Psychological challenge of sticking with a volatile portfolio

[Lucky C]

What I mean is it is interesting to me to tie specific scientific knowledge / psychological study findings to the behavior of investors throughout various market episodes. To go from the biology of brain chemistry to the System 1 impulsive behavior to the System 2 rational behavior and tie it all together to describe investors' behavior. Again, Thaler might be a good source for this but I haven't read his stuff yet.

Graham's advice to shift within the 25-75% allocations is based on what he believes will work for other people, which may or may not be good advice for other personality types, and which is not based on any scientific study - it just sounds like decent advice. Warren Buffett will give you a folksy sounding piece of advice about how to stay calm during markets but he won't point you to a scientific paper on the subject. Kahneman will share lessons from a psychological study but hasn't published an investing strategy. That's just what we get in a world of specialists. AFAIK there is no Renaissance Man author of a biologically/psychologically-based investing strategy (citing both scientific papers and economic/market data in the same tome). Dalio is indeed close to what I had in mind.

This is not something I require but something I would be interested in reading. It may or may not be more useful than a book from an investing specialist with no scientific background. Without such a book I can still connect the dots, but it's nice to have writings from others with more experience, who have lived through different historical episodes and have already connected the dots some years ago, and might have done so in a different way than me.

I have high confidence in my current self to stay the course and embrace the volatility required to achieve my goals. I think I will be fine in the future, but I want to implement whatever safety mechanisms I can to help my future self, just in case he needs it. It would be naively optimistic to think that I will always act 100% rationally from now until the end of my investing career.

[ertyu]

most professional financiers have given up the project for a lost cause. the desire to short-circuit emotional impulsivity is at least half of what's behind the rise of automated algo trading. The algo can be trusted to be rational - i.e. to behave strictly according to predetermined rules.

[Lucky C]

Also I imagine the most successful investors aren't really interested in a deep dive into scientific literature (outside their expertise) to explain why others fail. Their expertise is how to succeed in the way that they succeeded... if you have the same temperament and interests as them, without any weaknesses that they don't have or have overcome.

[ertyu]

theres lots of this stuff
haven't seen but do report if you find it turns up anything interesting

relationship of mbti to investing/trading psychology

https://www.youtube.com/watch?v=XwAQ1wNvSfA
https://www.youtube.com/watch?v=ZxNE57ypaAg

mental game of trading series real vision ran

https://www.youtube.com/playlist?list=P ... DrUAHkNp-q

[IlliniDave]

Just have a second to throw an item in. There's an entire field of "Behavioral Finance" that appears to have application in investing. Two names that come to mind are Kahneman and Tversky (hope I spelled those correctly). I dunno if any attempt has been made to apply any of it to the human component of the overall markets in pursuit of systematic exploitation. Applications I've seen are more aimed at helping individuals beware pitfalls they are susceptible too, i.e., tend to appear in the personal finance realm.

[jacob]

In my experience from talking to actual professionals whose track records of "beating the market" are way beyond random, successful ones are well-aware of various human-psychological quirks as well as their own quirks so they can work around them and profit accordingly. The field of finance is one of those strange domains that has utterly bifurcated into an academic branch and a practitioners branch. There's some cross-pollination and some defection/antagonizing from one camp to the other (Taleb comes to mind) but there's very little/nothing in terms of someone having a foot in both camps. There's no professor of "stock market profits".

(There is a bit of a mutually disgruntled grass is greener but yet also not greener. Rich people complaining that since they're so rich why are they not considered smart. Smart people lamenting that since they're so smart why don't they seem to be able to make more money.)

However, it's unlikely that there would be an academic-style study of practitioners because they're too busy making money. And vice versa. From a practitioner's POV, the idea that Nobel Prize winners have proved anything is ridiculous... or more fairly, it is taken as a starting point to look for inefficiencies. To give an example, Nobel Prize winners have proven Black Scholes. Whereas practitioners already had something similar (but unpublished) decades before, they now use BS to translate prices into more implied volatility which is more stationary and trade around that instead. BS is emphatically NOT used to quote prices as if the formula has proven them to be correct. Rather it's used as a more easily understood framework to trade new quantities (the greeks) based on the same psychology. IOW, BS was like inventing a new language (like math) only to talk about the same things more accurately.

