Behavioral economics is the study of how human nature impacts investment decisions.  For example, “self-attribution bias” is the term behavioral economists use to refer to the human tendency to equate portfolio performance with skill.  However, luck has a much larger effect on how investments perform than most investors realize.

 

Michael Batnick’s Irrelevant Investor blog last week included a chart that does a great job of making this point.  It shows how a ten-year investment in the U.S. stock market (based on the S&P 500 Index) would have fared, based on different start dates.

 

 

If you asked Inspector Harold Francis Callahan (the police detective played by Clint Eastwood in the legendary Dirty Harry films) what he thought of Batnick’s chart Harry might say, “Seeing as an investor who started in 1946 (black line) got the chance to invest in a stock market that compounded at 16.7%, whereas one who started in 1966 (light blue) saw stocks compound at just 3.3%, you have to ask yourself just one question:  ‘Do you feel lucky?’  Well, do ya?”  (To see Harry in action, click here: https://www.youtube.com/watch?v=8Xjr2hnOHiM).

 

The “recency effect” is the term behavioral economists give to our tendency to overweight recent experience when making investment decisions.  As Batnick points out: “Where the market goes in your first ten years can have a disproportionate impact on how you think about investing for the remainder of your life.”

 

If you were new to investing in 2018 you might be tempted to convert your investment portfolio into cash and hide your savings under a rock.  That’s because 89% of investible assets have lost value in U.S. dollar terms in 2018, according to Deutsche Bank.

 

Although luck has a significant role on portfolio performance, that doesn’t mean skill does not.  To the contrary, skill serves to magnify the positive impact that comes from good luck, and minimize the negative impact bad luck has on our investments.

 

Some investors and portfolio managers believe stock picking and market timing are important portfolio management skills.  While these investment approaches can work at times, these are “skills” that are very difficult to evaluate, and can also magnify the negative impact of bad luck (no one is perfect, after all).

 

By comparison, rules-based investment strategies that are the product of a sound analytical process can be tested thousands of times to determine how they perform in all kinds of scenarios.  Backtesting provides confidence that a strategy will perform as expected over the long term.  Confidence leads to discipline, and discipline is essential because bad luck will cause even the best investment strategies to underperform from time to time (and sometimes for extended periods of time).

 

That being said, a good backtest does not guarantee good results.  The stock market is a very complex system with millions of participants that is impacted by a countless number of influences.  As a result, even a nonsensical strategy can appear to generate stellar results in historical tests.  Unfortunately, history does not repeat.  As a result, it is essential that the rules that form the basis of an investment strategy are academically sound and make common sense.

 

In short, well-designed, rules-based tactical asset allocation strategies can tilt the odds of investment success in your favor by limiting the harmful role emotions can play when making investment decisions, and by constraining the adverse impact of bad luck.

 

Good luck, on the other hand, will take care of itself.

 

You can learn more about The Milwaukee Company’s rules-based investment strategies here:  https://themilwaukeecompany.com/strategies/.

 

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