Blog 2 – GOOD BEHAVIOR IS A SUPERPOWER

A TRUTH ABOUT THE CAPITAL MARKETS

Investor behavior can also be a strategic disadvantage.

According to several academic studies[1][2][3], only a very small proportion of day traders realize gains over a given year, and much less consistently over 5 years. According to Professors Barber and Odean, 75% of Day Traders quit within 2 years.

The real truth is that both the average retail investor and most professionals underperform the S&P 500. According to the 2023 annual Dalbar Study, over 30-years (Figure 1), active retail investors lagged the Benchmark (S&P 500) by ~2%. And according to the SPIVA annual report[4] over the last 20 years, 95% of professional fund managers underperformed the S&P 500 by ~1%.

Figure 1 Source: Annual Dalbar Study 2023

Institutional Investors

The majority of performance discrepancy for the professionals relative to the S&P 500 index is due to management fees and operating expenses[5]. Yet, equally critical is that most corporate policies constrain their professionals to deploy limited methodologies, such as security selection and adjustments to portfolio weightings of stocks, industries, and sectors.  The challenge for institutional investors is generating enough Alpha to create a positive separation from the index by following such constrained methodologies. Even the thriving low-cost ETF industry is incurring these very same corporate constraints.

RETAIL INVESTORS

Retail investors may save by avoiding the complex of professional fees; however, chronic long-term underperformance is rooted primarily in undisciplined trading practices, called the ‘Behavior Gap’[6].

THE BEHAVIOR GAP

In the studies mentioned above, Professors Barber Odean found that this performance reduction could be directly attributed to behavior, in particular:

      i.   Overconfidence – Single males traded 67% more frequently than single females, resulting in 1.4% less performance on average.

    ii.    Failed Risk Controls – The use of market timing to control investment risks.  Repeatedly entering and exiting the market introduced a new risk unrelated to the markets without the consummate rewards, and akin to gambling. Deploying market timing to sidestep proper risk management techniques actually increases the riskiness of a portfolio. The graph in Figure 2 compares investing versus gambling. In the short-term (blue circle), the results generated are nearly indiscernible between investing and gambling, suggesting that the deployment of high frequency trading is no different than gambling.

Figure 2 "Decision-Making for Investors: Theory, Practice and Pitfalls” by Michael J. Mauboussin from Legg Mason 

  iii.     Stubbornness – Investor behavior for wins/losses is asymmetric. Wins are typically truncated, while losers are retained. Savvier investors tend to sidestep their ego to sell losers for the tax losses.

  iv.     Following the Crowd (FOMO) – Investors favor trading on headline news and take greater confidence in going with the flow.  Contrarian trading stands out as a potential strategic investing advantage for disciplined investors.

    v.    Execution – The use of mobile phones to make “on-the-fly’ trades likely results in decisions with minimal diligence (research / analytics). Unfortunately, market trading is dominated by algorithms that are mathematically engineered to seek mis-priced trades. Retail investors are already at a disadvantage, if high frequency trading is their preferred investing strategy.

  vi.     Lack of Accountability – Professionals are held to account by a series of checks and balances, including investment policy documentation (i.e., Offering Memorandum), departmental supervision, internal compliance, and regulatory oversight. Retail investors only have their personal integrity to rely upon. This means that trades can be influenced unfavorably by trends, cognitive errors, personal emotions and social media hype.

MARKET TIMING – A SELF-FULFILLING PROPHECY

Even greed (FOMO) is the innate fear of ‘missing out’. As a deeply negative emotion, fear interferes with making clear-headed decisions whether running away from (perceived) dangers or chasing opportunities.

  A clear example of collective investor fear can be seen in Figure 3. The chart compares the 10-year history of real investor fund flows (buys/sells) for both US Domestic and US Global capital relative to the performance of the MSCI All-Cap World Index (ACWI). This graphic clearly reveals the impact on human behavior induced by market volatility.  Net capital inflows increase during rising markets (FOMO) and net capital outflows dominate during declining markets (panic).

Figure 3 Investors Buy High / Sell Low from PIMCO,

Overcoming the performance gap requires voluntary change. Let’s explore this further.

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VOLATILITY AND FEAR

See if you can relate to these two statements:

         i.    In a room full of people, ‘fear' and 'laughter' are two of the most contagious emotions. Both rely on the unknown to surprise us. Yet while both may cause involuntary convulsions, one also has the power to cause a massive shedding of wealth. 

        ii.    Market volatility also brings unique investing opportunities, yet most investors prefer investing when the market has calmed.

While most investors desire to make astute investments, they also crave certainty. It is only because the capital markets are uncertain and uncontrollable do they generate investing opportunities. Therefore, these two statements are at odds. 

Volatility

The higher the volatility, the greater the investing opportunities. Those who react to fear are subsidizing those willing to provide liquidity. The challenge is how to become pro-active to seize the advantage?

