Be mechanical about your investing approach

As I have written multiple times in prior posts, our gut instincts, friends’ views, media reports, and most expert opinions are really not that useful when it comes to investing. We, investors, consistently underperform even the ordinary index funds by as much as one-third due to panic selling, exuberant buying, and attempts at market timing. In the same vein, my friends are no good either at predicting market crashes. As for the financial media, I am reminded of this timeless advice from Ken Fisher: Whatever they [media] are fretting, you needn’t because they are doing it for you – a service.

Investors are affected by their emotions and make bad investing decisions. Emotions should have no place in our investing decisions. But it’s easier said than done. We are all humans after all!

Two things that’ve helped me in keeping emotions in check are:

• Understand stock market history, and
• Be mechanical in my investing approach.

Let history be your guide – understand how the stock market behaves over time, how often it falls, and by how much. See this blog post and this. Also realize that over the long run stocks grow in value as economy grows. And that makes stock investing different than some zero-sum game. Recessions come and go but stocks still march upwards.

Once you understand how stocks behave over time, you can create clear, concise, and simple rules to invest your money. In other words, you could adopt a mechanical approach. Set up a rule book, write it down somewhere, and follow it year in year out. Don’t let anyone (or any future event) change your mind.

If you are saving for retirement, figure out how much you can afford to contribute to your retirement account and then stick with it – every month or every quarter. Set up your account to invest your contributions appropriately – don’t just leave them all in cash. For most investors who are ten years (or more) away from retirement, majority of your money should go into stocks (not bonds, not cash or money market account). How much to allocate to stocks? A simple-minded rule of thumb is 100 minus age rule. It will work fine over the long run but perhaps it’s a bit too conservative. Consult with a financial advisor if you want custom asset allocation that suits your individual situation. Key is not to fret over nuances of asset allocation. Instead, make sure to keep a steady hand contributing and investing year in year out. See my own 20-year 401(K) investing journey for reference.

If you have cash sitting on sidelines, follow something like my advice to a friend’s wife. Take stock of how much you have, divide it equally into five or ten parts, and invest once a year into stocks. Pick a date — any date – and buy some stock index fund on that day. Ignore where the stock market is. And especially ignore what financial pundits are saying. Just invest mechanically – keep sentiments out.

Another example of a simple rulebook is what I have for my dry powder strategy. There, I use a few simple rules to decide when to deploy how much of my dry powder. I studied past market behavior and came up with those guidelines. My goal was two-fold: first, I wanted to make sure that I take advantage of expected market downturns. And then secondly, I knew it was easy to get affected by prevailing market sentiment, so I made those rules precise enough to measure and act upon. You can see my dry powder rulebook here.

There are many other investing scenarios where investors would do well to create a set of simple rules to follow. If you are a retiree looking to take money out from your portfolio to spend, you can set up a withdrawal rule to follow. If you have an active portfolio, you could write down how/when you plan to rebalance your portfolio – quarterly, yearly, by how much, etc.

During the Great Recession of 2008 – 2009, how many people told you then that the following ten years would be great for investing. None, I suspect. Even Warren Buffett said in the annual shareholder meeting last year that he didn’t think the market would recover that quickly. Going into the recession, he also didn’t believe that the market would fall as much as it did.

Likewise, today nobody knows precisely what would happen to stocks in next 5, 10, 15 years. Many have opinions. Some sound more confident than other – but they don’t really know. Howard Marks said this in his book:

We may never know where we’re going, but we’d better have a good idea where we are.

Howard Marks, The Most Important Thing

It’s up to us to understand the inherent cyclicality of the stock market, anticipate it by creating prudent set of investing rules, and follow them consistently. Key is to not let opinions, emotions, or random noise detract us one way or the other.

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