Mutual Fund Research Newsletter
Copyright 2011 Tom Madell, PhD, Publisher
March 2011 Published: Feb. 27, 2011

Why Successful Investing Is 90% Psychological

by Tom Madell

I used to think that successful investing mainly involved how astute one was at analyzing economic and financial matters and only involved psychology to a small degree. I am now convinced that it is the other way around: Successful investing involves only a small amount of economic and financial insight, but rather is mainly determined by one's willingness to use psychology as a means of gaining a huge advantage over most other investors.

But what exactly do I mean by "psychology" as it applies to investing and how does it differ from the types of analyses that most investors use?

By psychology, I am not necessarily referring to principles learned in an academic study of psychology. Rather, almost anyone can understand and apply the principles of psychology that I am referring to, even without any formal background in the subject.

Investor "Mindsets"

As I use the word, psychology refers to an analysis of the mindsets of the typical investor. Mindsets are nothing more than a commonly held set of beliefs that investors bring with them as they decide if, when, where (which investments), and how (e.g. conservative vs. aggressive, buy-and-hold vs. a more active approach) they will invest in the market. Such beliefs are usually acquired through prior experience in investing, what is presented in the media, or exposure to something akin to "folk wisdom" propagated down through the years.

But how helpful are the most prevalent mindsets in guiding investors and actually promoting success? I would argue they are not particularly beneficial at all. If not, it therefore behooves investors to examine their own beliefs and those of the majority of funds investors in an attempt to understand plausible, but in reality, primarily misguided mindset thinking. Those who do will find themselves potentially able to profit as a result being able to detect the performance-damaging tendencies within those mindsets.

Which mindsets are most common? Here is my list:

  1. The degree of strength of the economy, as well the stock market itself, should be one's primary guideline for decisions as to when to buy or sell stocks.
  2. Yields available from cash, CDs, or bonds should be a good guide as to not only when to keep your money in these investments, but also when to forgo these investments in favor of stocks.
  3. A current high degree of volatility of stocks may suggest not investing in stocks for the foreseeable future.
  4. Similar but not the same as 3, proximity to "market crashes" should be a good reason to defer investing in stocks for a considerable period, if not forever.
  5. Similar but not the same as 1, you should be able get a good sense of how the stock market has been doing by attending regularly to reports on the performance of the most widely reported stock index, the Dow Jones Industrial Average.

For those who might be taking just a rapid glance at this article, let me be perfectly clear upfront: Adhering to any or all of the above beliefs can seriously impair your chances of being successful as an investor.

If I have already begun to step on a few toes by suggesting that widely held beliefs among the majority of investors may have serious flaws, that is indeed my intention.

It should be noted, first and foremost, that each of the above 5 mindsets tend to imply that success as a funds investor relies to a great deal upon whether you have given at least some attention to, and correctly interpreted the "economic tea leaves" and their presumed implications, thereby enabling you to decide upon a prudent course of investment action.

Let's elaborate on each of the above mindsets to see why in many, but certainly not in all cases, I question relying heavily on any one or more of these beliefs when making one's investment decisions.

Strength of the Economy and Stocks

The strength of the economy and the stock market itself may be an effective guide, but perhaps not much more than 50% of the time. Why? Many of the biggest downturns in the markets occur after the economy and stocks have been doing well for a number of years. And, easily, many of the biggest upturns occur after a recession and a concurrent bear market. Thus, using these measures as data points tend to be most successful in the early stages of an downturn or upturn, but will likely fail in the latter stages. Even so, how is it possible to know how long such downturns and upturns will last to identify such stages?

A corollary of the above belief is the notion that strong economic growth equates with good stock returns, and vice versa. A recent article in the Wall Street Journal should dispel investors' confidence in that regard. It reports research going back over 100 years focusing on stock returns in 16 major countries including the U.S. The findings: Rates of growth as measured by gross domestic product are not readily discernible as a predictor of stock returns. Thus, last year's stampede by investors into emerging market funds based on superior growth prospects has not yet been rewarded by superior returns and may actually severely underperform US stocks for a considerable period.

Forgo Stocks When Rates Are High, and Vice Versa

Many investors believe that so long as they can get a reasonably high return from bonds, CDs, and money market accounts, they do not need to take on a considerably higher degree of risk by focusing on the stock market instead. But in times such as now when rates are near record lows, they believe that their available relatively less risky returns are so much lower than normal that sticking with these investments no longer makes sense. Thus, they tend to become stock market "converts." While such thinking can initially help investors to improve their returns from what they perceive to be unacceptably low rates, it may run the risk of increasing exposure to stocks when rates are near cyclical lows. If so and rates start to rise more than expected, this might not prove to be such a good entry point after all.

