Being an investor can be complicated, challenging, frustrating, and sometimes frightening. This is exactly why it is important to have an investment philosophy you can stick with, one that can help you stay the course, and respond rationally to unexpected events.
This simple idea highlights an important question: How can investors maintain discipline through bull markets, bear markets, political strife, economic instability, or whatever crisis du jour threatens progress towards their investment goals?
Over their lifetimes, investors face many decisions, prompted by events that are both within and outside their control. Without an enduring philosophy to inform their choices, they can potentially suffer unnecessary anxiety, leading to poor decisions and outcomes that are damaging to their long-term financial well-being.
When they don’t get the results they want, many investors blame things outside their control. They might point the finger at the government, central banks, markets, or the economy. Unfortunately, the majority will not do the things that might be more beneficial—evaluating and reflecting on their own responses to events and taking responsibility for their decisions.
Some people suggest that among the characteristics that separate highly successful people from the rest of us is a focus on influencing outcomes by controlling one’s reactions to events, rather than the events themselves. This relationship can be described in the following formula:
e + r = o (Event + Response = Outcome)
Simply put, this means an outcome—either positive or negative—is the result of how you respond to an event, not just the result of the event itself. Of course, events are important and influence outcomes, but not exclusively. If this were the case, everyone would have the same outcome regardless of their response.
Let’s think about this concept in a hypothetical investment context. Say a major political surprise, such as Brexit, causes a market to fall (event). In a panicked response, potentially fueled by gloomy media speculation of the resulting uncertainty, an investor sells some or all of his or her investment (response). Lacking a long-term perspective and reacting to the short-term news, our investor misses out on the subsequent market recovery and suffers anxiety about when, or if, to get back in, leading to suboptimal investment returns (outcome).
To see the same hypothetical example from a different perspective, a surprise event causes markets to fall suddenly (e). Based on his or her understanding of the long-term nature of returns and the short-term nature of volatility spikes around news events, an investor is able to control his or her emotions (r) and maintain investment discipline, leading to a higher chance of a successful long‑term outcome (o).
This example reveals why having an investment philosophy is so important. By understanding how markets work and maintaining a long-term perspective on past events, investors can focus on ensuring that their responses to events are consistent with their long-term plan.
An enduring investment philosophy is built on solid principles backed by decades of academic evidence. Examples of such principles might be: trusting that prices are set to provide a fair expected return (markets work); recognizing the difference between investing and speculating (long-term perspective); relying on the power of diversification to manage risk and increase the reliability of outcomes (Diversification); and benchmarking your progress against your own realistic long-term investment goals (monitoring progress).
Combined, these principles might help us react better to market events, even when those events are globally significant or when, as some might suggest, a paradigm shift has occurred, leading to claims that “it’s different this time.” Adhering to these principles can also help investors resist the siren calls of new investment fads or worse, outright scams.
It can be difficult for investors to develop a rational investment philosophy. And even the most self-aware find it hard to manage their own responses to events. Investing will always be both alluring and scary at times, but a view of how to approach investing combined with the guidance of a trusted professional can help people stay the course through challenging times. Keeping an objective view and separating emotions from investment decisions is incredibly difficult for most investors. By building knowledge and confidence, however, we are better equipped to remain disciplined in our responses even to the most extreme market events.