(A more widely understood metaphor would be that professional poker players don't play strictly by the statistical odds as computed by Nobel Prize winning professors of Pokerology. Rather the pros take these odds as a starting/reference point. Also, it's possible to play poker very well despite not knowing the exact odds.)

Personally I was surprised at how simplistic some of the most profitable models are. It's way more profitable to be half-way accurate in a situation where someone else is precisely wrong (but believes they're precisely right) than the other way around.

In short looking for interdisciplinary academic work between finance and psychology is not going to do you much good if the goal is to make money. What you'd want to look at are non-academic perspectives!

So naturally, traders turn to games of strategy and war for input rather than academia. There's a reason why Sun Tzu, Musashi, and various accounts and theories of poker, bridge, and chess playing are so popular among traders. The main problem "academically smart people" have in trading is an inability to conceive and therefore perceive how moronic(*) other people can be. I don't mean this in a condescending way but as a lament. If you can't imagine how anyone would be crazy enough to make X mistake, it's hard to figure out that you should set yourself up to take advantage of it.

For example, imagine that you spend years studying bias as an academic. Eventually this training makes you very good at spotting it. In fact, you risk getting so good that you begin to presume that everybody can see bias as well as you can. From this point on, you'll start missing inefficiences caused by whatever bias because you can no longer process the idea that someone would still have this bias.

(*) As a challenge, try to write a realistic account of a village idiot. You'll probably find your "theory of mind" to be completely lacking. It's a kind of "curse of knowledge" in reverse. Insofar you know something so well you take it for granted, it's hard to imagine that someone might be completely oblivious to it. For example, modus ponens might be hardwired into your system but I assure you that this is not universally the case in practice! However, it's probably challenging to accurately predict the behavior of someone who lacks this. It would fall under "I couldn't even make this up if I tried"-category.

[7Wannabe5]

Nowadays the village idiot is the coded default option.

[Lucky C]

@ertyu Thanks for the video links - they sound interesting!

@jacob Thanks for explaining and helping to bring it all together. I was veering off in this discussion going into formation of investment strategy using the psychology of others, vs. my original intent of consistent execution of investment strategy through self control. As you said, academia is not a good source to develop a trading strategy. However studying psychology, biology, etc. can certainly help you to understand why you might do something stupid and what you might do to prevent it. Of course this isn't an investing-specific problem, so it probably makes sense to go about it in a more general sense. For example, I am bad with routines. If I can retrain myself to be a routine-oriented person, then I should be more likely to stick to an investing strategy that requires reallocating on certain predetermined days and basically ignoring the market on other days.

[plantingtheseed]

..

[ertyu]

found this article that might be of interest to ppl

http://nautil.us/issue/87/risk/what-i-l ... million-rp

[Dave]

What is lacking is investors who talk in depth about the emotions you feel through the market swings and how to overcome them. Again, the authors who do simplify things with a phrase or two like "don't just do something, stand there!" OK but how do you permanently change someone's natural tendency to "do something" to one who is willing to "stand there" when conditions are difficult? A lot of authors touch on this subject but don't go in depth to tie in psychology and turn that into actionable advice to defeat psychological difficulties when investing.

Hopefully this isn't annoying in repeating myself, but I really believe that deeply understanding what you own mitigates an awful lot of the emotional response of market swings. If you experience intense fear when a stock you own falls, it's possible that you don't understand it well enough, because if you did you wouldn't be as distressed. Again, if someone tells you the $100 bill you have is worth $60, you wouldn't care a bit. It's about approaching that ideal. As said above, I believe this is easier with individual businesses rather than funds, but I think @shemp lays out a reasonable case that this can be done with even index securities. I'd boil down this by basically saying that the deeper you understand something, the less you are bothered by other people (who generally know less) telling you you're wrong. This applies to anything, but staying calm with volatile markets is the specific case we're talking about here.

Going beyond the repeat, I have found that meditation helps me. Meditation cultivates a number of mental attributes that help, specifically mental clarity and equanimity. The mental clarity helps you observe your sensate reality piece by piece, each thought, feeling, and sensation that comes along. This helps you identify and distinguish "fear emotion arising" from the normal flood of experience, and by identifying it as something separate it creates a layer of separation between "you" and it. (Note, this isn't' really strictly accurate as a meditator would think of it, but functionally for this purpose this is what's happening). This layer of separation helps be more rational about it, as opposed to "being" (consumed by) the fear. Beyond clarity, equanimity is helpful for very clear reasons.

