Think long-term

Outstanding investors train themselves to think long-term. I learned this lesson the hard way early in my career.

When I was fresh out of business school, I worked as a bond trader for a primary dealer.  My job was to watch the bond market minute-by-minute and to try to make money by outguessing it. Looking back on it, I don't know what the head trader was thinking. There I was, my first job out of school, with no experience or training, and he hands me several million dollars to play with! It was like handing a loaded gun to a child. I was scared to death.

The way I dealt with the pressure was to watch the market and my trading positions like a hawk. At any minute during the day, I could tell you my gain or loss. I was like the guy on TV who bends spoons with his mind, except I was trying to bend the market to my will. I just stared at the screens. It didn't work and I was a nervous wreck.

My trading experience came to mind yesterday when I met with someone who was looking for help getting his portfolio back on track. As we spoke he showed me a spreadsheet and described how he tracks the value of his portfolio on a daily basis (and sometimes even more frequently.)

I asked him, "Why do you do that?"

He said, "Because I want to be in control."

"Is it working for you?"

"Not really. That's why I need some help."

That's when I introduced him to a basic aspect of what is known as prospect theory.

Prospect theory attempts to describe how people make decisions under conditions of risk. The theory was developed by Daniel Kahneman, a professor of psychology at Princeton University, and Amos Tversky, a mathematical psychologist at Stanford.  Though Tversky died in 1996 at age 59, their work resulted in Kahneman receiving the Nobel Prize in economics in 2002.

Prospect theory recognizes that people are loss averse, meaning people suffer more psychological pain for a given loss than they reap in psychological benefit for an equivalent gain. In fact, some psychologists estimate that the pain from loss is 2.0 to 2.5 times the pleasure derived from an equivalent gain.

If this is truly the case, then what happens to an investor--even a very talented and successful investor--when she slips into the habit of watching the market too closely. For this example, I am indebted to Nassim Taleb in his book Fooled by Randomness. (Click here for a review of Fooled by Randomness.)

Consider a hypothetical retired dentist who sets up a trading station in her attic. The dentist is a talented trader. Based on what we know about her, we expect that she will earn an annual return of 15% with a standard deviation of 10% per year. Armed with these statistics and our knowledge of the properties of normal distributions, we estimate that this dentist has a 93% probability of a positive return in any given year. Clearly this is an exceptionally talented trader.

However, when this 93% probability is broken down into narrower time intervals, the probability of success in each interval diminishes dramatically. For example, during any one month interval, this trader has only a 67% probability of success; on any given day, she has a 54% probability of success; and in any given minute, she has less than a 51% chance of success. Let me repeat this point for emphasis: Even an outstanding trader has only a 50/50 chance of winning over any given minute!

Do you see where this is leading? If the psychological pain for losing is greater than the pleasure for winning (as prospect theory postulates), then even the very best investors are going to feel emotionally whipped if they judge their success or failure by the short-term gyrations in their portfolios.  You simply cannot allow yourself to get caught up in short term market movements and maintain your mental acuity. When I was trading bonds and watching the markets minute by minute, I was setting myself up for failure. There is no way I could have won that game and you can't either. If you want to become a better investor, you must train yourself to think long-term.