“It is the emotional side of investing that destroys even the greatest minds. If you can’t master your emotions, all the data in the world can’t save you,” he said in a presentation at Talks at Google.
James O’Shaughnessy is a legendary investor and the Founder, Chairman and Chief Investment Officer of O’Shaughnessy Asset Management LLC (OSAM). His areas of expertise include quantitative equity analysis, portfolio management and investment models.
O’Shaughnessy has written several books providing extensive quantitative analysis of stock market behaviour.
He says typically a stock investor makes both active and passive mistakes.
O’Shaughnessy says investors with broadly passive and diversified portfolios react emotionally to a market selloff and sell their holdings, often near a market bottom.
On the other hand, investors who use actively-managed strategies make two major mistakes:
- React emotionally to a selloff in the market, which leads them to liquidating investments at the very wrong time
- Sell out an active strategy that is doing worse than its benchmark, often in periods of less than three years.
Often, the second mistake occurs even when the investors maybe earning positive returns on the strategy, says he.
While both active and passive investors make the same mistakes by selling during volatility and challenging market conditions, only active investors fall into the second trap.
Research has revealed that when investment managers are fired due to poor performance over a three-year period, they typically go on to outperform the manager with whom the investor replaces the first one.
O’Shaughnessy lists out seven traits that are necessary to be a successful in long-term active investing.
- Have a long-term perspective: Having and sticking to a long-term perspective is the closest any investor can come to becoming successful. But most investors lack this ability as evolution has programmed human beings to pay far more attention to what is happening now than to what might happen in 10 or 20 years, which do not help them keep a long-term perspective on investments.
O’Shaughnessy believes when investors give more weightage to short-term information for investment decisions, they create a reactionary model, not an anticipatory one.
Quoting researchers Henrik Cronqvist and Stephan Siegel, he says, “Human beings are born with a lot of investment biases— e.g., the reluctance to realise losses, performance chasing and home bias. Genetic factors explain up to 45% of these variations in those biases across individuals. There is no evidence that education is a significant moderator of genetic investment behavior.”
He says majority of investors succumb to short-term volatility in the market by selling and waiting to buy again until markets become very strong, even though more than 30 years of studies have proven this is exactly the wrong thing to do.
O’Shaughnessy says investors are prone to a slew of cognitive biases, from overconfidence in their own abilities to the tendency to overweight things simply based upon how easily they are recalled.
According to him, successful active investing runs contrary to human nature and investors should not comply with nature, but should try to defy it.
“This is not an easy thing to accomplish,” says he, as it is difficult to remain unmoved when watching others go through a range of emotions like greed and fear, which cause joys and panics. “Also, it is hard to remain unemotional when short-term chaos threatens an investor’s portfolio.”
- Value process over outcome: A vast majority of investors make the mistake of selecting investments based upon past performance of a manager or an investment strategy.
O’Shaughnessy feels it is basic human nature that investors just can’t help themselves find out past performance of an investment when confronted with great or lousy recent performance.
Yet, he believes successful active investors go one step further and ask about the process of making the investment decisions.
Although outcomes are important, O’Shaughnessy feels that it’s much more important to study and understand the underlying process that led to the outcome, be it good or bad.
“If you only focus on outcomes, you have no idea if the process that generated it is superior or inferior. This leads to performance chasing and relying far too much on recent outcomes to be of any practical use. Indeed, shorter-term performance can be positively misleading,” says he.
- Ignore forecasts and predictions: Investors tend to make the mistake of taking recent events and forecasting similar returns into the future. He says one should be careful of these projections or forecasts as they create an illusion of apparent precision.
“You can’t turn on business TV or read all of the various business news outlets or even talk with other investors without being bombarded with both short- and long-term forecasts and predictions. Against all the evidence, the forecasts and predictions about what might happen in the future tend to be intuitively attractive to us, since we are desperate to have a narrative about how the future might unfold. We tend to extrapolate what has happened recently well into the future, which almost never works. Since we literally hear or read so many forecasts about markets, stocks and commodity prices, to follow up on the efficacy of each would be a full-time job. Luckily, others have done this job for us, and the results are grim,” O’Shaughnessy says.
