Taking the emotions out of investing

IS IT possible to invest your way to financial independence, and if so, how?

Essentially, investors can grow their money in a fast or slow way. The fast way involves stock picking, securities selection and market timing – and such approaches are favoured by many retail investors. Many of them reckon that if they just pick the right stocks, they could hit the jackpot in just a few years or even months.

In the slow way, investors can expect to multiply their money over 20 to 30 years, through asset allocation and index funds or passive indexing. Asset allocation is an approach fancied by financial advisers and the rich, while index funds are favoured by well-known investor Warren Buffett.

It is likely that average investors would have gone with stock picking or market timing, and they would have achieved an annualised return of 3.6 per cent from 2002 to 2021, according to JP Morgan. This would have barely beat the average rate of inflation, which means average investors in other countries likely have not fared too well in the long term.

What they may not realise is that how they manage their emotions and behaviour is likely to have an outsized impact on their long-term returns.

This is because average investors tend to buy high and sell low; they chase hot stocks or popular fund managers during a bull market and often buy at market highs. They then sell during market declines and often at market lows.

Buy high, sell low

Let’s look at the example of Ark Innovation exchange-traded fund (ETF). Since its inception in October 2014, its price has increased by about 125 per cent to US$45 (as at August), from US$20 initially. Did most investors make this kind of gains? No. Most investors bought Ark Innovation ETF only in 2020 and 2021 as the fund price grew by almost fivefold from the bottom in March 2020 to the peak in early 2021. The fund’s assets under management (AUM) jumped to about US$28 billion in 2021, from about US$2 billion in 2020.

The fund’s price has since declined by about 70 per cent. This means investors who bought near the peak are either currently underwater or have sold the ETF at a loss.

Morningstar estimated that the fund has lost investors US$7.5 billion since its inception. Such are the perils of chasing hot funds.

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Another example is the Malaysian glove stocks mania in 2020. Prices of glove stocks, including Top Glove, went up rapidly in 2020, but they have since declined 90 per cent from peak to trough.

At the peak in August 2020, the total market cap for the four leading Malaysian glove stocks was estimated at about RM186 billion (S$56 billion); it is now down to about RM30 billion as at Jul 5 this year.

As most retail investors would have bought the stocks near the peak, they would have lost a gargantuan amount of money, much of it their hard-earned savings.

In short, it is extremely difficult to master stock-picking or market-timing, especially considering that investors also need to manage their emotions. It is no wonder that the path to success is dotted with investors who have blown up their investment portfolios; the chances of success with either approach is too low for most investors.

Asset allocation

Next, let’s look at the asset allocation approach, which entails deciding where to put money to work in the market. Investors usually allocate money to different asset classes such as stocks, bonds, cash or commodities.

The typified asset allocation strategy is the US 60/40 portfolio, where investors usually allocate 60 per cent of their money to US large cap stocks and 40 per cent to US bonds. Portfolio investors then maintain their respective asset weighting by rebalancing it, say, once a year.

For example, in a scenario where the stocks value has increased to 70 per cent and bond value is down to 30 per cent by the end of the year, rebalancing can be done by selling some stocks and buying some bonds to regain the targeted weightage. Rebalancing can be done at different intervals, and the objective is to improve risk-adjusted returns.

Over a 20-year period, the annualised return for a 60/40 portfolio is estimated to be 7.4 per cent, said JP Morgan. Based on my research, the maximum drawdown is about -30 per cent should investors allocate money to S&P 500 Index (stocks) and the Bloomberg US Aggregate Index (bonds).

Most pension funds and sovereign wealth funds have largely mirrored their asset allocation strategies along the lines of the conventional 60/40 portfolio with some tweaks.

This investment approach is especially suited for investors who cannot stomach huge declines. This is because a well-diversified portfolio will have assets with low or negative correlation, and performance will be mixed especially during a period of heightened volatility. For instance, during the global financial crisis in 2008, US stocks were down, but US bonds went up to offset the loss.

Just remember, though, that with diversification, you will not hit the jackpot. Neither will you get wiped out. It is a trade-off, so to speak.

In short, this approach seeks to grow money steadily with reasonable returns over the long term.

Index fund

In 2020, Buffett famously said: “In my view, for most people, the best thing to do is to own an S&P 500 index fund. People will try and sell you other things because there’s more money in it for them if they do.”

Such an approach is estimated to have reaped an annualised return of 9.5 per cent over 20 years, noted JP Morgan. Based on my research, the maximum drawdown is about 51 per cent.

However, JP Morgan’s Guide to the Markets shows that investors can push annualised return to 9.6 per cent with a maximum drawdown of about 17 per cent by adopting a simple trend-following approach on the S&P 500 Index Fund.

This means buying the index fund when the monthly price is more than the 10-month simple moving average (SMA). Investors should then sell the index fund and move to cash when the monthly price is below the 10-month SMA. They need only to check the investment once a month and act accordingly.

A recent Singlife survey showed that most people in Singapore need S$612,000 to feel financially independent. Those who invested S$100,000 in 2002, would have seen their money grow to S$625,000 in 2021. If your initial investment is smaller, you just need a longer time frame, assuming all things being equal and without factoring in foreign exchange gains or losses.

What this means is that it is indeed possible to invest your way to financial independence.

Trend-following approach

Investors may argue that hindsight is always perfect. Still, over the past century, the historical long-term annualised return of the S&P 500 Index is 10 per cent. US stocks have also historically outperformed non-US stocks, bonds, commodities and cash in the long term. More importantly, returns on US stocks, so far, tend to be durable and duplicable – which means other investors can reproduce this kind of return.

Investors who had bought a stock at its peak in September 1929 would still have reaped an annualised return of 7.8 per cent if they had held it for 30 years until 1960.

During this period, stocks declined by -45 per cent starting in 1929, -83 per cent starting in 1930, -41 per cent starting in 1932 and so on. It was not a good time to invest in stocks, and yet investors were still up by almost nine times their initial investment by 1960.

On the other hand, returns on some individual stocks have gone down to zero. Some 40 per cent of all US stocks since 1980 have suffered a permanent decline of 70 per cent or more, said JP Morgan.

In short, the annualised returns of a simple trend-following approach beat the returns of the S&P 500 Index Fund, the returns of 60/40 portfolio and the returns of average investors profiled in the JP Morgan’s guide – and doing so incurs far fewer risks.

How did the trend-following approach manage to achieve this feat? It did so by helping investors to mitigate severe losses. Perhaps more importantly, it is a rule-based approach that takes emotions out of an investment decision.

Emotional investing

It is often said that the greatest enemy of investors is their own emotions. Investors tend to sell their winners too early, thinking that the prices are already too high; and hold on to their losers for too long, hoping that prices will eventually come back. Why?

Behavioural economics research suggests that people find losses more painful than gains. Thus, they believe as long as they have not sold their stocks, they have not yet suffered any real losses. Trend following does the opposite, by helping investors to “let winners run and cut losers short”.

Also, many investors tend to rely on “anchors” such as the previous prices they paid for their stocks in making decisions. This means if the current stock prices get away from the previous prices, they prefer to sit on their hands. Trend-following gets investors to buy stocks when prices are above trend, irrespective of previous prices.

Essentially, in a rule-based approach like trend-following, investors just have to follow the rules.

The question for investors is whether they want to grow their money quickly or slowly, while bearing in mind the degree of difficulty and chances of success for each approach. Perhaps it is worth considering getting rich reliably even if it is a slow process.

The writer is a private investor. He was previously a researcher at an international business school in Europe and an Asia-Pacific director at multinational corporations.