Long-term investing doesn’t happen by accident. You need to be prepared. There are three things that can allow you to use market volatility to your advantage: the right structure, a long-term investment process and a behavioral checklist to allow you to remain rational when everyone else is being anything but.
Why you should want to invest for the long-term
1. Investing for the long-term allows you to take advantage of high return opportunities that others might shun. Many short-term investors might pass on a high-return investment just because the near-term outlook is weak or uncertain.
2. Being a long-term investor helps guard against behavioral biases. Recency bias causes people to over-extrapolate the near-past further into the future more than the facts merit. Taking the long-term view on an investment should cause you to think about more than just what has been happening recently to arrive at a reasonable conclusion.
3. Long-term investing reduces frictional costs, such as trading expenses and tax impact.
4. Evidence shows that longer holding periods are associated with better performance.
• According to Dimensional Fund Advisors, over the 15 year period ending on 12/31/2015 the average holding period of a stock by U.S. equity mutual funds has been approximately one year.
• The data presented above shows that when equity funds were divided into quartiles based on their average holding period, a much higher percentage of funds with longer holding periods outperformed the benchmark over the full period than did funds in any of the other quartiles.
How the right structure can help you invest for the long-term
You never want to be in a position of being a forced seller if you are to going to invest for the long-term. What can cause you to become a forced seller?
• Needing long-term funds to meet short-term needs. If you do not have other means to meet your short-term financial needs, then you might need to resort to selling your long-term investments at very disadvantageous prices. If you are an individual investor you should have appropriate safety funds to meet unexpected short-term needs and only invest for the long-term with funds that you won’t need for 3+ years. Institutions need to plan out how they are going to fund the portion of their assets they plan to spend each year and structure the portfolio to meet those annual needs with short-term assets such as cash or short-term bonds.
• Behavioral biases. If you let market volatility get to you, it might scare you into selling at well below the value of your investments. It is one thing to have an investment process in theory – the question is how you are going to stick to it when things are not going your way and your mind is screaming at you to sell everything to avoid further losses. Make sure that defense against behavioral biases is a regular part of your investment process.
• Poor governance. You might be very comfortable with your long-term approach, but your board of trustees, your clients or your spouse might not share your conviction and exert pressure on you to change tack at the exact wrong time. Don’t have a mis-match in the time horizons between how you are investing your capital and how other key stakeholders are likely to act when the going gets rough. What can you do? At a minimum communicate in advance and prepare others for what might happen and how you plan to proceed in advance.
Develop a written long-term investment process
Some investors choose to rely on their gut instinct to make investment decisions. While there might be a few extraordinary individuals who can succeed this way, for most this would be a mistake. For your investment results to be repeatable over the long-term, you need to write down all aspects of your investment process.
An investment process is an internally consistent system for how you are going to implement your investment philosophy in practice. What you should realize is that there isn’t a one size fits all process that you should try to replicate. Instead, you should think about your own strengths and weaknesses and come up with an investment process that is built to maximize the former and minimize the latter.
Why should you write your process down? First, it will force you to think through your process much more rigorously than if you do not. Second, you can trace the evolution of your process as it improves over the years with additional study and experience. Finally, a written investment process acts as a form of commitment, to yourself and potentially to others that should help you remain rational when the pressure to deviate is greatest.
Once you write down your process you need to stick to it 100% of the time. What about improvements? These need to happen when there is no specific investment decision being considered so that you can be sure that you are not just looking for an excuse to deviate from your process under pressure. Too frequently in the investment management business is one thing written on the glossy pages of a marketing deck and quite another happens when no client or prospect can see what the manager is doing. That is unacceptable for many reasons, not least of them because presumably your written process is your best current way that you can invest capital wisely.
Use a behavioral checklist to help you stay rational
No matter how rational you think you are, you are going to face pressures to deviate and hidden biases that can impact your judgment. To help you be as rational as you can, take the following steps:
• Share your written investment process with clients, prospects, your board or even your spouse. Anyone who can and should keep you accountable.
• Explain all of your individual decisions in the context of how they comply with the process you outlined to all the above stakeholders. Knowing that you will have to justify your actions by the yardstick of your own written process will help you resist the temptation to act irrationally in the heat of the moment.
• Here are some of the questions you can include on your checklist:
o Is it possible that you are anchored to your initial conclusion? Have you sought out a strong opposite view?
o Do you feel any emotions with respect to an investment decision? A stock doesn’t owe you anything and doesn’t know your history with it.
o Have you considered the base rate probability of the events that need to happen for you to be correct? If most of the time things haven’t worked out well for others in similar situations, be as specific as you can be about why you think it will be different for you in this case.
o Are you being either too risk averse or too risk seeking? Investors are known to behave very differently when they have experienced a particularly bad or a particularly good period of performance. The ideal behavior that you are striving for is acting completely rationally all the time. Since you are only human, the next best thing is to recognize when your mental investing game is off and defer the decision until you have restored your equanimity.
Don’t get hypnotized by falling stock prices
One morning late last year I told my wife that I was planning on buying a stock after the prior week's sell-off.
"But how can you be sure that the price won't keep going lower? Haven't stocks been falling non-stop lately?"
I couldn’t be sure.
It's easy to get mesmerized by staring at the computer and watching falling prices.
To get hypnotized into inaction as fear of loss kicks in.
Your mind tells you: "It fell X%. It's going to keep falling. Just wait a little longer."
I went through this in the first downturn that I invested in as a professional value investor, in 2001-2002.
I kept watching the screens. I didn't act.
My process has evolved significantly over the years, informed by that market downturn, as well as the far greater one in 2008-2009.
I now have a rigorous, written process that I have shared with all my investors in the Owner's Manual.
It serves both as a guideline to remind me what I should do when under behavioral pressure, and to tie me to the mast of my best-reasoned logic to avoid the siren-song of fear and greed calling to me to act irrationally.
I made the decision the prior night, after calmly re-analyzing the business, stress-testing the fundamentals and considering various alternatives.
That morning I bought the stock.
I do not know what the price will do in the short-term.
I believe, based upon sound reasoning and analysis, that the value greatly exceeds the price and that the downside to the worst-case fundamental scenario is low.
That is the best one can do.
As Benjamin Graham put it: "In the short-term the market is a voting machine, but in the long-term it is a weighing machine."
Long-term investors have generated some of the best long-term investing track records around. Yet those who think long-term make up a small percentage of all investors. Investors who are also able to act long-term are fewer still. Don’t leave it up to chance. Set up the right structure for long-term investing, develop a written investment process and systematically guard against behavioral biases to maximize your chances of success.
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Note: An earlier version of this article was published on Forbes.com and can be found here.