Civilization is essentially a common set of rules or beliefs that a society holds to be important. We feel like we are more civilized, for example, when we aren’t busy eating one another. In that sense, rules are important—they provide a framework for controlling impulses we might otherwise act on. Nowhere is impulse control more important than in the financial markets, a conclusion buttressed by recent research by Dr. Philip Maymin, soon to appear in the Journal of Wealth Management.
We’ve written on this before. Don’t Trust Your Instincts was one of our most popular recent articles. Another article I saw on Trader’s Narrative speaks to the importance of controlling emotions because the cost is staggering:
Not surprisingly, the urge to trade increases with market volatility. But surprisingly it arrives immediately after the volatile period has ended. And that can cost clients dearly in performance: up to 4% a year.
This is the behavior gap that DALBAR finds when they look at investor performance in mutual funds. It’s also the behavior gap that the BCT study found for investors that were working with advisors. Trader’s Narrative has a really smart graphic that points directly to the truth: advisors are just as susceptible to emotions as clients.
You may claim that the fault lies in the inability of clients to follow the guidance of advisors. But that doesn’t really explain what’s going on here. Consider, for example, an indicator that tracks the sentiment of financial advisors, the Rydex SGI Advisor Confidence Index:
As you can see, in its relatively short lifespan it exhibits the same tendency to swing from ebullient cheerfulness to despondency that we see in the weekly AAII retail investor’s sentiment metric. If you look closely there may be a few divergences here and there but overall, financial advisors are not really immune to the same emotional forces that buffet their clients.
The first reaction of every advisor is to look at this data and say, “Boy, those other advisors are really dumb!” But as Pogo said, “We have met the enemy, and he is us.” We are all susceptible to the same emotions—it all boils down to what rules we have in place to civilize ourselves.
Source: www.lakeworthmedia.com
One of the reasons that a Systematic Relative Strength process is so important to us is that it provides an unemotional framework for action. A systematic process needs to answer what to buy or sell, when to buy or sell, and how much to buy or sell. The rules need to be robust and tested over a wide variety of market conditions over an extended period of time. Very importantly, we believe the rules need to be adaptive, for two reasons: 1) eventually you will face conditions different from any in the past, and 2) if you are not confident in the ability to adapt, you will emotionally short-circuit and circumvent the rules at the worst possible time. Finally, discipline is essential. Rules aren’t going to help you much if you can’t or won’t follow them.
Posted by Andy Hyer 
