a simple investment diary can do the trick. No matter what rationale you come up with to invest, you'll have to write it down to convince yourself, and you'll be able to learn from your mistake if your decision lacked exhaustive research.

Framing bias

What is it?

Similar to the way we love good stories, we are subject to change our outlook of an investment simply based on how the facts are presented to us.

People are usually familiar with the concept of a glass half-full or half-empty.

Financial media is filled with equity research that present a quarter as bad or good depending on how they want to spin the news.

For example, you'll read regularly headline saying that a company "beats on revenue but missed on earnings," but that's only a tiny aspect of the earnings report. Expectations set by a few analysts can be already baked in a stock price or overlooked because of negative rumors.

Framing bias portfolio returns

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How to counter framing bias?

What matters most is your capacity to demonstrate second-level thinking.

I recently read the book The Most Important Thing, in which Howard Marks explains the concept of second-level thinking:

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.” Second-level thinking is deep, complex and convoluted.

First-level thinking is fast and easy.

It's usually something easy that only solves the immediate problem without considering the consequences. Reasoning such as:

  • "I’m hungry so let’s eat some ice cream."
  • "I expect the company to beat on revenue, therefore the stock will go up."

Second-level thinking is more deliberate.

You have to think in terms of interactions and time, understanding that despite your best intentions, your decisions can lead to a worse outcome.

Second-level thinkers think about the consequences of repeatedly eating ice cream and are more likely to eat something healthy. They see that a company is expected to beat on revenue for the quarter, but that guidance will be lower for the full year due to a future project being cancelled.

The easiest way to achieve second-level thinking is to always ask yourself “and then what?”

Think through time and the consequences of your decision in 10 minutes, 10 months or 10 years. Describe the things that need to go well in your bullish thesis over the short, medium and long term. Calibrate your thinking with the very long term in mind. Guidance has just been lowered for the full year? The CFO is leaving the company? You have to ask yourself:

  • Does this impact the potential of the company?
  • Does this change my bullish thesis about the business and the total addressable market?
  • How will employees deal with this?
  • What will competitors likely do?
  • How will suppliers react?
  • What will regulators do?

Often the answer will be little to no impact, but you want to understand the immediate and second-level consequences before you make a decision.

It's incredibly important for you to be critical of any news you read about an investment you own.

Let's go through an example.

Back in May 2018, Facebook (FB) announced that they would be adding a dating feature. As a result, shares of Match Group (MTCH), the leader in online dating via popular apps like Tinder or Hinge, saw its shares fall more than 26%.

Chart Data by YCharts

At the time, I posted on Seeking Alpha a review of the impact to Match Group's long-term potential following a series of "and then what?" questioning:

  • Match Group already has a network effect with millions of paying subscribers unlikely to migrate to another service.
  • Online daters often use multiple services at the same time: Both Match Group and Facebook could coexist and serve a different purpose and audience.
  • People enjoy Tinder Plus and Tinder Gold subscription features. For example, the premium service allows users to “superlike,” to “swipe” on people outside of their city or country, and even let's its users know who has liked them. Unique features such as these would be nearly impossible to offer to users for free, because what makes them special is their exclusivity. A dating layer on Facebook would lack these features, which are important to Tinder’s paying subscribers.

As a result, I was presenting what appeared to be bad news for the company as a long-term buying opportunity. Since that day, shares of MTCH have appreciated 97% while the S&P 500 rose by 12%.

Chart Data by YCharts

Anchoring

What is it?

We tend to attach our thoughts to a reference point. We rely too much on pre-existing information or the very first information we have found.

The first price you see is likely to influence your opinion of a stock.

The more relevant the anchor seems, the more people tend to cling to it. The more difficult it is to value something, the more we tend to rely on anchors.

I recently wrote about SaaS valuations and how people anchor EV/sales multiples today to where they were in 2011 to evaluate them. Investors refuse to invest in a stock because it's 20% above where it was when they added it to their watch list. As a result, they potentially miss a huge investment opportunity simply because they anchor their opinion to the first price they have seen.

Anchoring portfolio returns

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How to counter anchoring?

How to alleviate this? Multiply your points of comparison by doing your own due diligence.

  • Compare a company's valuation to other businesses in the same industry.
  • Evaluate the intrinsic value of a company using a DCF calculation.
  • Compare the enterprise value of a company to its total addressable market.
  • Focus on the big picture and the fundamentals rather than the stock price.
  • Look back at the performance of a company over years rather than quarters or months.

