Investing Insights

The Agony and Ecstasy of Great Investing

Dan Irvine
Principal, 3Summit Investment, Management, LLC
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Note: If you would prefer the audio version of Investing Insights click here to listen to our podcast Episode 5: The Agony and Ecstasy of Great Investing.

Would you like to have the opportunity to improve your long-term investment performance by 20%, 30% and maybe even more than 50%? This magnitude of performance improvement is possible and how it can be achieved has absolutely nothing to do with picking better investments or finding the next hot stock. These gains in investment performance can be realized in the difference between being an ordinary investor and a GREAT investor. In this quarter’s Investing Insight, I am going to share with you the one skill you will need to master to profit from becoming a great investor.

This is not an infomercial, so please do not get the impression that what I am going to explain is easy…it is not! The great investors that achieve dramatic results are generally not the investors you see talking up their book on CNBC or sharing their latest stock tips with friends. The reason you do not hear a lot from great investors is because nobody is interested in learning their secrets to achieving exceptional results because quite frankly, the story is usually boring. There is no amazing trade or market prognostication that generated them millions of dollars overnight. Great investors use the investing skill I am going to share with you to gain a competitive advantage and then they compound on that advantage over time. Join me as I share with you the agony and ecstasy, but mainly agony, of great investing.

Focus your effort on skills that contribute most to great investing results

It is widely believed that the stocks or mutual funds an investor chooses to invest their money in ultimately determines their success and the amount of wealth they can create from their investing activities. While a portfolio’s holdings obviously contribute to success, there is one factor that contributes the most to investing success…investor behavior.

Investors spend up to 100% of their time picking securities and adjusting their portfolio and no time on their own investing behavior, which is the factor that will ultimately define their success and determine if they will produce just ordinary or great investment results. Regardless of your investment strategy, the ability of an investor to have patience is what separates average investment results from great investment results. Great investors have mastered the art of extreme patience and usually reap the large benefits of their behavioral discipline. Patience is the most important skill an investor can cultivate to influence and dramatically improve their long-term investing outcome.

Patient investors who have an inferior portfolio in terms of the average returns generated can easily accumulate more wealth over time than impatient investors with a portfolio that generates higher average returns. The best portfolio in the world cannot realize its potential without a patient investor behind the wheel. Great investors have one key skill in common, they can exercise extreme patience while enduring extraordinary levels of emotional pain because they have total conviction in their investment strategy and understand that patience is the most significant competitive advantage they possess.

Why is it so hard to invest with patience?

Investors consciously and unconsciously, continuously compare their portfolios to broad measures of the stock market. Investors are most familiar with the S&P 500 stock market index because they constantly hear its short-term performance quoted on news programs and printed on the front page of almost all news publications and websites. The news headlines and market hype focus on major market indices, in today’s markets, that is the S&P 500. Finance news benchmarks nearly all investment commentary to the S&P 500 because it is a broad measurement of the U.S. stock market, which for news purposes makes sense.

The ubiquity of the S&P 500 index causes investors to consciously or unconsciously “anchor” their investing expectations over short time frames to the S&P 500, while paying no attention to long-term performance of the index or to more relevant risk and return measures. More problematic still, investors do not consider how relevant a comparison the S&P 500 is to their portfolio in the first place. In rising stock markets, an investor’s portfolio that holds 60% in stocks and the rest in other assets is almost certain to underperform the S&P 500 because the index represents a portfolio of 100% stocks. What’s more, a well-constructed portfolio is intentionally designed to perform much differently than the S&P 500, so it is a problem when an investor blindly anchors their portfolio expectations to an unrelated and irrelevant index.

The alternating emotions of fear and greed that investing triggers in all of us is exacerbated by behavioral biases like anchoring and is the source of much of the emotional pain investors regularly suffer. The emotional power that fear and greed hold over us makes patience the hardest investment discipline to master. The combination of fear and greed put investors in an almost constant state of dissatisfaction. When the stock market is going up, investors are not satisfied with how much their portfolio has gone up relative to the market. Alternatively, when the stock market is going down, investors are not satisfied because no one likes losing money. When stock markets suffer extreme down-turns, dissatisfaction rapidly devolves to outright fear.

This stew of our most powerful emotions coerces us to take short-sighted actions because we all feel compelled to act when we experience fear or greed. Action is the wrong response because it causes investors to give up their competitive advantage by deviating from a well-designed long-term investment strategy, likely resulting in much lower levels of wealth at the end of their investing time horizon.

