Investors need self-discipline. Some new research shows this. Charline Uhr at Frankfurt’s Goethe University and colleagues studied almost 20,000 German investors and found that smokers – a group of people who lack self-discipline – earn lower returns than non-smokers because they are more likely to make mistakes such as trading too much.
This corroborates other evidence suggesting that self-control matters. Nicholas Papageorge and colleagues at Johns Hopkins University have found that genetic endowments related to educational attainment “strongly predict” people’s wealth at retirement. This, they say, is probably because such genes are associated with the self-discipline needed to knuckle down and do well at school. And experiments by a team of researchers led by Chiara Nardi of the University of Verona have found that men who became angry, fearful or happy took on more risk than those in more neutral states.
In their different ways these findings all suggest that disciplined investors who can control their emotions do better than others. Which poses the question: through what channels does self-discipline improve investment performance? Here are five:
- Start investing early. If you have the discipline (and income) to invest from an early age you will benefit from the power of compound returns. If you save £1,000 a year with an annual return of 4 per cent your money will grow to over £58,000 after 30 years. After only 25 years, however, you’ll have only £43,000. An extra £5,000 of savings thus earns a likely return of 200 per cent. That’s vastly more than you can expect from anything else.
- Don’t trade too much. Back in 2000 Brad Barber and Terrance Odean, two California-based economists, showed that we “pay a tremendous performance penalty for active trading”.
- Don’t follow the herd, or at least do so intelligently. There’s evidence that sentiment-sensitive assets such as emerging market equities are driven by momentum. If you must follow such bandwagons you need an exit strategy – because momentum can inflict big losses on us as well as big gains. One of these has been proposed by Meb Faber at Cambria Investment Management. He says we should buy when prices are above their 10-month average and sell when they are below it. If you don’t have such a strategy remember that long-term returns on the All-Share index are strongly predicted by the dividend yield: higher yields predict higher returns and lower yields lower returns. Longer-term investors should therefore lean against market sentiment, buying when it is low and selling when it is high.
- Avoid wishful thinking. A share will not rise simply because you own it. Be as dispassionate about analysing the stocks you own as you are about analysing those you are thinking of buying.
- Know your limits. Berkshire Hathaway’s Charlie Munger has said that his and Warren Buffett’s great strength is that they know the edge of their competency; they know what they don’t know. Investors must have the discipline to do this, and do so objectively – that is, without falling into the errors of overconfidence or illusory knowledge. It’s very easy to fail to do this and so trade on noise rather than signal.
From this perspective, many novice investors make a systematic error. They think they need research and knowledge before they start investing. It’s easy, though, to exaggerate this – it doesn’t take much research to buy a global tracker fund. Instead, what successful investors need is not so much brains as character. Mr Buffett has recognised this. “You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ,” he has said. “What you do need is emotional stability. “
Some people are smart enough to realise that they lack this. Dr Uhr found that some smokers did actually make good returns. These were those who, recognising their own lack of discipline, relied on advisers and fund managers and did not invest independently.
Perhaps not all of us have the self-discipline to be a good stockpicker. But we can all do something to avoid the damage done by our lack of self control.
