Why avoiding temptation is an investor's most important skill

Smart long-term investors generally have a good understanding of the mindsets and behaviours that lead to financial success.

They diligently act on a solid plan and have thought through the various trade-offs that all financial decisions demand.

However, even the best of us are still human. While the principles of smart investing may be simple to understand, they’re certainly not easy to act on consistently.

Every significant world event affects our financial system. These events typically evoke emotions that, when acted on, can be detrimental to our financial health.

Unfortunately, emotions are highly contagious, and when these emotions make it harder to be good investors, we must be careful about how we proceed.

In particular, there are two temptations we see even smart investors face on a very regular basis.

Successfully dealing with these temptations is what separates good investors from great investors.

Temptation 1: Forecasting the economy

Economists are charged with understanding how our economy functions. They help us understand the relationships between interest rates, inflation, economic growth and other factors. Their knowledge informs policy decisions that feed through the entire global economy.

However, they inevitably get seduced by the financial media into making predictions of the economy’s vital markers.

While understanding the current trajectory of crucial metrics helps understand the market’s current position in a cycle, relying on these metrics to make outright forecasts that tempt long-term investors into making financial planning changes is very dangerous.

Not many newspapers are sold by predictions of a slow reversion to the mean, so we expect the outrageous predictions to continue.

However, the reality is that making accurate forecasts about variables highly dependent on one another is a fool’s errand.

The success rate of past forecasts has been woefully bad, which makes sense as the trajectory of all variables is mainly dependent on future events that are currently unknown to us.

It might be fun to stay informed on the economy, but being caught up in the likely short-term changes does not make it easier to be a long-term investor.

Temptation 2: Timing investment markets

Linked to the first temptation of forecasting the economy comes the investor’s biggest temptation of all: the misplaced confidence that the investment market’s volatile cycles can be timed consistently.

The economic metrics we’ve discussed are usually lagging metrics that tell us what’s recently happened.

The market, made up of millions of investors (all with their own objectives), is a forward-looking organism.

In aggregate, it tries to discount future events and cash flows into a market price investors can trade on.

The reality is that stock markets are highly unpredictable, often reacting in ways that are confusing even to seasoned investors.

A television pundit trying to summarise why the global market moved in a specific direction on a particular day is, unfortunately, nothing more than an attempt to fill airtime.

The unvarnished truth is that we don’t know why the market behaves the way it does.

Trying to guess when markets are about to go down so that we can profit or run for cover has cost many investors their fortunes.

The long-term investor’s focus is better directed at ensuring that they’re invested in the right asset mix, controlling their expenses, making heavy contributions, and understanding that their behaviour is vital to their financial success.

A better way

While the current moment always feels more uncertain than past events, we know the ending.

Most investors can agree that we never really have any certainty about the immediate future. History is just a long list of surprises we were dealt, which we ultimately navigated in the best way we could.

The current economy has potential risks, as every economy always has. Our minds are extrapolating machines, but assuming that recent trends will continue indefinitely is unrealistic and not helpful in our quest to make smart financial decisions.

The current investment market is also no more uncertain than ever. While we invest with certain average return expectations, the short term will almost always be volatile in both directions.

Avoiding the temptation to time these cycles is the intelligent investor’s most important skill.

We permit you to opt out of these unwinnable games. Your time and energy are better spent remaining clear about what’s important to your family over the long term.

Sam Instone is co-chief executive of wealth management company AES