When investors perceive that their portfolio is underperforming the stock market, greed pushes them to chase returns, if an investor is generating losses, fear pushes them to protect their assets. At the point an investor feels irresistible greed, markets have made strong moves up already and taking action on their emotions pushes them into riskier investments at potentially high price levels, therefore setting their portfolio up for large future losses.  When an investor feels compelled to act out of fear, they have already incurred losses and by decreasing or eliminating their exposure to risky assets they will likely miss their opportunity to recover those losses when the market unpredictably and suddenly changes directions and moves up. In other words, making emotional investment decisions results in systematically buying high and selling low…the opposite of a winning strategy. The solution to emotional decision making is patience.

Patience is hard…but pays well

Perhaps you have been to the DMV lately and feel you have mastered the art of patience. Unfortunately, investing usually requires patience far greater than navigating even the worst DMV visit. We are going to explore just how much patience is required to become a great investor and how that patience can be developed within you.

Analyzing investment strategies is always done with the benefit of hindsight, which is not helpful in understanding the level of emotional fortitude that may be required of an investor in order to realize the benefits of a strategy over the long run. If an investor does not understand what type of emotional pain they may have to endure in an investment strategy, they are very unlikely to stick with their strategy for their entire investing time horizon. I am going to show you an analysis that takes a different approach to evaluating an investment strategy. We are going to put ourselves in the shoes of a great investor to see what it really means to have Zen like patience and achieve exceptional long-term investing results.

Empirical evidence demonstrates time and again that portfolios that have less risk can create dramatically more wealth than higher risk portfolios over the long-term. When we analyze a low-risk investing strategy we can confirm that low-risk investing is a compelling strategy as illustrated in the chart below. The chart displays the growth of a $100 dollar investment in a portfolio that is invested 100% in the lowest risk (least sexy) U.S. stocks between 1937 and 2017 (blue line). This low-risk portfolio is compared to the higher risk S&P 500 index (green line) over the same time period.

Hypothetical Portfolio Growth 1937 – 2017 (Growth of $10,000)

low risk investing can create great investing results.
Source: paradoxinvesting.com, S&P 500, 3Summit *see chart disclosures at bottom

We see in the chart that the low-risk stock portfolio turned a $100 investment into $544,000 over the time period, while the S&P 500 turned the same $100 investment into $304,000. The low-risk portfolio generated almost twice the amount of wealth for the investor than the S&P 500. Aside from the low-risk investor ending up much wealthier than the index investor, this chart makes low-risk investing look quite easy, in hindsight of course. Simply looking at this growth chart the low-risk portfolio not only finished ahead but appears to have been ahead for the majority of the time period analyzed, it is therefore easy to conclude that not only did the low-risk investor have a good strategy, but that it was also relatively a smooth and ride for the investor.

However, there are a few problems with how this chart represents the performance of these two investment portfolios, while the chart is accurate, it oversimplifies the challenges the low-risk investor had to endure to realize these excellent results.  Had you invested in the low-risk portfolio in 1937 without the benefit of hindsight analysis like the growth chart we just reviewed, you would have rightfully earned your title as a great investor and master of patient investing. Over the 81 years you were invested, the low-risk portfolio would have underperformed the S&P 500 in 39 of those years, or 48% of the time. Even more difficult to tolerate, in the years the low-risk portfolio underperformed, it did so by an average of 8.5% compared to the S&P 500.

The low-risk portfolio investor encountered some performance situations that ordinary investors lacking iron clad conviction in their investment strategy would find intolerable. Let’s now put ourselves in the shoes of the low-risk investor and imagine that we do not know what the future of the markets or our portfolio hold in store for us. Afterall, the uncertainty of not knowing the future is the painful daily reality of every investor. Investors rarely if ever engage in thought exercises like we are about to do and instead depend entirely on superficial hindsight analysis, which is one reason ordinary investors lack the emotional tools to patiently confront the investment challenges we all inevitably will encounter on our investing journey.

Our tale of investor patience when faced with extreme levels of emotional pain begins in 1950. The table below shows the annual return of both the low-risk portfolio and S&P 500, the cumulative underperformance of the low-risk portfolio versus the S&P 500 and emotional commentary related to likely emotions you may have encountered if you invested in the low-risk portfolio without the benefit of hindsight

Investor Emotional Pain Analysis (1950 – 1956)

great investing - have patience
Source: paradoxinvesting.com, S&P 500, 3Summit

I bet there are a lot of you who can relate to the feelings this investor experienced during this truly awful investment experience over these seven long years of loathing and self-doubt! I would also venture to guess that you did not think about what it would have been like to own this low-risk portfolio during the 1950’s when you looked at the growth chart I originally presented, but instead focused on the long-term end result. If this is the case, there is almost no chance you would have achieved the excellent results you expected because you would have been completely unprepared emotionally to weather this epic investment storm.

