Our clients at Calyx Capital Advisors lean toward describing themselves as long-term investors, caring that their money is secure and wanting it to grow to take care of their needs and plans for the next decades. Our strategies and processes are built around that as a goal.
At the same time, all of us, clients and advisors alike, hear the news and worry about how events are affecting our portfolio. With the 24x7 media cycle of quasi-news our emotions get buffeted this way and that, and it is easy to get caught-up in the short-term ups and downs of the market. Countless studies show that the #1 enemy of long-term investors is their emotions. That is why at Calyx we have a disciplined, rules-based process of portfolio management that starts with risk management, selective asset allocation and individual investment selection. We can’t avoid short-term emotional reactions, but we can minimize our reacting to them with discipline.
The most important development in investing over the past two decades is the access to market data and investment opinion in real time, any time of day, by the average person. For decades the real-time access of market information was available to professionals who paid significant sums of money to access proprietary information sources. Average people could see market information once accumulated after the trading day and read or heard about market factors and individual company news when compiled and delivered after the trading day by newspaper or on a radio/TV program. Control of the information meant control of the recommendations and control of the fees.
Today, any person can see the market action with a slight delay of minutes and get constant, almost 24 hour commentary on the radio, TV, Twitter, or other media sources. Today there are thousands of self-proclaimed experts offering their opinions on the market and media outlets with self-interest in whipping emotions (to attract viewers/listeners/eyeballs) about every twist they can find. Access to market data and economic/financial information is no longer a limiting factor to long-term investment management.Couple this with the ease of buying and selling enabled by large broker firms, be they the traditional banks like Morgan Stanley or the retail brokers like Fidelity, Schwab or eTrade. People can get information and react in minutes; something that was difficult to impossible not that many years ago.
So, how has all this access to information helped the average investor?
According to Dalbar, a group that has tracked investor behavior for some time, not much. Investors still pour into markets well after they have been improving, typically inflows surge as the market is peaking, and they sell when the market is down, typically bailing out near the bottom.
The #1 killer of investment returns is emotions. We humans react strongly to fear of missing out and fear of loss. Professionals who have had long track records of success in trading and investing in the markets have all learned to manage their emotions. It isn’t that they are cold-hearted people. Instead, they are clearer about what is important and have created rules to help them make decisions regardless, or in spite, of their emotions. Markets wiggle, they gyrate up and down. In any year at least one 5% “correction” is almost guaranteed. In any year a 10% decline is actually quite common. A 1% or 2% “correction”, which is so exciting to the talking heads on CNBC or Bloomberg, happens quite frequently. In the long term, all of these are noise.
But we humans live in the here-and-now. To us, each gyration causes adrenalin to flow – fight or flight. We are not programmed to ignore. If you claim to be investing for “the long term”, today’s access to instant information raises the need to fight your emotions to act long-term because every one of these hiccups feels frightening.
Successful investment professionals have learned to control their emotions – typically not by employing a therapist or teacher of meditation – but instead with discipline. Discipline based on using learned rules based on observable market factors that have had high correlation with meaningful market behavior. Calyx uses a range or economic and financial market measures and trends that have historically mapped to changes in trends, both upwards and downwards, as input to our processes. Facts, put in context of time, enlighten us to volatility that is meaningful and that which can be ignored.
Individual investors do not typically have the time to investigate market factors on a continuous basis, nor have they developed, and tested successful rules, nor do they have processes to track their rules, nor the simple discipline to follow the process week in and week out over years. But this doesn’t keep them from watching the news and looking at their portfolio. They feel out of control and they worry.
Mark Ritchie, a world-class investor interviewed by Jack Schwager has something to say about this. If you are investing for the long term, then to be successful you need to “Do what is right, not what feels comfortable,” says Mark Ritchie. What does this mean? If you are investing for the long-term, then you need to act long-term, not let your gut suck you into acting short-term. You need have discipline, rules and processes based on long-term. Watching the market during the day or tracking it each day is not just useless, it is actually harmful.
Three factors that can help manage emotions and protect our assets as the markets wiggle forward. They are: trend following, automatic sell orders, and position sizing. Describing the details, specific high probability rules, and processes for seamless execution could be a chapter or a book for each. In short, “the trend is your friend” is a mantra that has spawned systems that have delivered above-market returns and help with the fear-of-losing-out emotion. Likewise, automatic rules for selling when markets decline helps to manage that “fear of loss” emotion by providing an automatic protection mechanism that has been effective in avoiding large losses if implemented with market-tracking rules.
Position sizing is a little-understood factor in controlling emotions. Many investment professionals talk about reducing the size of positions in a portfolio to limit risk. Logically we can see that a portfolio with one position has inherent risks compared to a portfolio with two, three or four positions that are meaningfully different from each other. Mathematically we learn that the risk reduction tapers off after a handful of positions, and is only slightly less with twenty and really not much different with 100 positions. Academics have weighed the balance of risk reduction with smaller position sizes vs. the fact that a larger return of a very small position can result in an almost negligible improvement in overall performance.
Mark Ritchie provides an interesting twist: Ritchie says that positions should be small enough that any individual trade has virtually no impact on your emotions. “Magnitude of losses and profits is purely a matter of position size. Controlling position size is indispensable to success. Of all the traits necessary to trade successfully, this factor is the most under-valued.” – Mark Ritchie, again.
And regarding individual positions, if you are worried about a position to the point that it keeps you up at night, there is no possible way that you can clearly assess any aspect of the position. The best solution at that point is to liquidate the position. “I have a rule that whenever I’m still thinking about my position when I lay my head on my pillow at night, I begin liquidation the next morning,” says Ritchie.
Managing Emotions to enable Long-term Investing
Before we create rules for investing, the first order of business it to acknowledge that without a disciplined process for managing our investments, any strategy will be de-railed by our emotions sooner or later. That’s why, at Calyx, developing and committing to use a rules-based approach to investing came first. Our strategies of risk management, selective asset allocation and position choice are built on data and rules with a long-term view.
God bless you,
At Calyx, we help families protect and manage their financial resources. We are a financial advisor and investment manager that partners with our clients to administer their financial affairs with personal attention and active risk management.
Calyx is also an advisor to several not-for-profit charitable trusts and endowments, working with committees of faith based organizations to preserve their legacy while providing operating income. We are sensitive to the investment needs of these clients while working within the guidelines they have established to reflect their principles.