This article appeared first on The Stock Market Blueprint Blog.
What would be your response if someone asked you, what does it take to profit in the stock market?
Some common answers may be: an expensive education, a job in finance, years of experience, brilliant analysis, or high intelligence.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy Read More
None of these responses would be right. The correct answer to the question, what does it take to profit in the stock market is: self-control.
You Can Be A Stock Market Genius
If you think that’s nonsense, consider this quote from hedge fund manager Joel Greenblatt:
Simply put, if your goal is to beat the market, an MBA or a Ph. D. from a top business school will be of virtually no help.
Furthermore, on the first page of Greenblatt’s book, You Can Be A Stock Market Genius, he says:
The well-heeled Wall Street money managers and the hotshot MBA’s don’t have a chance against you and this book.
It may sound like Joel Greenblatt has a vendetta against successful money managers with MBA’s, but that’s not the case.
In addition to being one of the most successful hedge fund managers of all-time, Greenblatt earned his MBA from Wharton and is an adjunct professor at Columbia Business School.
Being one himself, he has nothing against well-credentialed money managers or academics. He’s just being honest.
Control Your Emotions
In an interview with Family Wealth Report, Jason Zweig – The Wall Street Journal columnist and best-selling financial author – was asked how much education is needed to become a smart investor.
Zweig’s answer is quite profound:
Among the many things my father taught me was this paradox: It’s remarkable how much you need to learn in order to discover how little you ever needed to know. Smarts are overrated; the world is awash with smart people. What’s in short supply is wise people. Apply the basic principles of the wisdom you’ve acquired from your experience elsewhere to investing, and you will probably fare better than many ‘smarter’ investors. Be skeptical, think for yourself, ask for evidence and probe it for weakness, control your emotions, distrust the fashionable, remember to assess not just how much you will make if you are right but how much you will lose if you are wrong — steps like these are basic good judgment and simple wisdom. Often, people who know a lot about investing become so taken with their own knowledge that they forget the power of a few obvious questions.
In this context, it’s easy to see how Mr. Greenblatt can hold an MBA and at the same time say it’s ofv irtually no help. The more he learned, the more he realized how little he needed to know.
The most notable phrase in Mr. Zweig’s above response is: control your emotions.
Controlling your emotions is by far the most important characteristic of any successful stock market investor. The inability to do so has led to rampant underperformance for the majority of investors.
Investor Performance vs. Market Performance
It’s no secret that individuals who invest in mutual funds consistently underperform the mutual funds they are investing in.
For the last two decades, Quantitative Analysis of Investor Behavior study. This year’s results are just like all the rest.
According to the study, the mutual fund investors underperformed the S&P 500 by 3.66% in 2015. At the end of 2015, the 20-year annualized returns were 8.19% for the S&P 500 but only 4.67% for mutual fund investors.
Although fees, taxes, and commissions play a role in these discrepancies, Dalbar concluded that the primary causes of underperformance were psychological factors:
No evidence has been found to link predictably poor investment recommendations to average investor underperformance. Analysis of the underperformance shows that investor behavior is the number one cause, with fees being the second leading cause.
In other words, a lack of self-control prevented investors from obtaining the same returns as the investments they invested in.
While controlling your emotions is the most crucial aspect of any investment approach, it also happens to be the most difficult to put into practice.
This has do to with evolution. Humans are emotional animals. Fear, anger, excitement, joy, and sorrow are deeply ingrained in our DNA.
Each emotion plays an important role in our lives depending on the circumstances. Each emotion can also wreak havoc in our lives if expressed at an inappropriate time.
In an interview with the American Association of Individual Investors (AAII), Thomas Howard, Ph. D., explains that myopic loss aversion and social validation are two evolutionary traits which work against investors.
Dr. Howard is professor emeritus at the Reiman School of Finance and author of Behavioral Portfolio Management: How Successful Investors Master Their Emotions and Build Superior Portfolios.
Myopic Loss Aversion and Social Validation
Howard states in the interview:
The two most important emotional brakes are myopic loss aversion (MLA) and social validation, which are the result of millions of years of evolution. The fight or flight reaction triggered when a saber-toothed tiger showed up was critical to our survival as humans. However, a sudden drop in portfolio value can trigger the same MLA emotions as did that predator thousands of years ago, but without the same life-or-death consequences. So being governed by an ancient set of emotions often leads to poor financial decisions.
Doing the same thing as everybody else, the definition of social validation, also made sense thousands of years ago when life was full of danger. Since we lived in small groups then, we depended on others to sense danger and react instinctively. You didn’t want to be the slowest member of the group when fleeing the tiger. In contrast, today we frequently want to take positions different from the emotional crowd as a way to harness the price distortions resulting from collective behavior.
So two of the most important emotional responses which kept humans alive for millions of years, are now the main causes of poor investment performance.
We panic and sell our stocks as they’re going down the same way we would run from a predator when we were in actual danger. Likewise, we join the crowd and buy the stocks everyone else is, just like how we start running if the rest of our group is running.
Although there was a time when these instinctual reactions were beneficial, the modern investor must continually fight them off in order to do what it takes to profit in the stock market.
Capturing high returns in the stock market does not require brilliant analysis or intellectual ingenuity. Rather, it requires controlling emotional urges and overcoming psychological obstacles.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a free site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.