You are probably familiar with the marshmallow test.
It started back in 1972 at Stanford University. Three researchers (Mischel, Ebbesen, and Zeiss) conducted an experiment on delayed gratification.
The test is simple. Put a marshmallow in front of a child. Give the child a choice: eat it right away or wait for 15 minutes and get two marshmallows instead.
This experiment in delayed gratification revealed how children would handle the frustration of waiting for the desired reward.
Their success depended on suppressive and avoidance mechanisms that reduce frustration:
Investing, in many ways, is the ultimate real-life marshmallow test.
You can double your money every seven years on average in the stock market, using the S&P 500 (SPY) average returns over the past century.
We are all playing the delayed gratification game as we speak, trying to keep ourselves occupied while we contemplate the possibility of doubling the reward.
Picturing your financial assets as a growing pile of marshmallows doubling every seven years can certainly help you keep perspective.
Of course, seven years is a lot longer than 15 minutes. So you'll need more than a nap and a few songs to reduce your frustration and give yourself the best odds of success.
Let's cover the four factors that can optimize your investing journey and give you a better chance of leaving that marshmallow alone.
I call them the "four Ds" of investing.
The stock market can be a very stressful and frustrating place.
In the face of stress, we all have different coping mechanisms.
As perfectly put by Adam Smith in his book The Money Game:
If you don’t know who you are, this [the stock market] is an expensive place to find out
Your capacity to cope with volatility will remain an enigma until you have to deal with your entire portfolio falling by 20% or more in a matter of days or weeks.
The graph below shows the drawdowns of the S&P 500 in the past 70 years. In the 21st century alone, the market dropped three times by more than 30%, including last year's decline in March.
If you held on through these large market declines, you achieved about 11% annual returns on average (including re-invested dividends), beating inflation by 8%.
The past 70 years have been filled with uncertainty. But those who stuck with their investment strategy through the ups and downs were likely to create tremendous wealth.
As explained in my article dedicated to the 4 Simple Rules of portfolio construction, instead of asking how much volatility you can tolerate, you should be looking for ways to improve your tolerance for it.
I discussed in a previous article how investing has a lot in common with dieting or exercising. It can be hard to know how to do it right, with many contradicting philosophies.
We all try to stick to good habits and indulge once in a while. Gambling is hazardous to your wealth, the same way a bowl of ice cream is hazardous to your health. Harmless in moderation but devastating if not kept in check.
One of the greatest challenges in investing is that you can destroy years of returns with one poor decision. With this in mind, it's critical to define clear boundaries that can protect your portfolio.
The most important factor in your portfolio returns, as I've written previously, is your temperament.
You don't have to be born with the right temperament. You can build it over time with a specific set of habits.
In his book Atomic Habits, James Clear explains:
The ultimate form of intrinsic motivation is when a habit becomes part of your identity. It’s one thing to say I’m the type of person who wants this. It’s something very different to say I’m the type of person who is this.
This idea struck a chord with me.
"I don't smoke." That's what I started saying several years ago when I decided never to touch a cigarette again. Using such an affirmative way of asserting it made it part of who I am and what I do. It became a part of my identity.
It might sound obvious to someone who has never smoked, but addictions have a way of creeping back into your life if you don't build protective mechanisms to stay away from them.
Similarly, I have defined several investing habits that have become part of my identity using "I" statements:
I elaborate more on these rules here.
Being accountable to others is also a great way to stay disciplined.
Since I started my investing newsletter in 2018 (App Economy Portfolio), I share all of my trades with a community of like-minded investors. Every move in my portfolio must now be documented and explained online. When I add a new position, it must come with a 5,000-word bull case. That's an effort I suspect most investors don't undertake.
Having other investors join me on my investing journey set me on a path I'm sure not to deviate from.
When the inevitable market crash happens, having mantras you live by can be the difference between staying the course and having a meltdown. It can empower you to stay disciplined.
Habits are the core that can define your investing journey:
Your daily, weekly, and monthly habits are the inputs you have control over. Recognizing them as such can tremendously boost your odds of success.