- Be patient and persistent: In addition to following a well-thought-out process, great active investors are patient and persistent.
O’Shaughnessy points out that although great value investors like Warren Buffett, Ben Graham, Peter Lynch and Joel Greenblatt have very different ways of looking at the stock market, they all share the common qualities of being patient and persistent.
“Successful active investors are not simply defined by their process, as many have very different approaches and processes that they follow, but rather by their diligence and persistence in sticking with their strategies even when they are underperforming their benchmarks. But all of these investors are also defined by the clarity of their processes,” he says.
- Have a strong mental attitude: Investors need to have a strong mental attitude to withstand the volatilities of the stock markets.
This is one of the traits that is not innate, but learned by investors, and it takes constant study and learning from both own experiences and that of others to create habits that lead to success.
“Most successful active managers not only have strong mental attitudes, but many border on stoicism. Stoics taught that emotions resulted in errors of judgment and they thought that the best indication of someone’s philosophy was not what a person said, but how they behaved,” O’Shaughnessy notes.
He says successful active investors understand the only thing they can control is their mind, which means they do not base their actions, feelings, emotions and thoughts on external events or on what other people are doing or saying.
He feels successful active investors only focus on their own actions, beliefs and habits, all of which are in their control.
He believes successful investors do not blame others or events for how things turn out but rather continually focus on their process and try to improve it. Instead, active investors learn from every lesson, be it good or bad, and continually strive to incorporate that learning into their process. Above all, they understand that they must control their emotions rather than emotions controlling them.
He says once investors have a strong mental attitude, it frees them up to persistently follow their processes rather than make investment decisions on the basis of fear, greed, envy and hope.
- Think in terms of probabilities: It is natural for humans to crave for certainty about how things will unfold, which is precisely why investors fall for predictions and forecasts.
Although nothing in the stock market or in life is 100 per cent certain, many people confuse possibility with probability even though the two are almost exact opposites. “If we focus on ‘possibilities’ rather than ‘probabilities,’ we are lost. Almost anything is possible, even when highly improbable. Focusing on possibilities can lead us to a state of constant fear —thus create our desire for orderly, known and ‘certain’ information and actions,” he says.
O’Shaughnessy notes that emotions in uncertain or risky market situations are more sensitive to the possibility rather than the probability of strong consequences which leads to investors overweighting even the smallest probabilities.
“During the Global Financial Crisis, people were most certainly thinking of possibilities rather than probabilities. In the stock market, the best way forward is to look at the long-term results for an investment strategy and how often — and by what magnitude — it beat its underlying benchmark,” says he.
Investors can have an incredible edge if they know the past odds of how often and by what magnitude a strategy either outperforms or underperforms its benchmark, he says.
According to him, successful active investors know this and pay close attention to this information, thereby putting the probabilities on their side.
- Be highly disciplined: Many investors lack the discipline required to succeed as active investors as it is normal human nature to hit the panic button when the market goes against them.
“Being highly disciplined is extremely difficult. It goes against almost every impulse we have baked into our genes. Sure, it’s easy to be disciplined when things are going your way and when you are significantly outperforming your benchmark. Real discipline kicks in when things are going against you, sometimes significantly. When every week seems like a month, when you are filled with self-doubt and constantly questioning every single part of your investment process, when others express skepticism about your core beliefs, and even friends and colleagues begin to doubt you and your process, that’s when discipline is required,” says he.
O’Shaughnessy believes if investors develop these seven qualities and can dedicatedly implement them, over time, they can do remarkably better than passively indexing their portfolio.
He advises investors to keep a detailed account of all their investments and note their successes and failures. This, he says, will help them work on their weak points until they are gone.
He is convinced that if investors can honestly follow this practice, they can become a member of a shrinking but potentially elite club of long-term, active investors.
(Disclaimer: This article is based on James O’Shaughnessy’s presentation at Talks @ Google).