CPM Investing LLC - Research Publications
Key ideas will help you handle the psychology of investing, especially doing ETF rotation:
Understanding these adages and the feelings they embody will help you improve your investment disciplines over time. This is especially important when you are trading your own account and checking account balances and performance each week.
7 minutes
Investing one’s own retirement account can sometimes become an emotionally high-stakes situation, and this tension can get in the way of making the right moves and decisions. In this article, I discuss some useful perspectives on and approaches to the psychology of investing.
I have heard adages over the years that relate to asset allocation and rotation approaches in general, and many of these come to mind as I do my work. The one that comes in mind most often is that you will always wish that you did more or less.
At Focused 15, we focus on avoiding losses in the stock market, and the stock market either goes up or down. When it goes up, if you moved into it a little bit, you’ll wish you did more. When the market goes down, and you moved out of just a little bit, you’ll wish you did more. So the usual approach is that because the market only goes up or down, you should have a very high investment in the stock market or very low investment. However, our disciplines often call for being somewhere in the middle, which can lead to a feeling of regret when looking at historical performance; for example, we may have been right on the direction, but we didn’t move as we could have.
The second adage that comes up is don't just do something, stand there! Of course, that’s a twist on the more familiar saying, just don’t stand there, do something. But in asset allocation and investing in general, one can do a great deal of research, devote a lot of effort to figuring out a right course of action, and you may come up with the best course of action being no action at all. Sometimes that’s very difficult to apply. As I observe investors around me and in professional settings, sometimes they feel like they just have to do something. There’s a crisis in the markets—they may look out the window and see that the sky is falling and feel like they have to do something. But in investing, particularly in asset allocations, sometimes the best course of action is to do nothing.
Another adage is to focus on trading when trading and don’t dwell too much on each week's profit or loss. When we are trading, we are setting up the portfolios for the future. There is a time to analyze what has taken place in the past, but usually that’s every month, or every quarter, or even less frequently, just because of the natural ups and downs of the markets. So looking at your profit and loss of each week is a little too frequent.
Related to Focused 15 Investing in particular, something that I keep in mind is that our portfolios are invested in the most developed economies: very mature and very liquid markets. When we look at the Dow Jones Industrial Average, it’s been around for over a hundred years: it’s been through a couple of wars, the Great Depression in the 1930s, the Global Financial Crisis in the 2000s, several period of inflation, and major shocks. Yet somehow those major blue-chip companies still muddle through.
Another point about Focused 15 is that we evacuate the building on all alarms. So if we got a signal that the markets are vulnerable, that’s a fire alarm. We will take money out of the stock market even if we have a sense that the alarm is going to be a false alarm. We will vacate the market and wait until the coast is clear, and then we get back in. So not every move that we make is going to be justified. Making those moves is easy because of the ease of trading ETFs. But there are probably more false alarms than justified moves that we will make. So when we move out of the market, it may be that no decline will take place. We may even miss some returns during that period of time, but then we will get back into the market. The goal is to capture the upside when that does take place.
The final adage for Focused 15 is that commentary takes backseat to the algorithms. So the commentary that I write, the commentary that you hear on business news channels or read in the press, all of those thoughts, all of those views about the current circumstances take a backseat to the algorithms. The algorithms have been developed over many years and incorporate a perspective on history that humans can’t match. So it is best to base the ETF rotation decisions on those algorithms. Those algorithms are very important to the disciplines that we have in Focused 15 Investing.
These disciplines mean that we take the same course of action every time we encounter certain circumstances. The algorithms look back over a long period of time—over a hundred years in case of the Dow Jones and for bond markets, for 20 or 30 years—and make a determination about the most prudent asset allocation given those circumstances. So those views are based on all available history, not just recent memory. If left up to me or someone else evaluating the markets, without those disciplines, the actions would be heavily influenced by recent events. The disciplines help us avoid the negative impacts of being human.
There are many ways that natural emotions can get in the way of investing. When we have unrealistic euphoria in good market environments, we may be biased in our decision-making to remain invested in the market. We may also, of course, have unrealistic despondency in bad market environments, which may cause us to panic. We may have unrealistic euphoria when Focused 15 Investing specifically does well, and that may lead to a higher sense of conviction in the approach and lead one to take on a more aggressive portfolio than one is comfortable with on a long-term basis.
On the flip side, we may experience unrealistic despondency when Focused 15 Investing does poorly—and there are times when the model portfolios won’t perform as expected, but there is usually a recovery. But during those times when Focused 15 does poorly, it’s natural to want to correct a situation that one perceives. The final emotional experience is that humans often require some time off when something has gone poorly—some time to lick their wounds. There are times when the algorithms just failed to accommodate what’s taking place in the markets, either because of the presence of news of the day which overwhelms the resilience measures that we base our decision on, or the algorithms are simply wrong.
But it takes just a week or two for them to recalibrate, get back in, and make a determination about the right asset allocation going forward. For humans at the end of a period of declines, when things don’t go well, they may say, I need some time off—the game is over—I have lost. I need some time to think about what to do going forward. The algorithms don’t need that. They get back up and resume their work without any painful memories. So it’s important when you’re trading your accounts to stick with the disciplines and follow through on them. Investing is a game that really has no end—a perpetual game. So you have to stay with it and recover quickly from an emotional point of view from times that don’t go well. You have to continue to implement according to what the disciplines call for.
Understanding these key adages, strategies, and the feelings they embody or elicit will help you maintain your investment disciplines over time. This is especially important when you are trading your own account and checking account balances and performance each week. An appropriate mindset will help you handle the psychology of investing, especially using an asset class rotation investment process such as Focused 15 Investing.
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