What is easily lost in this example is that the low-risk portfolio over the seven years, while severely underperforming the S&P 500, did not produce a single year of losses, where the S&P 500 had one year that had negative returns. However, because the investor was anchoring to the S&P 500, powerful feeling of greed constantly tested the patience of the low-risk investor and created doubt about the quality of investment strategy the low-risk investor was pursuing.

The low-risk strategy is a 100% stock portfolio, just like the S&P 500, so it seems to make sense that investors would feel a comparison between the two is appropriate, but in reality, the comparison is irrelevant. The S&P 500 is more than an index, it is in fact also an investment strategy. It does not just invest in the 500 largest companies as many believe but has specific criteria that must be met by a company to be included in the index.  The index has rules and is quite complex, but generally companies must have a specific market cap, have the headquarters in the U.S. and have four straight quarters of positive earnings to be considered for addition to the index. The qualifying stocks are then weighted by market cap (this is oversimplified as the math is complex) therefore giving the largest weighting to the largest companies by value. The low-risk portfolio invests in the lowest risk stocks as measured by the three-year historical volatility and weights the holdings equally. Don’t worry if that did not make much sense to you, the point is that the two portfolios follow entirely different investment strategies and are only similar in that they both invest in U.S. stocks, making a comparison between the two irrelevant.

The great investor we followed in our example would not have been able to stick to the low-risk investing strategy over the entire time horizon with blind faith or a desire to have patience. The investor’s mastery of patience flowed from total conviction in the low-risk investment strategy of the portfolio and by maintaining a long-term perspective regarding performance. This great investor understood the math behind why his investment strategy was likely to work in the long run and understood how and why the low-risk portfolio differed from the S&P 500. Deep knowledge of the investment strategy built the foundation for his iron clad conviction and his iron clad conviction provided him the confidence to be patient.

The grass is always greener on the other side

We have established that it was anything but easy to earn nearly twice as much wealth by investing in the low-risk portfolio. Many emotional challenges arose for the low-risk investor, much of them caused by the investor’s natural tendency to anchor to the ubiquitous S&P 500. Perhaps if the investor had invested in the S&P 500 for the entire time period, instead of the low-risk portfolio, the investor’s strategy would require less patience because the portfolio would be invested in the same index the investor is anchoring to, therefore avoiding uncomfortable and irrelevant return comparisons that result from anchoring. The lower levels of wealth accumulation the investor would realize could then simply be considered a cost of a more comfortable investing experience, after all, the index portfolio did not perform badly. Furthermore, the investor may still accumulate more wealth than investing in a strategy they could not stick with for their entire time horizon due to the performance penalties an investor will likely incur by switching strategies midstream. Let’s examine if the index portfolio would have been an easier strategy for an investor that has not mastered patience.  

Investing is hard, and so of course anchoring isn’t the only challenge that investors face, even tougher than fighting greed is enduring fear.  Nothing induces emotional decision making more than large investment losses. Both portfolios suffered their share of losses during the time period, which is logical given they were both invested 100% in stocks (stocks are a risky asset), but the S&P 500 would have proved very difficult to stick with because it had a tendency to generate slightly more frequent losses than the low-risk portfolio, and generated gut wrenching losses much more frequently. The chart below illustrates the maximum loss during each year we have been examining

Annual Maximum Portfolio Losses (1937 – 2017)

great investing - reduce drawdowns
Source: paradoxinvesting.com, S&P 500, 3Summit

The S&P 500 generated losses greater than 20% seven different years versus only three separate years for the low-risk portfolio. When we zoom out and at the entire time period instead of individual years the S&P 500 is a much riskier portfolio with a maximum cumulative loss incurred during the entire time period of -50.95% versus -38.50% for the low-risk portfolio. Stone cold patience far beyond what the average investor can endure would have been required to keep fear at bay during the stomach-churning losses both portfolios but particularly the S&P 500 encountered. Most investors cannot stand by patiently as half their investment portfolio’s value is lost.