Being disciplined is your capacity to show up to karate class every day, even when you don't feel like it.
Being determined is your capacity to get back on your feet every time you're knocked down.
You probably have heard before the classic Warren Buffett quote that investing is "simple, but not easy."
What does he mean?
Despite being one of the best investors of all time, Buffett has been criticized many times over the years. For example, his investing style was considered "obsolete" during the dot-com mania in the late '90s.
Even the best investors in the world have extended periods of underperformance. Their capacity to stay the course is where they make a difference.
The most successful investors tend to have a few things in common:
One of the greatest skills in investing is perseverance—the idea of a continued effort to do something, despite the difficulties or failures along the way.
A disciplined approach is not sufficient. You also need the tenacity to go through long periods of doubt and uncertainty.
I wrote previously about how to prepare for the inevitable next stock market crash:
To illustrate with real-life examples, I pulled a chart with some of the best performers of the past decade. I included the FANG stocks (Facebook (FB), Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG)), as well as Tesla (TSLA).
The chart shows the sell-offs in the past ten years in % off the previous high.
Several of them have dropped more than 50% from their highs in the past decade. And you can expect a drop of 25% or more every other year.
When a stock crashes 50%, it usually means the market really dislikes the prospects of the business looking forward. In these situations, negative rumors abound, sentiment is bleak, and the bears control the narrative.
It's easy to forget how it feels to hold an investment facing such uncertainty:
Whether you invest in index funds, ETFs, or individual stocks, the emotional roller-coaster to ride out when the tide turns is the real challenge.
At times, investing feels like being stuck out in the ocean, tumbling in the waves. The temptation to head back to the beach and never set foot in the water again can be irresistible.
Since you will be tested through multiple economic cycles, it's essential to know what you are doing.
Behind the concept of determination is the idea of being in the driver's seat.
Conviction is what will enable you to hold through thick and thin.
I might as well have called this second D "diamond hands."
Used initially on the subreddit r/WallStreetBets, diamond hands are generally referred to as the idea of refusing to sell a highly profitable position and waiting for even greater gains. They are used in opposition to "paper hands" or weak hands.
While the term was born in the context of individuals day-trading meme stocks like GameStop (GME) or AMC (AMC), the concept of diamond hands is likely to benefit many investors now that it has become part of the lexicon.
Investors are hardwired to sell their shares on any occasion:
The saying "nobody ever got hurt taking a profit" is one of the biggest cliches and falsehoods in investing. Tell that to anyone who sold their AMZN shares more than ten years ago.
When stocks go up (not all of them do), they don't go up in a straight line. Both the success of a business and its stock price movements are not linear. An investment going nowhere for years and tripling in a matter of weeks is not uncommon. Ask shareholders of Tesla or Teladoc (TDOC).
Every day, I see someone on Twitter explaining how "relieved" they are to have sold a stock because they couldn't "bear" watching it go down. This reasoning is incredibly flawed.
Watching a stock you own go down is inevitable. If you try to avoid it at all costs, you are in for a wild portfolio rotation and the tax consequences.
For those who can weather the storm unscathed - holding a diversified portfolio of great companies tenaciously - there is a pot of gold at the end of the rainbow.
Diversification is "the only free lunch" in investing. That's a quote attributed to Nobel Prize laureate Harry Markowitz.
Behind this quote is the idea that diversification can significantly reduce the risks without necessarily compromising returns.
To diversify is essentially a protection mechanism. It's the tool that empowers you to stay disciplined and determined all the way through.
Most investors are well versed with the idea that they need to build their portfolio on the efficient frontier with the right risk-reward balance.
In a previous article, I tried to answer a simple question: How many stocks should you own? I tried to explain that the right number is different for everyone.
In his book The Psychology of Money, Morgan Housel explained the concept of being rational vs. reasonable.
A rational decision means making a decision strictly based on what the facts and the numbers say. It all sounds great in concept. The implication is that you let the data decide for you.
Being rational is not always a realistic approach. We all have emotions at play that can get in the way of a sound plan. Sometimes, what would make the most sense for you will be different from the most rational decision. Instead, you need to define what is reasonable for you.