In truth, level of rates of return available may be much more immaterial than most people think. Usually when interest rates are high, unlike now, inflation tends to be high as well. Say you could make 6% in a money market or bond fund. If so, many people might think why gamble on the stock market. But if rates turn considerably higher than today's low rates, inflation is likely going to be considerably higher than now too. So if inflation simultaneously rises to say 4.5%, when you subtract out inflation from what you thought was a respectable 6% return, your "real" return may now become about the same as when available rates are at 2.5% and inflation is at 1%, that is, 1.5%. Thus, the 6% "available" environment may be no different than the 2.5% "available" one because one's inflation-adjusted return (i.e. spending power) is the same. Conclusion: While the income-seeking investor may feel worse off when rates are low, there may actually be little practical difference as compared to when rates (and inflation) are both higher as well; therefore, one should think twice before becoming a stock convert just because rates are low.

Volatility as a Deterrent

It can certainly appear to make good sense to avoid a highly volatile market. Why expose yourself to the possibility of even greater losses than might typically be the case? But volatility, while certainly "scary," should mainly be of concern if you are short-term oriented, rather than a long-term investor. Thus, it should be of little practical significance to you if your investment goes down, say 20%, in the next 6 months if you intend to be a holder for the next 5 years or more. Assuming the average long-term return for stocks is about 9% annually, this knowledge should be a better guide to making investment decisions than being overly concerned where stocks might go in the short run.

Why else do investors react so negatively to volatility to the extent of possibly avoiding exposure to stocks even during a long-term rising market as we have been witnessing since early 2009? Studies have shown that people have a much greater aversion to losing money than they do to the prospect of making it. Thus, even in spite of a doubling in stock prices lately, many investors will stay out of stocks because they may envision the possibility of the pain short-term losses which they are not confident they can withstand and just ride out. But if one adopts a more positive mindset, it becomes apparent that one can never make anything by investing over the longer term without exposing oneself to price drops over the shorter term which do not have to realized (i.e. "paper losses" turned into real losses).

"I Will Not Be There During Another Market Crash"

It is a well-known fact that a large number investors will remain spooked for many years following a "market crash." But realistically, such an event or even multiple crashes such as during the prior decade should have little bearing on a truly rational investor's actions. Why? Because past performance is not a reliable indication of what lies ahead. In fact, as suggested above, buying after a crash usually turns out to be far more profitable than buying after a huge market run-up.

Since a crash is actually a rare event (in spite of what happened in the last decade), it likely makes sense to view the occurrence of one as an event that may actually diminish the prospect of future ones (at least for quite a while). A good analogy might be the occurrence of a highly destructive earthquake on the California San Andreas fault. While rare, scientists believe that a huge quake serves to relieve the built up pressure within the earth. As a result, Californians who actually get through a "big one" may wind up better off even though they may not feel that way immediately. Market crashes, like earthquakes, do serve their "purpose" - they remove excesses and return things to a more sustainable state.

"The Stock Market"

Over and over, one hears the phrase "the stock market." For example, look at this question: How did "the stock market" do last year and over the last decade? For most investors, there would be a single answer to each part of the question: Moderately good last year, but pretty meager over the last decade. But do these answers really capture the wide array of possible outcomes for investors? The answer is "not hardly at all." Why not? Because it is difficult to come up with a single index of how "the stock market" has been doing. And if one's thoughts are narrowed by the phrase "the stock market," this may foster failing to recognize outstanding, but less obvious opportunities, in what is in reality "a "multi-faceted stock market." Of course, the same is true for the phrase "the bond market."

Consider this: Last year (2010), the Dow Jones Industrial Average was up 14.1%. However, over the entire decade, the annualized total return was only 3.2%. If you use these numbers to guide your investing decisions, it might suggest that while investing in stocks was reasonably profitable last year, when considered over a 10 year span (that included 2010's results), you could easily conclude it was hardly worth bothering. But such a "wholistic" appraisal of stock returns misses the fact that investors had many opportunities to do considerably better. Investors in small, mid-cap funds, and real estate funds had returns averaging about 26-27% last year, while those in gold-oriented funds 43.6%. And over the decade, investors in emerging market funds, Asia/Pacific, natural resources, and gold funds earned anywhere from 9 to 25% per year. Thus, rather than merely viewing the stock market as a single entity that is doing either well or not so well, it makes far more sense to be aware that there are actually many markets, each with their own investment prospects.

Conclusion: Thought Processes Are Crucial Determinants of Investor Success

All of the above "mindsets" or ways of thinking can have a significant bearing, predominantly negative, on the results that any given investor will achieve. This is because each may lead to an appraisal of what appears to make the most sense, when a closer look might suggest little of the expected relationship, or even the opposite, as what the mindset predisposes us to believe.

In fact, you might say that much of what one does when investing, and why one does it, can be regarded as "psychological," that is, highly influenced by your own predispositions. This would suggest that the opportunity for improving one's overall chances of, as well as degree of, success lies far more within one's own hands than most investors realize.

In other words, if you would like to be more successful as an investor, examine what you and others are thinking inside their own heads, that is, "psychology," rather than mainly assuming that you can do better only if you learn more about the world of finance, economics, and an assortment of fund data. This is also a far better "mindset" than assuming that little can be done to improve investment success or that it is mainly determined by luck or chance, and therefore, doing little to try to improve it.


click here to read Part II of this Newsletter, the article "Government Shutdown: Stock Market Impact" by Steve Shefler.