The power of process in turbulent markets

What a fascinating/crazy week for equity markets. In my recent weekly 80-20 Investor newsletter I gave a sense of perspective to what had been happening. Since then investment markets have become even more volatile.

By Monday stock markets globally were in full blown panic mode. The FTSE 100 for example lost 4.67% in a single day! That was one of the worst days since the financial crisis. Forget stock market corrections (a fall of 10% from recent highs) investment commentators were talking potential bear markets occurring (falls of 20% or more).

The press and Bloomberg TV wheeled in loads of people to explain what was going on and where markets are headed next. These experts broadly fell into two camps:

• those telling you that the world was ending
• or the majority who were saying this was a great buying opportunity

Oddly, these same people had been wheeled out the week before when the markets were falling. Yet in light of the new down-leg in equity markets I didn't see any of the bullish commentators say, 'do you know what? I was wrong last week, it wasn't the time to buy but now is'.

Yet none of this 'press noise' is helpful especially for DIY investors as I explain below.

Don't shorten your investment time horizons

When markets are behaving like they are right now everyone is searching for answers of when the sell-off will stop. They start thinking about whether they should get out of the market or change their asset allocation.

In effect what people are doing is shortening their investment time horizon, when in fact they should be lengthening them if anything.

If you are investing money then you must have an investment timeframe of at least 5 years, preferably 10 years or more. Therefore what happens on a given day is irrelevant. As I mentioned in my newsletter last week, 10% stock market corrections happen around every 18 months while 20% falls happen every 9 years on average. We were overdue a 10% correction and a 20% fall will only be around the corner if the current market volatility doesn't end up that way.

That means if you are investing for 10 years at the very least you should expect to experience 6-7 corrections (10% falls) and probably 1-2 bear markets (20% falls). Of course your whole portfolio won't be exposed to equities but if you've found this week uncomfortable then you need to be honest with yourself as to whether investing is really for you.

The newspapers and the likes of Bloomberg TV sell news. Therefore they are not going to be sanguine about what's going on, if they were then no one would buy their news.

Here's a tip to realign your thinking and get a sense of perspective. Let's say your investment timeframe is 20 years. The next time markets sell-off ask yourself the question, will what happens today matter 20 years from now. Clearly it won't.

Don't give in to confirmation bias

This current market volatility provides another great DIY investing lesson. Most investors will have spent the week pouring over the news looking for someone to tell them that everything is going to be ok and that their losses will be erased. Let's be honest in a market like this gripped by panic no matter which equities you held you will have lost money, at least on paper anyway. The FTSE 100 is currently down over 12% and even the average balanced fund manager (who invests in bonds as well as equities) is down nearly 6% in the last week.

The TV is full of investment managers who run billions of pounds of investors' money saying why this time is different. Or maybe they are saying why the world is about to end. They will pull up charts that back up their view. Yet there are only two things that are certain from all of this:

• they can't all be right
• that their view will match what they are doing with their investors' money, even if they think personally that they've got it wrong. Professional pride is a powerful thing.

All of the above are perfect examples of confirmation bias in action. Confirmation bias is a human flaw. It's the tendency for us humans to put more faith in information that agrees with what we already believe and to ignore opinions and data that disagree with this belief. Confirmation bias even means that we tend to more easily recall things that reaffirm our belief over those things that don't. There is more on confirmation bias along with a great video in a previous newsletter of mine called - 'Can you solve this?' Do have a go at the challenge in the video as it shows how we all easily fall victim to confirmation bias.

So all the noise we hear from the press when markets wobble encourages confirmation bias when we invest. We will have all been guilty of it this week but that's what being human is all about. The trouble is that confirmation bias encourages you to make emotional investment decisions based on fear and greed. The successful investors keep confirmation bias and their emotions in check.

The great news is that by simply being aware that you are looking to reaffirm what you would like hear is enough to make you stop. Which in turn limits your capacity for making emotional investment decisions. So enjoy reading the press and watching the investment news by all means but try spotting the confirmation bias in their experts as a bit of fun.

Don't think the market only goes up

Hearing news anchormen ask their expert guests 'what is going?' always seems to have an undertone of 'because markets shouldn't go down'. Investment markets behave like the waves of the sea. Every wave has an upside and a downside and the tides ebb and flow. Investing is akin to surfing those waves and it requires a bit of skill, technique and luck. Bemoaning the very nature of investment markets is like standing in the sea and moaning when a big wave gets your hair wet. If you don't want to get wet then don't go swimming.

Why is there never as much news coverage when markets go up? The answer from TV producers would likely be 'markets tend to go up, that just isn't news'. Unfortunately this is what causes people to assume markets always go up. It encourages speculation and investment bubbles and inevitably market crashes. Ironically at that point the TV producers then become interested.

The power of process

This week has been a great opportunity to pull together a number of DIY investing lessons. You should have worked out by now that I am pretty sanguine about where the market is headed from here. That's not to say I'm complacent, of course I'd like the stock market to only go up but as I've pointed out that doesn't happen.

The key thing to take away from the recent market rout is the importance of having an investment process. We have no control over what happens. So what do we do? Studies have shown that if you focus on process rather than outcomes it leads to better decisions. This is also true in investing.

Focusing on process frees us from worrying about the things we don't have control over such as the performance day-to-day (or whether China is growing or heading for recession). That's not to say you won't have periods of underperformance, every sound process will have. Yet focusing upon a process has been shown to maximise the potential to generate good returns over the long-term, as long as it is a sound process such as one based on momentum like the 80-20 Investor algorithm.

The chart below shows what would have happened if you'd applied the strategy at the heart of 80-20 Investor (the green line) since 1995 when investing in UK equity funds. You'd be up 1,089% versus 255% from the FTSE 100 (blue line) and 242% from the average UK equity fund manager (red line). Click image to enlarge.

This investment timeframe takes into account multiple equity market corrections and bear markets. What you notice is that the process doesn't make you immune form market falls. In fact the scale of the falls of the 80-20 Investor strategy is the same as those of the other strategies, the scale just exaggerates them.

What you will notice is that when markets turn that the green line rides the wave upwards. Sticking to a strategy through thick and thin is the key to its success. Sometimes it will be uncomfortable but ultimately profitable. So while the recent market falls are unwelcome you can see why I calmly accept the ride. It's because when markets rise different parts rise at different rates. The 80-20 Investor algorithm is designed to jump on to those parts that are likely to ride the best waves upwards.

To use my surfing analogy again, it's worth watching how a surfing competition is won. If you watch a surf competition it's difficult to see who is winning as the waves come crashing down and surfers bob around. Surfers spend their time riding lots of waves but not every wave counts. Essentially judges score each wave that the surfer rides and then ditches his best and worst ones before averaging the rest. Or in other words the key is to catch a few big waves and ride them well. Investing is the same and the 80-20 Investor algorithm is designed to boost your chances of riding those big waves.

More importantly the best surfers don't worry about choppy seas and neither should DIY investors. So when might the next big wave come along? Have a read of my article 'The best strategy in a stock market crash – Stick or Twist?'

 

(photos by phil1950 via freedigitalphotos.net)

 

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