The right diversification is the one that keeps you in the game over multiple market cycles.
That's why portfolio suitability is so essential.
The proper amount of diversification is the one you can stick with for years or decades on end. Finding the proper allocation by geography, sector, category, and at the company level is a matter of personal preference.
The more you know what you're doing, and the more certainty you have about a specific investment, the higher your concentration can be.
It's essential to use diversification as a safeguard, a way to prevent you from getting in the way of your portfolio's success.
I personally have a max allocation to an individual stock at 8% of my portfolio on a cost basis. This means that if I already invested 8% of the funds added to my portfolio to an individual stock, I cannot add more to it.
If you focus on your risk allocation from a cost-basis perspective rather than your current value, you will benefit from two leverages:
Having a rule-based approach to diversification can be a lifesaver in the heat of the moment, when emotions run high. Safeguards are made to keep things in control right when emotions could take over.
The role of diversification is to make sure you stay in the game under all circumstances and keep the compounding of your returns uninterrupted.
You probably knew this one was coming.
As explained by Charlie Munger:
It's waiting that helps you as an investor, and a lot of people just can't stand to wait. If you didn't get the deferred-gratification gene, you've got to work very hard to overcome that.
Two main factors drive our investing success:
I've written previously about the power of compounding.
A fundamental part of the success of an investment portfolio is how early in your life you start and how much you contribute to it.
Until you have been investing for 20+ years, the amount you save probably matters more than your returns.
I came across this graph via Meb Faber, showing how two types of portfolios would create value over time:
Using the example of someone who starts investing at the age of 25, the investment return starts to matter more than the savings rate only after 25 years of investing.
As you can see, you should try to save aggressively just as much as you are seeking alpha. Most of your portfolio value - at least in the first 25 years of your investing life - is likely to come from your savings rather than your returns.
In the book the Millionaire Next Door, Thomas J. Stanley and William D. Danko discuss the concept of the "prodigious accumulator of wealth." It's not about hoarding pennies under your mattress. It's about paying yourself first and taking risks when they are worth the reward.
Success in the investing game depends on our willingness to take care of our future self:
It may feel like a sacrifice in the short term, just like watching a marshmallow and not eating it can feel unbearable.
Patience is an essential virtue of the investor. Probably the most precious one.
Investing is the closest thing to a real-life marshmallow experiment.
Every dollar unspent and invested can double every seven years or so.
Just like children patiently waiting to double their reward, we need to find ways to stay focused while we let the process unfold.
We can do it through discipline, determination, diversification, and an understanding of delayed gratification.
The rules of the game are straightforward:
It may sound like a simplistic view, ignoring the market and economic cycles. But this simple rationale is easily overshadowed by the daily noise of inflation, interest rates, the Fed, and more. And it shouldn't.
Ultimately, the way you invest matters immensely more than what you are investing in. How much you save and how consistently and diligently you put it to work will be the key to your investing success.
By focusing on the four Ds of investing, I believe you are one step closer to resisting the urge to eat that first marshmallow.
How about you?
Let me know in the comments!
Stay well and invest on!
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Discipline and consistency win the game over time. Unfortunately, many investors violate their own model or strategy when their portfolio performance is temporarily disappointing. I would rather sell too late than too early, so I tend to never sell. I let my winners compound to a significant portion of my portfolio and let my losers become insignificant over time.
All App Economy Insights contributions to Seeking Alpha, or elsewhere on the web, are personal opinions only and do not constitute investment advice. All articles, blog posts, comments, emails, and chatroom contributions by App Economy Insights - even those including the word "recommendation" - should never be construed as official business recommendations or advice. In an effort to maintain full transparency, related positions will be disclosed at the end of each article to the maximum extent practicable. The premium service App Economy Portfolio is a research and opinion subscription. I am not registered as an investment adviser. The majority of trades are reported live, but this cannot be guaranteed due to technical constraints. Investors should always do their own due diligence and fact-check all research prior to making any investment decisions. Liability of all investment decisions reside with the individual investor.
Disclosure: I am/we are long AMZN FB GOOG NFLX TDOC. 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.