Swedroe: 7 Investing Rules

November 16, 2018

Legendary investor Warren Buffett famously stated: “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.”

The reason temperament trumps intellect is that having the right temperament is what allows you to ignore the “noise” of the market and be a patient, disciplined investor, adhering to your well-thought-out plan through the inevitable bad times—times when even good strategies deliver poor outcomes.

What does it take to be an investor whose temperament allows you to be patient and disciplined? My almost 25 years of experience as an advisor has taught me that there are seven keys to success. The first—and most important—one is that you need to understand the nature of the risks of an investment before you commit to it.

1. Understanding the Nature of Risks Before Investing

When investment strategies are working, delivering positive returns, it’s relatively easy to stay the course. However, your ability to withstand the psychological stress that negative returns (or even relative underperformance) produces is inversely related to your level of understanding of the nature of risks of an investment.

That means you have to understand the sources of risk (what could cause returns to turn negative or be below expectations) and return for an investment. You should also understand how the risks of each investment correlate with the risks of other investments in your portfolio (whether correlations tend to rise or fall when your other portfolio assets are doing poorly).

2. Know Your Investment History

To paraphrase a noted Spanish philosopher, those who don’t know their investment history are condemned to repeat it. Before investing, you should not only have an estimate of the expected future returns (based on valuations and historical evidence, not opinions) but also the knowledge of the historical volatility of returns.

In addition, you should know how often returns have been negative for such an investment over one-, three-, five-, 10- and 20-year periods. For example, according to factor data from Ken French’s website, you should expect that U.S. stocks will underperform riskless one-month Treasuries about 10% of future 10-year periods, and about 3% of even 20-year periods. While having such knowledge won’t prevent you from being disappointed if that occurs, it should keep you from panic-selling because you were prepared for that eventuality.

Finally, you should have a strong understanding of the potential dispersion of returns: Are they expected to be normally distributed around a mean, or are there reasons to expect the distribution exhibits skewness and/or kurtosis? Skewness measures the asymmetry of a distribution. In terms of the market, the historical pattern of returns doesn’t resemble a normal distribution, and so demonstrates skewness. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from it than values to the right of (greater than) the mean.

For example, the return series of -30%, 5%, 10% and 15% has a mean of 0%. There is only one return less than zero, and three that are higher. The single negative return is much farther from zero than the positive ones, so the return series has negative skewness. Positive skewness, on the other hand, occurs when values to the right of (greater than) the mean are fewer but farther from it than values to the left of (less than) the mean.

Studies in behavioral finance have found that, in general, people like assets with positive skewness. This is evidenced by an investor’s willingness to accept low, or even negative, expected returns when an asset exhibits positive skewness. The classic example of positive skewness is a lottery ticket—the expected return is -50% (the government only pays out about 50% of the sales proceeds) and the vast majority end up worthless, but investors hope to hit the big jackpot.

Some examples of assets that exhibit both positive skewness and poor returns are IPOs, “penny stocks,” stocks in bankruptcy and small-cap growth stocks with low profitability. Alternatively, investors generally don’t like assets with negative skewness. High-risk asset classes (such as stocks) typically exhibit negative skewness.

Kurtosis measures the degree to which exceptional values, those much larger or much smaller than the average, occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a normal (bell-shaped) distribution. High kurtosis results in exceptional values that are called “fat tails.” Fat tails indicate a higher percentage of very low and very high returns than would be expected with a normal distribution. Low kurtosis results in “thin tails” and a wide middle to the curve. In other words, more values are closer to the average than would be found in a normal distribution, and tails are thinner.

An asset that exhibits both negative skewness and excess kurtosis should have high expected returns. However, it should also be expected to occasionally produce very large losses. Successfully investing in such assets requires acceptance of that risk and the ability to stay the course, rebalancing, and thus buying more after those large losses—just when it’s hardest psychologically to do so.

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