One of the biggest obstacles to long term investing success is our inability to think, act, and implement long term habits.
In short, we quit. We quit far too often, and we quit far too early. These effects are well replicated even in facets of life well-related to your own. Perhaps it was not investing for you, but in other aspects of your life.
It could be;
- learning a new craft/skill
The reality is that humans find it innately difficult to change habits and that we find certain activities painful to continue.
This effect is magnified once you start considering the effects a stock market might have on an investor. The magnification is two fold.
First, time -> Everybody wants to get it quick. Nobody wants it slow.
Second, money -> When real money is on the line, the urge to protect capital is almost visceral. Investors yank money out when they should really be invested and invest when they should be yanking money out and locking in returns. This is a well-researched phenomenon, particularly by Joel Greenblatt. Even experts are not spared.
In 2011, I published a book called The Big Secret for the Small Investor. I always say it’s still a big secret because no one bought it. It talked about a couple of studies, including the best-performing fund from 2000 to 2010, which was up 18% a year even when the market was flat. The average investor in that fund went in and out at the wrong times on a dollar-weighted basis to lose 11% per year.
Meanwhile, the statistics for the top-quartile managers for that decade were stunning: 97% of them spent at least three of those 10 years in the bottom half of performance, 79% spent at least three years in the bottom quartile, and 47% spent at least three years in the bottom decile. So our fund would compromise: Reduce the tracking error but add the benefit of buying cheap stocks and shorting expensive stocks. In a more muted return environment for the S&P 500, that extra additional return should be very attractive to investors.
“”Joel Greenblatt has found that investors struggle to implement his Magic Formula in practice. In a great piece published in 2012, “Adding Your Two Cents May Cost You A Lot Over The Long Term,” Greenblatt examined the first two years of returns to his firm’s US separately managed accounts. Greenblatt conducted a great real-time behavioral investing experiment. He gave his clients two choices to invest in US stocks.
One account was like the business owner. They picked what top-ranked stocks to buy or sell and when to make these trades. The other was like the quant investor. This account followed a systematic process that bought and sold top-ranked stocks automatically.
Essentially, business-owner accounts had discretion over buy and sell decisions, while quant-investor accounts were automated. Both choose from the same list of stocks.
So, what happened?
The business-owner accounts didn’t do badly. Those accounts averaged 59.4% after all expenses over the two years, a good return. But the S&P 500 rose 62.7% over the same two years.
The quant investors account averaged 84.1% after all expenses over the same two years, beating the business owner by almost 24% (and the S&P 500 by well over 20%). That’s a huge difference, particularly since both accounts chose stocks from the same list and were supposed to follow the same plan.””
Given that we understand investor performance is tied to investment returns, and that investors more actively move to “protect” capital, how should we go about designing a good course that can reliably bring students from Point A(beginner) -> Point B (successful investor over the long term)?
- The portfolio must be easy to handle mentally. To do so, it must be innately defensive so that it drops less than the market average
- It should have lower volatility than the market
- It should generate cash flow so that investors can still receive some reward in the midst of panics
- Dividend portfolios will handle this well since dividend generating businesses tend to be mature, highly defensive businesses with recurring revenue setups such as REITs
This is very important because an investment portfolio needs to be stress-free and mildly addictive so that a rookie investor can be incentivised to learn more about investing as they progress towards expert status.
However, investors should not be thrown against the forces of market chaos without a beneficial long-term outcome. A viable strategy should feature short term random benefits but long-term predictability. You are, after all, creating an investment portfolio to build long term wealth.
As it turns out, a portfolio centred on REITs with satellite holdings in blue-chips and business trusts serves the role of a rookie portfolio beautifully. REIT dividends, unlike bonds, are never guaranteed but are generally predictable as it is based on rentals coming from various commercial properties.
A portfolio of REITs in equal proportions products dividends of approximately 6.2%. Overall back-test returns are higher than equities with a lower downside risk.
The following screen-shot traces the investment portfolio of ERM early-2019 student “whythefuckcare” as he built a portfolio from ground zero.
As you can see, as the portfolio evolves, monthly dividends are relatively random. In the grander scheme of things, dividends are quite stable on a quarterly basis. The combination of randomness as well as predictability probably gave a student like “whythefuckcare” the drive and motivation to build up his portfolio over time.
This is essential if you want to sustain your drive to develop into a better investor over time.
The odds of success are far lower if you start with a portfolio that has massive volatility swings since it disincentives learning and incentivises retreat – both of which are harmful to your journey as an investor.
In this case, he was able to generate a dividend income approximately $100 per month after one year of attending the ERM course. This does not account for the generous capital gains that have been made over a year.
In the next installation, I will discuss another psychological component of a good investment strategy design by looking at successful marriages.
If you would like to find out how we design, build, and implement dividend portfolios, you may register for a seat here.