Fear

Before every trade, even the most confident investors have trepidation. Privately, we all have our breaking point. When fear is triggered, it’s too late. No amount of rational thought can overcome the fateful chemical cocktail delivered by the Amygdala to our rational brain. Self-preservation blinds us into selling stocks against our own better interest.

Professional Response

At this stage, professionals can usually arrest spontaneous trading impulses either by self-discipline developed through the market cycles or due to accountability mechanisms, such as regulatory oversight, the investment policy document, supervisory oversights, or team feedback.

Retail Response

For retail investors, the absence of such accountability mechanisms, combined with easy access to technology, enable reactive trading. Investors must rely on their integrity and discipline to minimize market timing trades. This works for some, but they are in the minority.

There are many incremental ways to improve performance without venturing into higher risk, leverage, or market timing. And let’s clarify; there are two separate challenges at issue:

1.     Eliminating persistent underperformance relative to the market (Behavior Gap)

2.     Generating consistent out-performance relative to the market.

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A FULL BRAIN SOLUTION

The analytical left brain naturally seeks order and desires to apply logical solutions to the challenges. Redesigning a portfolio can render improved results. Behavior, on the other hand, is expressed through the right hemisphere and is deeply influenced by rogue emotions.  Eliminating reactive trading (behavior gap), and then raising your game to challenge ‘Mr. Market’ requires putting the two halves together.

Left-Brain - Four-Tiered, Contrarian Methodology (Portfolio Design)

As a testimony to a more comprehensive portfolio management strategy, the author has designed 4 tiers of contrarian methodology to manage the Oasis Growth Fund; a diversified, equal weight, core North American hedge fund comprised of 30-35 quality, compounding stocks.  The expectation is to outperform the market not by being smarter than the market but rather by deploying a more comprehensive strategy than the industry. These practices are summarized through this blog series and outlined more fully in "The Investing Oasis: Contrarian Treasures in the Capital Markets Desert". 

Right Brain - Better Results will come from Better Behavior (Trading Actions)

Becoming a pro-active trader, however, requires a sea-change in perspective.  Self-preservation is a sign of a healthy mind and is probably the most powerful behavior known to all creatures. Unfortunately, by spending too much time watching the markets, we invoke fears that fool ourselves into action when no action would likely have been the better course.

  Babies are born with a limited sense of fear. Most of it is learned. Those fears are kept alive in our hippocampus; an area of the brain that stores bad memories. Unfortunately, it also recalls trading mistakes and the fears derived from watching trading patterns on stock screens. By spending too much time in front of a computer, we are literally training our brain to assess patterns that then potentially trigger our Amygdala into taking self-destructive evasive actions.

“Don’t do something. Just stand there.”

~ Jack Bogle

Founder of the Van Guard Group of Funds

In real life, there is very little difference between the fear experienced from a charging bear and witnessing the collapse of the stock market. Both result in heightened physical reactions, yet only one has real life consequences. Sadly, selling into a market downturn is entirely voluntary, and needless, given that the market has a 100% recovery track record. Despite that major sell-offs are cyclical (every 4 years, on average), the majority of investors fail to plan and fall victim to the ensuing panic.  This is an investible advantage.

The foundation to being a contrarian[7] is that investing opportunities are embedded in the generally bad behavior of the competition. Yet, to be a contrarian, requires recognizing that your fears are a favorable signal. The greater the queeziness, the greater the opportunity. 

TRUST IS KEY

On the other hand, ‘trust’ is a high vibrational energy.  To be able to stand your ground and take a position opposite the masses requires having faith in:

• your stock picking skills (quality)

• the design of your portfolio (diversified)

• a portfolio protection plan (rather than relying on market timing), and

• the market. 

Although the degree of trust varies according to the investor, buying quality assets and building a diversified portfolio already set a long-term plan on solid footing for improved performance. Thereafter, trust can be further bolstered by learning to deploy the five contrarian trading tactics as outlined across this educational blog series. And being pro-active allows trades to be set on your terms, despite the dominance of the algorithms.

Slow-Twitch Decisions

Yet the biggest lesson to being pro-active is that if shifts critical decision-making to our slower, more mindful brain. In Daniel Kahneman’s acclaimed 2011 book Thinking Fast and Slow, relying on our sub-conscious brain (automatic processes) to render investing decisions is like allowing our inner child to drive the family car on a freeway. Never a good idea.

Setting pro-active trades allow an investor to step back from the highly uncertain and emotional front lines of the capital markets. If a trade is triggered it was because you had previously set the conditions. No second guessing required, other than to learning just how shallow or deep to set your protection trades. This is an art. No-one truly knows when to buy/sell a stock.  This approach takes a large part of the guesswork out of the investing process and offers more time for an investor to pursue more value-creating activities, such as selling and harvesting covered calls.

“Too many investors spend more time researching their annual vacation than doing due diligence on a promising stock to be held for a decade.”

~ Peter Lynch

Ex-PM of the Magellan Fund

GIVE YOURSELF A FIGHTING CHANCE

If you're still reading, likely you are open to some new ideas on how to improve your investing outcomes. The following encouragements are segregated into three categories:

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NEUTRALIZING THE ENVIRONMENT

• Seek a place of calm for trading. More clear-headed decisions will happen in the warmth and comfort of your home (or a preferred place), surrounded by natural light, plants and ethereal music.