Prospect theory and loss aversion

What is it?

Many investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. Usually, the more an investor experiences losses, the more likely they become prone to loss aversion.

Investors tend to feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit.

Loss aversion portfolio returns

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We are hardwired to sell our winners to secure our gains and double down on our losers to break even faster. That’s inherently a recipe for a losing performance because winners tend to keep on winning and losers to keep on losing.

Here are some ways loss aversion manifests itself:

  • Investing primarily in low-return, guaranteed investments over more promising high-risk/high-reward investments.
  • Holding on to a loser even though your thesis has changed.
  • Selling a stock that has gone up slightly just to realize a small gain, even though your bullish thesis is intact.
  • Telling yourself that you haven't lost until your investment is sold.

How to counter loss aversion?

First, you need to understand the importance of the power-law distribution and how your winners are likely to be your main source of alpha over a lifetime.

Know your investment history. Seeing a pattern in your winning and losing investments will inspire you to make adjustments if necessary. A very easy step to encourage this is to have a very long-term horizon.

Know your investment history. Recognize the returns delivered by the stock market over more than a century. Ideally, you want to have a lifetime commitment to public equities. After all, the stock market goes up more than it goes down (several bull markets have lasted more than 10 years - at more than 17% average annualized return, while bear markets have lasted less than three years, from -22% to -83%).

Bull bear market cycles

Source: MorningStar (2014).

Herding mentality and contrarianism

What is it?

Investors tend to follow what other investors are doing. As humans, we are hard wired to herd. We just want to fit in and look for conventional portfolios that would get a stamp of approval from the majority of investors. We invest blindly in a new company because a coworker mentioned it at the water cooler.

Interestingly, trying to avoid popular investments for the sake of being a contrarian investor at all costs can be just as damaging to your performance. Warren Buffett explains:

The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.

Some of the most damaging investment decisions investors make are often exactly when they think they are outsmarting the entire market and making the best decision they have ever made.

Ask anyone who has shorted Netflix, Amazon (AMZN) or Match Group over the last few years. If you want to generate alpha, you have to make choices for yourself, but not necessarily against everybody else.

Optimism Herding Contrarianism

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How to counter herding mentality or contrarianism?

If your temperament and your holdings aren't congruent, you are very likely to underperform the market over time. You will avoid this pitfall if you truly believe in your thesis. Since sticking to your plan will be a major component of your success, a healthy dose of optimism will go a long way.

You need to make investments based on your very own opinion and avoid buying a stock just because its price went up. Stage your buys, (build your position slowly over months or years rather than putting all your chips in at once), add on dips and dollar-cost average whenever applicable.

To wrap things up

The single greatest factor in your portfolio's return is your temperament.

Once you understand that you are your own worst enemy, you might be able to stay focused and overcome negative behavioral tendencies in relation to investing.

Here are the key items discussed today that can help you improve your temperament and avoid pitfalls:

  • Understand the market before investing: History, risks and returns.
  • Define your goals, risk tolerance and risk mitigation as a result.
  • Define your maximum allocation to any investment on a cost basis.
  • Let your portfolio concentrate for you.
  • Don't forget to invest in riskier asset classes, sectors and companies if you have a long-term horizon.
  • Focus on the process rather than the outcome (you may under-perform over an extended time - even Warren Buffett does).
  • Journal and keep scores to learn from your mistakes.
  • Makes investments based on your own opinion using second-level thinking.
  • Do your own due diligence via exhaustive research.
  • Focus on the facts and the knowable, judge statistically and logically.
  • Ignore all forecasts predicting the unknowable.
  • Seek opinions that are the opposite of where you stand.
  • Use systematic asset allocation tools to remove emotions when possible.
  • Stage your buys, add on dips, dollar-cost average.
  • Create a plan that you can keep over the years to come and stick to it.
  • Minimize how often you check your portfolio and focus on your research.
  • Hold your winners forever, ignore your losers (and eventually sell them).
  • Don't forget that patience will be your most precious virtue.

Some of the best ideas and investments can take a very long time to deliver on their promising premise. And to end on a Warren Buffett quote:

Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant.

What about you?

  • What's your primary temperamental weakness?
  • What are some steps you've taken to mitigate it?
  • Are there any other emotional or psychological pitfalls that I've missed?

Let me know in the comments!

Disclosure: I am/we are long AAPL AMZN FB GOOG MTCH NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.