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THE COST OF LONG TERM OUTPERFORMANCE - SHORT TERM PAIN

Summary

Meaningful long term outperformance cannot be achieved without periods of short term underperformance, and thus pain.

Emotional Capital is the currency with which a trader pays for long term outperformance.

So you have found a great investment strategy or investment manager that you believe will provide you with a long term edge and better risk-adjusted returns than benchmark exposure – after fees, commissions, and taxes, of course. You’ve done your diligence, you are confident in the methods employed and you like the performance metrics. You know that nothing in investing is ever guaranteed, but you feel that this strategy will give you the best chance at long term success. You are ready to put some money to work.

So you sign up for that newsletter, fund your brokerage account and start following the trades. If its a money manager you will be working with, you sign the paperwork and you wire money into your new account.

You feel good about this – you are going to follow a disciplined process and you are ready to be a long term investor with a long term, persistent edge. You look forward to reaping the benefits of this decision over the next 3, 5, 10+ years.

Month one rolls by and your performance comes in -5.6% for the month.

“That ain’t hot. Well let’s see how the market did…S&P was -8.5%...ah, at least I did better than the market…that’s good.”

Fast forward a couple months and you have been working with the manager for a full calendar quarter now. The performance over this time period comes in at -2.5%.

“Down 2.5%. Not what I wanted, but its only the first quarter and the S&P 500 was down 5.5%, so at least I’m outperforming. But my advisor isn’t making me any money. Wait…am I paying this guy to lose me money? Well I guess it’s better than I could do on my own in an index fund. Stay the course.”

Fast forward a few more months and check again – the first six months of following the strategy and the strategy has recovered. It’s now +0.6% over this time period.

“Up 0.6%...looks like this is going to be a slow year. Boring. What’s the market doing? S&P 500 is -0.5% so far this year, so my advisor is doing a good job – at least he is outperforming the market by about 1%. But still, the outperformance doesn’t seem to be worth the fees I am paying. Let’s see how things go for a little longer.”

You close your computer and forget to check the markets for the next six months (LOL!). Six months later you remember that you have money with an advisor and decide to check how things are going. At this point you have invested with this guy for one full year and you expect to see some results – you are paying fees after all! You open your account and what do you see? One year performance, -14%.

“WTF? -14%? I thought this guy was supposed to be good? I thought he had a system? I thought this was supposed to work? Ugh. Well I pay this guy to help protect me from losses in addition to making me money, so maybe the market has been bad, lets see…S&P 500 one year returns…-8.1%. W.T.F. So I am paying this guy to manage my money, and over the last year he has not only managed to lose me money, but I would have been about 6% better off in a low cost index fund than by keeping my money with this guy. Screw this…I’m moving my money to Vanguard.”

Sound dramatic? It’s not – it’s actually commonplace. It’s the reason why a lot of hedge funds, which often cater to high net worth individuals and institutional investors (investors who are supposed to have a long term time frame and a level head when it comes to investing) often stipulate “lock up periods” when investors work with them.

But this isn’t just unique to high net worth individuals and institutions, it happens all the time with “retail traders” (mom and pop investors) and financial advisors too.

It’s called performance chasing. It is absolutely toxic to long term investment success. And it is the result of inadequate Emotional Capital.

What is Emotional Capital in this context? Continue Reading