Temperament is more important than intellect


Summary

Legendary investor Warren Buffett states that Success in investing doesn't correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Successful long-term investors have the ability to keep calm and remain level-headed when the investment environment around them turns volatile, as is often the case with public markets.


70% of retail investor accounts lose money

The European Securities and Markets Authority has mandated brokers to include a statement of the percentage of losses on retail trading accounts, which makes for shocking reading. Brokers report that up to 70% of all retail accounts lose money, with this figure increasing to up to 90% for retail accounts trading more risky derivative products such as contracts for difference and binary options.

Understanding the history of investment returns

Long-term investors should maintain detailed knowledge of the historical returns and volatility of markets, it is critically important for investment success.

Geometric average investment returns

The average annual equity market return is approximately 10% over the previous 100 years, as measured by the benchmark S&P 500 Index. However, between 1926 and 2022 returns were in the ‘average’ band of 8-12% only seven times.

In addition to the disparity of annual returns, the S&P 500 Index has experienced an average intra-year drop from peak to trough of more than 14% since the 1980s. These short-term corrections also wear on investors' nerves and test their investment resolve. Despite these sharp intra-year declines, annual investment returns were positive in 32 of 42 years.

The probability of positive investment returns is directly related to an investor's time in the market. Investing for a single quarter results in a ~65% probability of a positive investment return. This increases to more than 70% if an investor remains invested for twelve months and increases further, to almost 95%, with an investment horizon of a decade.

Statistical characteristics of investment returns

It is also important for long-term investors to understand the dispersion of investment returns. Unfortunately, investment returns are not distributed normally around a mean, but display negative skewness as well as high kurtosis.

Skewness measures the asymmetry of the probability distribution around the mean. The negative skewness of investment returns (the tail is on the left side of the distribution) indicates that equity markets produce a low number of large negative returns and a higher number of moderately positive returns.

Kurtosis measures the degree to which exceptional values, either much larger or much smaller than the mean, occur more frequently or less frequently compared to a normal distribution. High kurtosis indicates exceptional values that are referred to as ‘fat tails.’ Fat tails indicate a higher percentage of very low and very high investment returns than would be expected with a normal distribution.

Behavioural finance implications

The high volatility, negative skewness and high kurtosis of investment returns carry important behavioural finance implications and are the reasons why the average retail investor achieves terrible investment returns. Unsophisticated investors tend to sell during times when markets produce large losses and double-up during times of positive returns. Fear and greed cause the average investor irreparable damage.

Successful long-term investing, meanwhile, requires investors to accept the high volatility, negative skewness and high kurtosis of investment returns and to maintain a temperament that will allow them to stay the course. Successful long-term investors do not sell out during times of poor investment performance and do not chase returns during periods of exceptional performance, two junctures at which it is hardest psychologically to do so.

Conclusion

Successful long-term investors cultivate a temperament that allows them to remain calm during times of high market volatility. This mindset is one of the main differences between investors who reach their long-term investment objectives and the traders and speculators who do not.



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