• Reduce the distractions. Following multiple trading screens in search of a perfect decision screams of uncertainty. Don’t let reams of data seduce you into seeing patterns where there are none. The brain is easily fooled. Best long-term decisions aren’t made by watching price-ticks.

• Minimize trading on your phone. While it may be convenient, it also enables multi-tasking. Would you want a hired professional to be managing your money while multi-tasking out of the office on their phone?

• Accountability to yourself and others – If necessary, consider having a periodic discussion/review. The objectivity of others may bring inspirations and/or pause for reflection. Either way, periodically solicit feedback.

NEUTRALIZING THE EMOTIONS

• Stay away from mood-altering substances that can unduly stimulate or deflate the range of emotions, coffee included. Consider switching to Matcha tea. Calmer minds deploy smarter decisions.

• Choose your financial pundits carefully. Often a public persona reflects our own world view. Hyped-up and angry makes for fascinating entertainment but better decisions require less turbulence. The markets are already tumultuous enough.

• Five ways to help reduce reactive trading:

  1. Use a checklist. Like a pilot preparing for takeoff, follow a decision-making sequence as outlined in chapters 14 and 23 of ‘The Investing Oasis’. Professionals follow a series of guidelines before plying a trade. Having to review the purpose and merits of a trade will temper unnecessary portfolio turnover.

  2. Embrace your ‘inner contrarian’. Trading discipline will improve your performance. Buy on down days, trim on positive days. This is the key to cash management.

  3. Limit your screen time. The market tone can resonate across your entire day. If deep energy emotions have been triggered, step away. That next decision will not likely be our best. According to Dr. Adam J. Story,squeezing a ball or taking a brisk walk can provide a nearly instant calming effect.

  4. Meditate. Billionaire Ray Dalio claims that transcendental meditation changed his life.

  5. Give yourself reprieve. We all make mistakes. We don't learn unless we do. Self-reflection is also a strategic advantage. Harboring guilt, embarrassment, or shame is a self-induced disadvantage. Keep the faith that ‘Mr. Market’ eventually repairs poorly timed trades.

NEUTRALIZING THE PORTFOLIO

• Prepare your portfolio for uncertainty. Blog 13 provides 7 concise steps to shape a portfolio for pending market trauma.

• Pre-set trades to avoid the daily opening market insanity. The first and last 30 minutes of the trading day can induce poor trading decisions (FOMO and FOSS[8]).

• Set protective Stop Loss and/or Trailing Stop Loss orders. When the market pulls back, no need to jump into the fray. You can trust these pro-active decisions were calculated mindfully during a period of relative calm. Rather than abandoning a previously confident holding, let the market trigger a sell. Then proactively set a new buy trade.

• Keep building cash. Blog 9 provides 5 methods to internally increase your cash reserve.

“Regret is an appalling waster of energy.

It’s only good for wallowing in.”

~ Katherine Mansfield

New Zealand author: “The Garden Party”

(1888-1923)

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SUMMARY

As investors, we need to respect that we are still only children of the capital markets. When we act badly, we get punished. And it's not that the pros have more knowledge, or that the algorithms have better math, the two primary reasons for underperformance are that investors trade without accountability and pay minimal attention to portfolio mechanics. Improved performance can be introduced through simple but powerful left and right-brained measures. It’s not about being smarter than everyone else. The strategic advantage lies in deploying tactics contrary to the generally bad behavior of the rest of the marketplace. Discipline is the superpower. Generating better results lies entirely within you.

RESOURCES:

• Chapters 1-6 of The Investing Oasisom PIMCO,

SHARING is CARING

If these blogs resonate, it would be appreciated to share this series with others who may benefit from the education and insights offered.  Equally, your feedback and questions are always appreciated.  In a community of mindful participants, education is a strategic advantage.

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

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The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.

[1] “Do Day Traders Rationally Learn About Their Ability?” published in 2010 by Brad M. Barber, PhD & Terrance Odean, PhD, then at the University of Berkley

[2] “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” Brad M. Barber & Terrance Odean at the University of Berkley

[3] “The Average Investor Is His Own Worst Enemy” Forbes Article, June 10, 2010

[4] https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2023.pdf

[5] https://www.evestment.com/wp-content/uploads/2020/08/eVestment-State-of-Institutional-Fees-Report-August-2020.pdf

[6] The term ‘Behavior Gap’ was coined by financial planner Carl Richards in his book, “The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money”, and refers to the difference in returns between an investment and the benchmark.

[7] In the context of The Investing Oasis, ‘contrarian’ refers to the willingness to seize an investment advantage counter to the market’s general direction (market down = buying opportunity).  It does not embrace the more traditional higher risk/reward search for deeply discounted stocks.  

[8] FOMO – Fear of missing out. FOSS – Fear of a sinking ship.