"Experience is the toughest teacher because it gives the test first and the lesson later."
It is so easy for anyone to open a brokerage account, or a futures account and just start trading or investing. While I admire the spirit of independence and self reliance that leads non-professional investors to manage their own money, the statistics suggests that very few are successful. For example in the futures markets we have weekly data on all the positions in aggregate for 3 different classes of investor. There are 2 separate classes of professional trader, and then the Small Speculative (SS) positions of the remainder. These are the non-professional investors. The chart below shows the S&P 500 index and the net positions of the SS.
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Clearly, this chart shows that SS traders in aggregate usually have the wrong position at the major turning points. The red triangles highlight the points at which they had maximum long positions. In each case these positions marked a significant high for the market. Somewhat disturbingly they are once again at an extreme long position.
This is not just a one off finding for SS traders who trade S&P 500 futures in the last 5 years. The same analysis held true across 43 different commodities traded over the last 13 years. The conclusion is inescapable. Most non-professional futures traders lose money over time. Most self-directed investors, however, do not necessarily trade futures, but does this mean they fair any better?
Another class of self-directed investors is mutual fund investors. How well does this group do? Not so good says John Bogle, and he should know. He was former Chairman and founder of Vanguard, one of the largest mutual fund groups in the world. Why is this you might ask? Well, there may be many reasons but clearly the main problems are the level of expenses in mutual funds, and ?investor behavior?.
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This table shows it all. The Quantitative Analysis of Investor Behavior (QAIB) is compiled regularly by Dalbar, a leading financial services market research firm. Whatever period you look at, the relative performance is much the same. The difference between the performance of the S&P500 and the average fund, here 3.2% (16.3% ? 13.1% from the bar chart) per annum, largely represents the expenses of investing in mutual funds. The gap between the average fund return and the performance of the average fund investor, here 7.8% (13.1% - 5.3% from the bar chart) per annum, is put down to investor behavior.
Whatever the reason, it is also clear that once again self-directed investors in aggregate experience very poor performance. We have covered surely the most active and involved investors, who trade futures, as well as the most passive, who just stick to mutual funds. So it is highly likely that what we have seen from these two sets of results covers the full spectrum of self-directed investors. There are always exceptions but clearly very poor results are clearly the norm.
Investors therefore need to inform themselves of what is needed to become successful, and decide whether this is realistically within their grasp, whether from a time commitment point of view, or for any other reason. Certainly, one starting point is to consider what the most successful investors suggest is needed.
What is a self-directed investor to do?
The evidence above strongly suggests that self-directed investors need to take great care in how they proceed, as they will need to separate themselves from the average if they are to have any chance of long term success. So what are the key factors that will lead to success? While libraries have been filled trying to answer this question, I believe that there are at least a few common factors that any successful investor needs to address. Here are a few of them:
- Excitement. Any activity which has the possibility of instant gratification or immediate reward - for example sports (hitting a good shot in golf, cricket or tennis), short-term trading, horse racing - will attract hopeful participation. It is because of this scope for instant gratification that short-term trading is rarely started as a business proposition. Money control is at the core of any business organization. And no business has survived without in-depth market knowledge which precludes market judgment. At the same time very few are attracted to long-term investing. This activity is boring to many investors.
- Patience and discipline. Investing is for the most part extremely testing psychologically, because the markets don't always reward us for doing the right thing. This `random reinforcement? can be both frustrating and destabilizing. The successful participant must have the discipline to remain true to their strategy and also possess the patience to wait for markets to set up for genuine money making opportunities.
- Behavior and emotional intelligence. Many smart and successful people from other occupations find that successful investing does not come easy. Often the reason for this is that a very different set of behavior is required from what made people successful elsewhere. Participating in the markets is essentially a `mind game? and controlling your emotions is ultimately the key to success. EQ (emotional intelligence) is far more important than IQ (intellectual intelligence) in investing. The psychological side of investing is the least understood and most often overlooked aspect of the business.
Another point here is the issue of being `right? or `wrong?. Many people find it very difficult to take losses, as it seems in some sense to be admitting defeat. However, the market doesn't know if you are `right? or `wrong? and doesn't care. The focus should be solely on maximizing profits and minimizing losses. Spending emotional energy on the egotistical issue of being `right? or `wrong? is a waste of time and effort.
- Work and analysis. You need to be confident of your work and analysis. Does your analysis set you up genuinely for the probability of success? Have you tested and understood the nature of the outcomes you should expect? If you have used someone else's work, have you really studied it sufficiently well that you have taken ownership of the analysis? If you are not prepared to do the work, should you really be investing?
- Money management. A clear set of rules that determine the size of each investment and your buying and selling criteria are crucial to investment success. This set of rules will not only greatly simplify your decision making but will also set you on a path for consistent investment success.
- Contrarianism. We are all social animals who prefer to be in agreement with others, and are brought up to be so. However, if you find it difficult to do anything without support and agreement from someone else, or you do not like to think independently, you should be aware that most likely the very best investment opportunities will escape you. As Warren Buffett said ?Most people get interested in stocks when everyone else is. You can't buy what is popular and do well.?
Summary
Just because I am an Investment Advisor does not mean that I am against people becoming self-directed investors. I myself have chosen this path and after twenty years I have learnt a great deal about what it takes to become successful, and I am still learning and always will be. It is a great life time occupation for the right kind of person.
However, like most occupations it is not for everyone. So I hope that investors think carefully about what their approach is to this particular venture. It is important that investors think clearly about their investment needs as well as their direct involvement. Not only your motivation but also your aptitude and commitment need to appropriately aligned if you are to have any realistic chance of achieving long term investment success as a self-directed investor.
