Running and the art of investing

When I think about investment advisors selling high fee products it brings to mind the story of two politicians who were shouting at each other. One of them stands up and shouts, “You’re lying!” The other one answers, “Yes I am, but hear me out!”

In my forty years of investing I’m sure I bought into some questionable sales pitches more than once. You’ve heard them: “The easy money’s been made, but it’s going to be a stock pickers market going forward.” Or, “Only losers are satisfied with just earning market averages, we want to put you in funds that beat the averages.”

Fortunately, this intellectual battle is over for the majority of small investors who are paying attention and adopt a long term buy and hold philosophy. The folly of looking to invest in the latest hot mutual fund or stock has been debunked through wise sages like John Bogle, founder of Vanguard.  He succinctly described his long-term investing philosophy using index funds: “…the winning strategy is to own all the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return they generate in the form of dividends and earnings growth.”  (The Little Book of Common Sense Investing)

But there is another ongoing battle that is waged in the minds of long-term investors that is not so much intellectual, but psychological. This battle is the inner voice that starts talking to us every time there is a significant downturn in the market which plays on our fears and doubts. I have watched investors over the years cash out of the market just as it bottoms. And then when the market rebounds and recoups all the losses, the regret of bailing out at the bottom haunts them. 

There are probably a number of reasons why some investors make this same mistake time after time in investing, but I want to focus on two of the big ones: failing to accept in advance the psychological cost to be a successful buy and hold investor and failing to manage our investing time horizons.

Lessons from Running

Consider an analogy from the exercise world. My first job after college was working for the U.S. Treasury department as a bank examiner. I traveled around the Midwest from bank to bank and was given an expense account. That’s where the problem started for me.

Growing up I can only remember a few times my parents ever went to a restaurant, so when I was given an expense account, I found myself in heaven every night enjoying one buffet after another, all at government expense. And even with the metabolism of a 23-year-old, I began to pack on the weight.

Fortunately, I worked with a marathoner who ran every day after work. Because of his influence, I took up the sport for health reasons and have never stopped running for over 40 years now.

The benefits have been great! I achieved weight loss and learned how to manage stress better immediately. Longer term, I think the running habit contributed to my current ability to still run and hike in my 60’s. And there are occasional moments of extreme delight as I run watching a beautiful sunrise or just feel one with nature as the endorphins kick in.

But the costs have been real too! Sacrificing an extra hour of sleep before work was tough. Running in the cold Montana winters can be bone chilling. Frankly, I just don’t feel like it sometimes, but I know that is the cost to achieve the healthy benefits I want in life. After 40 years, I know it works and that the costs are worth it.

Counting the Costs of Investing

We know this is how life works. There is a cost to be paid to achieve success. But for some reason, we don’t expect to pay a big psychological price to be a successful investor. In fact, not considering the psychological cost of down markets may be the primary reason some bail out of the stock market at just the wrong time.

We objectively look at the evidence of how the market has performed over long periods of time and decide we want to invest and grow wealthy that way too. However, we don’t properly factor in the inevitable cost we will endure when the dramatic dips in stock prices occur. The fear, regret, embarrassment and self-doubt when our 401(k) drops are costs that aren’t easily factored into our analytical models in decision making.  In fact, it’s hard to imagine the stress of a downturn and watch our retirement nest egg go down by 30% in just a few days until we actually experience it.

And during these emotional times we are most susceptible to the siren call of a market timing pitch that promises to give us all the gains of the market without the stressful losses. But those temporary losses are the price that have to be paid in order to enjoy the long-term success we desire.

I like Warren Buffett’s advice to see a decline in stock prices as stocks going on sale at a discount price. That is a great way to look at it unless you’re at the end of your prime earning years. If we need to cash out of stocks in a down market to live on in retirement, his advice doesn’t help at all. So, we need a second strategy to mitigate this risk.

The Bucket Approach to Managing Money

For those of us toward the end of our careers, I really like combining long term buy and hold diversified stock index investing with the low stress benefits of the bucket approach to managing our finances.  In other words, to keep from panicking when the market drops, try to keep stock investments in a “bucket” that you don’t need to draw on for at least five years, or better yet, for ten years. On the other hand, funds you will need in the near future, such as replacing a car next year, should go in less volatile places like short term bond funds or money markets.

Kiplinger magazine recently showed a chart listing the probability of negative returns for the S&P 500 over various time periods since 1929. While there is a 46% probability of a loss in a one-day time period, the loss probability drops steadily over time and is only 11% over five years and only 6% over 10 years.

Based on these probabilities and my bucket approach, when I lose money in the stock market, I can honestly assure my wife that its money we don’t need for several years and we have a high probability of gaining it back plus some. That is a much better conversation than explaining why we can’t take the vacation this year because I just lost the vacation money.

Getting the greatest benefits from exercise includes the need for rest. I look at the low risk bucket as the equivalent of my days off from running. We can let that money rest while the other buckets with low cost stock index funds do the serious running in the pursuit of wealth.

Joe Kesler, Smart Money with Purpose