For what it's worth, there are a number of investors/traders who meditate - Ray Dalio has done Transcendental Meditation for a long time.

The second practical tip that comes to mind is Cognitive Behavioral Therapy (CBT). I'm friends with a hedge fund manager who told me this has helped them with both biases/distortions and emotional reactivity. I have not tried this myself, but see it as another practical option worth trying. This individual did self-guided CBT, so no expensive therapist required.

To ground this all in my specific set of experiences today (market closed ~30 minutes ago), my portfolio was down a couple percent on the back of a challenging period. My experience was something like:

-sense disappointed/frustrated sensation
-asks why I have this sensation
-remembers no negative fundamentals developed (actually the opposite) and that underlying cash flows are intact, so no cause for any negative feeling
-accepts that I have no plans to sell near current prices anyways and that there is nothing I need to do
-moves on

Not very exciting, interesting, technical or complex. But enough for me to reduce the frequency and intensity of negative experiences.

[shemp]

I went back and read the OP. It's possible you have put yourself in an excessively vulnerable position by retiring early.

All passive investments are risky. Fairly valued stock markets can fall 50% and then stay down 20 years, and even worse for expensive markets. That's what it means to own the bottom of the corporate capital structure. If this frightens you, consider that inflation can do even more damage to cash and bonds. Gold fell for 20 years from 1980 to 2000, and the fall was worse in real terms and after accounting for storage and transaction costs. Real estate can fall for decades: consider much of the USA midwest, especially Detroit, starting around 1980.

Active investment in a business you own is traditionally thought of as very risky, but not so risky if the business is actually just a structure for receiving full value for your labor and you design the business to be robust from the start, with a big margin of safety for everything. Keep fixed ongoing costs to a minimum. Plan to work an average of 15 hours per week with option of 60 hours when there is a surge of demand or zero hours if you get sick. Focus on high margin business, but be willing to accept low margin work temporarily when nothing else is available. Etc. Maybe if you had a business like this to supplement your passive investments, you wouldn't be so worried.

You might also need to ve prepared to cut your living standard so that a permanent 50% drop in your wealth and also 50% drop in your passive income wouldn't be a problem. As the bottom of the capital structure, stocks don't just drop because of irrational herd behavior by investors. Stocks can also suffer permanent impairment because of unexpected disasters like this covid-19.

Finally, you might have strong trader instincts and your anxiousness is because you are repressing those tendencies. Such repression could eventually build up pressure and cause you to make very bad decisions. Either you get rid of the instincts, or you indulge them. Note that success at trading (market timing) is definitely possible. First step is to identify the dumb money you plan to win from. If you are market timing at intervals of less than a year, you are competing against the smartest people in the world. More than likely, you are the dumb money, not them. If the timing is 10 years between swings from all stocks to all cash/gold/bonds, then there is little competition, and you can indeed profit from the tendency of the foolish herd to buy tops and sell bottoms.

[Lucky C]

Hopefully this isn't annoying in repeating myself, but I really believe that deeply understanding what you own mitigates an awful lot of the emotional response of market swings.

...

Going beyond the repeat, I have found that meditation helps me.

A mathematical question relating to my strategy popped into my head yesterday and I was able to write a script to answer it, the answer providing me with confidence that my strategy is robust. Basically that despite it having a decent amount of volatility, it would hold up well against a bad sequence-of-returns FIRE scenario compared to a typical buy and hold portfolio. As for meditation, while I haven't started it, I have set myself reminders to start it that will hopefully be enough to nudge me into starting.

Plan to work an average of 15 hours per week with option of 60 hours when there is a surge of demand or zero hours if you get sick.

Though your advice is relating to running a business, I would be happy to work 15 hours per week as an employee just for variety, social aspects, etc. were it not for Covid. If the risk of the virus drops significantly both my wife and I would consider part time work and just one of us working part time even in a low paying job would cover a good portion of expenses.

Thanks for the advice guys. This past month I have transitioned from my old low-yielding conservative ways to my more volatile strategy, and fortunately it has been working great. Of course on such a small time scale I know this is mostly luck, and next month could be the opposite, but for now it's been very rewarding to have such a great start. Combined with my recent results in "proving" the strategy in a different way than backtesting, I'm feeling pretty confident now.