If we look at investment losses as a gauge of investor fear, the index portfolio registers much higher on the fear gauge and it can be concluded that more conviction and patience would be required to invest in the index portfolio as opposed to the low-risk portfolio. Additionally, despite the index portfolio investor having to worry less about anchoring induced greed, the low-risk portfolio may still require less patience because despite underperforming the index portfolio 48% of the years, it outperformed the index portfolio in 52% of the years. Therefore, the investor would be feeling confident in the low-risk portfolio performance over more than half the total investment period. Anchoring does not always have to be bad, it can often act as an emotional tailwind pushing the investor along.

Monitor portfolio behavior not returns

To hang on to the low-risk portfolio like grim death through periods of massive underperformance to the S&P 500 and occasional large losses, required total conviction in the investment strategy on the part of the investor. Conviction in the investment strategy you choose to implement is built on a foundation of deep understanding of how the strategy gains its advantage and why you have chosen that strategy for your objectives. If we identify what the great investor understood about his low-risk investing strategy that gave him the conviction to be patient then we too can learn master patience.

The low-risk investor understood the following characteristics about his low-risk investment strategy:
  1. Portfolios that generate lower average losses (less risk) can generate more wealth over time than portfolios that generate higher average losses (higher risk) because the portfolio compounds on higher average balances.
  2. Even if a portfolio generates lower average returns, it can still accumulate more wealth in the long run by being less risky and limiting the frequency and size of losses.
  3. Low-risk portfolios tend underperform during strong, broad based market rallies.
  4. Low-risk portfolios tend to outperform during recessions.
  5. An investment strategy can deliver emotional pain and poor performance longer and with greater magnitude than you would have ever thought possible.

Looking back at the first half of the 1950’s there was a sustained, broad based market rally, our great investor would have understood he was likely to underperform in those market conditions as that is a characteristic of his strategy. Additionally, instead of using the portfolios short-term returns to evaluate the success of his strategy, he would have been monitoring his portfolio’s behavior against the behavior he expected from the strategy given its characteristics. He would have noticed that his portfolio was consistently generating smaller losses than the stock market as measured by the S&P 500, which is the behavior required to accumulate more wealth over the long-term and why low-risk strategies work. In other words, his strategy was working, while he may have been disappointed and anxious about his return results at any given time, the courage to have patience came from unwavering conviction that his strategy was behaving in a manner consistent with the investment strategies characteristics. Finally, to get through even the toughest emotional torment, he would have been comforted to a degree, by the fact that he had mentally prepared himself before investing by internalizing and accepting that investment strategies can and will deliver emotional pain longer than he could have ever thought possible.  

Great investing is hard!

The only thing worse than not having an overarching investment strategy is not sticking with your investment strategy come hell or high water. An investor that has no conviction in their investment portfolio cannot have the patience to see it through to the end, regardless of the strategy they pursue. Switching investment strategies and moving in and out of the markets many times over your investing time horizon will almost certainly cripple your long-term results because the changes you make are driven by an emotional instead of rational decision-making process. An emotional investment strategy is a strategy of systematically buying high and selling low.

The example we have discussed, demonstrated that neither the low-risk strategy or the index strategy was a walk in the park for an investor. Remember great investing is hard! The only way an investor could have achieved worse results than either of these portfolios is by lacking patience and emotionally switching investment strategies again and again or not having an investment strategy at all. It is never too late in an investing time horizon to establish a long-term strategy and to do the work required to understand the characteristics of that strategy with the detail necessary to develop the high levels of conviction required to master patience and become a great investor.  

Patience means waiting a long-time. We all hate waiting and we despise uncertainty. If you have the fortitude to stick with an investment strategy that is underperforming (often dramatically) with the understanding that you may not know for a decade or more if you made the right decision; your patience automatically positions your portfolio contrary to the irrational masses of ordinary investors that make up the market. Patience is profitable because taking a contrary position to most market participants allows you to capitalize on their undisciplined, irrational and emotionally driven behavior. The irrational behavior of the masses is what creates investing opportunities. Following the pack will place you among ordinary investors and deliver just ordinary results. My advice to you, endeavor to be a great investor and profit from patience.


Additional Resources

In this quarter’s Investing Insight I used a low-risk portfolio strategy to illustrate the points discussed. Low-risk investing is one of the most power investment strategies an investor can utilize to produce great investing results. In a previous quarter I went into detail describing the benefits and math behind why low risk portfolios are so great. I would recommend reading that Investing Insight or listening to the podcast.

Investing Insight: Low-Risk Investing Paradox – The Most Import Investing Topic
Read Investing Insight
Listen to Podcast

3Summit Investment Management, LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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