The Virtuous Investor: Rule 8

Don’t worry about temptations – start worrying if you think you have no temptation, because that is when you cannot distinguish good from evil

This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.

“If the storm of temptation shall rise against thee somewhat thick and grievously, begin not forthwithal to be discontent with thyself as though for that cause God either cared not for thee, or favoured thee not... It is a very great token a man to be reject from the mercy of God when he is vexed with no temptations.”

Erasmus of Rotterdam

Hi, my name is Joachim and I am a chocaholic. I admit to living a good life most of the times. I don’t smoke, I almost never drink, and I eat less and less meat. Yet, I am addicted to chocolate. To be more precise, I prefer Swiss chocolate, which is just better than Belgian chocolate (apologies to my Belgian friends). In case you ever want to buy me a present, I prefer chocolate from Läderach and Sprüngli. 

I cannot live without chocolate or at least my daily dose of sugar (if there is no decent chocolate, a soda will do). I know this increases my risk of diabetes and obesity and shortens my life expectancy, but then again, what is a life worth that has no joy in it? I try to be good and healthy most of the times, but often, I cannot resist the temptation of chocolate.

And the same is true for my investments. I have a portfolio that is geared towards achieving my individual goals and follows a long-term investment plan. Yet, I am constantly tempted to deviate from this long-term portfolio and become a sinner:

• I have a tendency to invest in short-term opportunities, even though I know that trading is hazardous to my wealth.

• I am tempted to invest based on a good story (e.g. technology is going to revolutionize the world) instead of looking at data.

• I am tempted to invest my portfolio in companies I think I know, which introduces would introduce a home bias into my portfolio.

The temptations of investing are manifold, and it is all too easy to give in to these temptations. In fact, most people do give in to them as the chart below shows for the case of home bias in equity portfolios around the world. 

Home bias around the world

Source: Faruqee et al. (2004).

As Erasmus of Rotterdam wrote, temptations are nothing to worry about. They are a part of life and we all have to deal with them. And there are two main ways to deal with them.

First, one can become an investor monk who stays away from all temptation and devoutly follows only the long-term plan. As I have written in the first rule of the Virtuous Investor, this is clearly the best way to maximise investment success. But honestly, who is disciplined enough to stick to a long-term investment plan for decades?

Let me rephrase that. Who is disciplined enough to stick to a long-term investment plan for decades and is not German?

Unless you have super-human levels of self-discipline like the Germans, it is unlikely that you will be able to withstand temptation all the time. You will give in and that is fine. The problem only starts, as Erasmus said, when you feel you have no temptations. That is when you have given in to them and you can no longer differentiate between what is good for your investments in the long run and what makes you feel good. The outcome is likely going to be disastrous because many of these temptations cost a lot of performance. Below is a famous chart from the seminal study by Barber and Odean on trading behaviour and its impact on investment returns before and after costs. The more investors trade, the lower their returns after fees.

Trading is hazardous to your wealth

Source: Barber and Odean (2000).

But there must be a middle ground between becoming an investor monk and giving in to all the temptations of the investment world. What I would suggest is to make room for the temptations in your portfolio and ringfence them, so they cannot negatively impact your long-term portfolio.

One way to do this is to invest 90% or 95% or your savings in your long-term investment portfolio. Then, you go and open another account with a discount brokerage. This will be your investment playground. With 5% to 10% of your savings you can invest to your heart’s delight and buy all the things that sound great and make you feel smart as an investor. 

The first rule for this playground is that you are not allowed to move money from the long-term portfolio into the playground. If you run out of money in your playground that’s it. No more playing with the other children. The second rule for this playground is that you are not allowed to enter into debt. This means no naked short options, no Lombard loans on your portfolio and no investments that require additional injections of capital in the future that is not covered by money in the playground portfolio. 

• These two rules are designed to ringfence your long-term portfolio from any mistakes you might make in the playground portfolio. Ideally, you also record all your investments in an investment diary as I have proposed in rule seven last week so that you can review your investment decisions and the temptations you have succumbed to. Over time, you may find that these temptations become so unpalatable that you avoid them altogether. 

Though, I wouldn’t be so sure of that. No matter how much bad chocolate like Hershey’s Kisses I eat in my life, I seem to be unable to ween myself off of chocolate…