Understanding yourself, cycles, and your risk tolerance

Understanding yourself and risk

Understanding yourself is critical in developing an investment strategy and sticking to it when the pressure is on.

Interestingly, this ties into our notions of risk.

The first question a financial advisor often asks is: ‘What is your risk level?’.

The first problem is that most of us have no idea!

Most folks end up saying: ‘Um, about average, like everyone else?’.

The second challenge is that your risk tolerance will tend to fluctuate with whatever’s currently happening.

Why?

Because when the stock market has fallen by 50% and the media is running a series of doomsday headlines, then you’re unlikely to be thinking ‘Wow, what a great time to put a lot of money into the stock market!’ (it usually is, by the way).

We’ve watched people spending their money, and it often makes little logical sense.

For example, we have a friend who is extremely risk-averse and sees the stock market as an unfavourable gamble (he currently holds a few hundred thousand dollars in cash, earning next to nothing).

But he will happily spend $500 per week gambling on horse racing and football (and probably two flies racing up a wall, for all we know!).

Logical? Hardly.

We could offer our friend an excellent, conservative investment strategy which makes solid returns, but he’ll never budge because he’s wedded to his beliefs, which stem from his innate personality and approach to money.

Our individual personality heavily influences our approach to money: what money means and how it should be spent or invested.

My spending may not make sense to you, but that may be because we have a different personality type from each other.

Many things we do may not make sense to others, unless they are of the same personality type.

We’ve seen this constantly on several levels.

Market cycles

Apart from the extremely high valuations in US and some other developed stock markets, there are any number of soft indicators of a market cycle ‘in its eighth inning’.

One is the apparent redundancy of old industries as a new wave of genius entrepreneurs (Musk, Bezos, and others) sweeps to the fore.

Another is a rise in optimism about future returns and recency bias as market momentum delivers positive returns for several years in a row (in this case 11 years consecutively!).

It’s been an outstanding stretch for a passive approach with the S&P 500 roaring 400% higher from 666 points to 3,330 since 2009, but in the words of Kenny Rogers you should ‘never count your money when you’re sittin’ at the table’.

Yet some are loathe to believe markets are too expensive…

Real world risk tolerance

If you started investing after March 2009, it’s very likely that your risk tolerance isn’t as high as you think it is.

One of the dubious advantages of being British-born is having lived through several brutal recessions, when not only were stock markets and housing markets hammered, but turning up to work on a Monday was a nerve-wracking experience as HR indiscriminately frogmarched employees from the premises.

But here’s the thing: from an investment perspective this is often a good time to be more aggressive, not to batten down the hatches.

It’s easy to calmly plug assumed returns and strategies into a spreadsheet.

It’s another matter to execute your strategy without losing faith after several years of negative returns, or if things don’t play out as hoped.

Having a written, systematic plan is likely to help you stay the course.

4 reasons to understand yourself

We seek to understand ourselves for the following reasons:

1. We get to understand our own emotions and see how they impact our stock market investments and our responses to market events;

2. We get to understand why we do the things we do with money as a result of understanding ourselves and what money means to us individually;

3. We get to control our emotional responses better and thus not make bad decisions by simply responding to events. We develop an ability to approach the market and our investments more rationally; and

4. We seek to counter our negative behaviour patterns before we act.

Avoiding the madness of crowds

We aim to avoid the crowd, because we know that the crowd is unlikely to understand much about the investment and what the risks are.

The most effective approach is to have a systematic method that delivers the best probability of you making successful investments based on sensible decisions.

As John Templeton, a famous investor, said:

‘It’s impossible to produce superior performance unless you do something different from the majority.’

It’s difficult to stand alone, but we can tell you this is how you can get better than average investment returns in all markets.

And with more practice, by using a systematic strategy your emotional framework will become familiar with the approach, so it becomes easier over time.

Better returns

There are investors who do consistently beat the market.

Here’s a brief summary of how they do it:

  • They have a system which they stick to and apply. This is usually based on being contrarian – that is, buying when a market is cheap. They don’t wander off into the latest public fad or whatever is ‘hot’;
  • They don’t follow the crowd (act emotionally) – you’ll often find that the most profitable investments are made when everyone else is running in the opposite direction.

For example, we made a series of successful investments in 2009 when the global financial crisis struck (yes, in Sydney properties, as well as in stocks).

And again in 2011 buying US banks after the financials sector was smashed lower:

US Financials ETF Returns

And again in 2014 buying Russia after its currency crisis and stock market crash (yes, Russia! We know what you may be thinking, but these have been hugely lucrative investments that we still hold, as they’re still cheap):

Russia ETF Returns

(Side-note: observe what happened in the 24 months following the 2008 crash. Because out of the outsized impact of negative returns, the most powerful way to compound your wealth safely is to (a) not lose money by investing in expensive markets, and (b) buy markets that are exceptionally cheap).

More recently we picked up bargains after the ‘Brexit’ vote shock, and again in Greece after its 2018 market implosion, and again with the Pakistan ETF after its 70% market crash, and so on.

Remember, think statistics over stories: you’ll find that buying markets that are down 50-80% generally delivers stronger returns than buying euphoric or over-valued markets in the rampant speculation phase (as indeed, you should expect).

The investment universe has opened up marvellously – there’s no logical reason to have such an ingrained home bias these days, and wonderful opportunities to buy markets low come around regularly.

On each of these occasions, investing may have appeared on the face of it to be a dangerous gamble (at least, if you believe everything you read);

  •  They follow market cycles and understand that there are times when it is better to buy and better to sell;
  • Most of them use a rational decision-making approach when allocating their capital; and
  • They don’t put all their allocated funds into the market at once. They may choose to ‘average in’ to an investment because they’re aware that even cheap stocks and markets can get cheaper.

The proof is in the returns generated over a long period of time, and the dramatically superior performance of buying and selling shares using the value (e.g. CAPE ratio) or contrarian method.

Source: Meb Faber

The fundamental edge that value investors like Warren Buffett, George Soros, Ed Thorp, and many others have used to beat the market is rooted in the psychology of individual investment behaviour, and this approach has been successful for the past 75 years.

Remember, though, if you don’t know much about yourself, then the stock market can be an expensive place to find out!

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To find out more about our coaching programs see here.

Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: petewargent.com petewargent.blogspot.com Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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