Much ink has been spilt about the great benefits of investing in the stock market.
We constantly read about the power of compounding, how investing in stocks can help you beat inflation and the beauty of passive income from dividends.
But there’s a flip side to all this. Stock prices will fall every so often.
The size of the drawdowns can be big and they can happen frequently.
It’s inevitable and will always be part and parcel of the stock market.
That’s what makes long term investing so hard
Fundsmith is the UK’s largest fund by assets under management and also one of the country’s top-performing funds.
Its annualised return since inception (from November 2010 to May 2020) is 18.2 per cent, compared to the MSCI World Index’s gain of 11.2 per cent per year.
Its investment philosophy is summed up by three simple but profound investing principles: (1) Buy good companies, (2) Don’t overpay, and (3) Do nothing.
But Fundsmith is quick to point out that though their investment philosophy may sound easy, it is anything but.
In fact, Fundsmith says that the most difficult part is following its third principle – doing nothing.
As investors, we are so caught up in the day-to-day commentary about the market that doing nothing to your portfolio is so mentally difficult.
One of the reasons why this is so because investors tend to try to avoid pain as much as possible.
It’s human nature.
Infants enter the world with a natural instinct to avoid pain.
Think of the time you touched a hot surface, and immediately retracted your hand.
This is just one example of our bodies reacting to pain.
In his book Thinking Fast and Slow, Daniel Kahneman refers to our instinct of avoiding pain as System 1 thinking, which is the automatic and fast-thinking part of the brain.
But this instinct, though very useful in certain situations, can cause us to make very bad decisions in the stock market.
Instead, we should force ourselves to think logically and more in-depth when it comes to investing, using the slow, logical thinking part of the brain- what Kahneman terms System 2.
Our human tendency to avoid pain
In his recent article Same As It Ever Was, Morgan Housel writes:
“There are several areas of life where the best strategy is to accept a little pain as the cost of admission.But the natural reaction is to say, “No, no, no. I want no pain, none of it. The history of the stock market is that it goes up a lot in the long run but falls often in the short run. The falls are painful, but the gains are amazing. Put up with one and you get the other.
”Yet a large portion of the investing industry is devoted to avoiding the falls. They forecast when the next 10 per cent or 20 per cent decline will come and sell in anticipation. They’re wrong virtually every time. But they appeal to investors because asking people to just accept the temporary pain of losing 10 per cent or 20 per cent – maybe more once a decade – is unbearable. The majority of investors I know will tell you that you will perform better over time if you simply endure the pain of declines rather than try to avoid them. Still, they try to avoid them.
”The upside when you simply accept and endure the pain from market declines is that future declines don’t hurt as bad. You realise it’s just part of the game.”
Yet, it is this same aversion to pain that creates opportunities in the stock market.
My blogging partner, Ser Jing, wrote in an article of his:
“It makes sense for stocks to be volatile. If stocks went up 8 per cent per year like clockwork without volatility, investors will feel safe, and safety leads to risk-taking.
”In a world where stocks are guaranteed to give 8 per cent per year, the logical response from investors would be to keep buying them, till the point where stocks simply become too expensive to continue returning 8 per cent, or where the system becomes too fragile with debt to handle shocks.”
In other words, the fact that stocks are so volatile is why stocks can continue to produce the kind of long-term returns it has done. Investors are put off by the volatility, which causes stocks to be frequently priced to offer premium returns.
Investing in the stock market is never going to be a smooth journey.
Even investing legends have endured huge drawdowns that have resulted in their net worth moving up and down.
Warren Buffett, himself, has seen billions wiped out from his net worth in a day.
Yet, his ability to accept this pain and invest for the long-term makes him able to reap the long-term benefits of investing in stocks.
Morgan Housel perhaps summed it up best when he wrote: “Accepting a little pain has huge benefits. But it’ll always be rare, because it hurts.”
This article was first published in The Good Investor. Disclaimer: All content is displayed for general information purposes only and does not constitute professional financial advice.