Not too long ago, I was asked a seemingly simple question: “What is the single most important investment I can make right now?” I get that question a lot.
The question was posed by juniors at Skidmore College, where I was lecturing last week. They wanted to know what they, as college students, could do to ensure their financial futures. I thought about it for a few moments, then responded:
“Discipline.”
Investors are faced with a unique challenge, I explained. Many are not at the mercy of the markets, as they believe, but are actually subject to the whims of the person they see in the mirror every morning. That’s why consistent investment results are often more dependent on behavior than stock performance. Put another way, investors who “behave” themselves by being disciplined tend to do far better than those who don’t.
Beating the Markets Takes Discipline
For example, DALBAR, a Boston-based research firm, released a 2011 report that showed investors had achieved a mere 41.9% of the S&P 500‘s performance over the 20 years ended December 31, 2010. In other words, investors managed to leave a staggering 58.1% on the table.
According to the report, the average investor achieved a mere 3.8%-a-year return, versus the 9.1% annualized return of the S&P 500, because they tended to jump in and out of the markets at the worst possible times depending on their emotions. This reinforces something I talk about all the time in my presentations — investors lose billions by trying to time their decisions based on nothing more than greed, fear or simple paralysis. In my opinion, it’s why the single biggest investment anyone can make is “discipline.”
It sounds simple but in reality discipline can be elusive, especially for “old dogs” like me. College students and new investors have an advantage here in that they have not formed years of bad habits…yet. Luckily, they have the potential to avoid them if they learn to be disciplined investors now.
I remember talking with a gentleman a few years back who was lamenting the fact that he and his wife hadn’t listened to me. He noted that his portfolio had dropped 10% from its peak, and he was none too pleased for having lost $15,000 despite the fact that he also told me he used 25% stop losses and had a total of $100,000 at risk. So he cashed out — and missed the 45% run-up of the following year.
When I asked why, he replied that he didn’t have the discipline to stick it out. And that speaks to something else I frequently cover — being disciplined means staying in the game if you expect to reap the rewards for having played. I’m not saying you should do anything stupid like rearrange the deck chairs on the Titanic if the markets are falling. But you do need to recognize that discipline can help you get out of the boat and take the sting out of market gyrations that would otherwise set us on edge and cause us to make boneheaded decisions.
We experience this in strange ways, I noted to the students. As an example, I asked them how many had moms who suggested they take an umbrella when the skies didn’t look like rain or pack sunscreen when they headed to the ski slopes on a cloudy day. Hands shot up all over the room. My point was that we tend to take risks when we “think” we know better and the unapparent doesn’t appear apparent. By the time it does, it’s too late.
Similarly, we tend to be cautious when the sky has already fallen — not when the clouds are building on the horizon. This is like the people who fail to heed emergency warnings and evacuate in front of a hurricane, reasoning that they’ll get out, only to risk being completely wiped out. In practical terms, it’s easy to invest when the markets are rising.
A monkey throwing darts can do pretty well (something that has actually been studied — and probably on a government grant, too. It turns out that the same holds true for many investors who confuse profits with genius under certain circumstances. But throw in a few down days or months — the markets lose about one year in three over time — and fear threatens to overwhelm discipline.
That’s why it’s a lot tougher to stick it out when things are rocky. In closing, I noted to the students that the markets are almost always focused on short-term news, both good and bad, and that the daily gyrations can be wildly exaggerated. But what I really wanted them to take away was this:
The future is not wrapped up in the headlines. Instead, it’s almost entirely dependent on the discipline we need to read them intelligently. With that, you should invest accordingly.
This story was originally posted in Money Morning.
