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A reader asks:

Instead of diversifying is it ever worth advising clients to build mental toughness? This would be similar to how we teach youth athletes to grow through losses and failures. Learning to take short term investing losses knowing over long term they will get larger gains in stocks.

This is an excellent question because money is more about behavior than numbers.

On the one hand, dealing with losses is one of the most important aspects of investing. No pain, no gain.

I get the idea behind keeping your risk level at a place that allows you to sleep at night. It might help you sleep better at night right now if you have your entire portfolio sitting in cash because there is no volatility or nominal downside. But you’ll probably have a lot of sleepless nights in the future.

Risk and reward are attached at the hip. If you want to keep up with or beat the rate of inflation, you have to put your capital at risk. You can’t allow short-term worries to derail your long-term plans.

Sometimes, staying the course requires feelings of discomfort with your investments.

If there were an easy solution everyone would do it. There is no easy solution when it comes to investing.

On the other hand, the best predictor of future behavior is past behavior.

Certain investors simply cannot help themselves. They get greedy when others are greedy. They get fearful when others are fearful. They try to time the market. They might have a plan, but they either can’t or won’t follow it at the most important times.

These people might need a behavioral release valve or a change of strategy to help them stay the course.

The reason for this is knowledge and willpower alone aren’t enough to change behavior.

Researchers examined the relationship between the knowledge of HIV/AIDS and the prevention methods employed by people in Africa. In Botswana, more than 90% of people said they knew the use of a condom could help prevent the spread of the disease. But just 60-70% of those people said they used one.

One of my favorite examples of this is from The Little Book of Behavioral Investing: How to Not Be Your Own Worst Enemy by James Montier. Montier wrote an excellent book that goes into detail about our many misgivings as a species when it comes to poor investment behavior.

In the book’s conclusion, Montier makes an admission:

It is confession time. As anyone who knows me can attest, I am overweight (although I prefer to think of myself as simply too short for my weight). In fact, according to the body mass index which compares height to weight (designed by size fascists, I’m sure) I am on the borderline between overweight and obese.

I know how to correct this problem. I should simply eat less. However, I find this incredibly hard to actually do. So despite the fact I know how to change, I don’t change, so my knowledge doesn’t translate into better behavior. Rather I file the information in the category of “things I know and choose to ignore.”

He knows what he should do but information is no match for human nature.

You have to put systems in place to protect against your lesser self.

Another study observed hundreds of diners at Chinese buffets across the country to get a better sense of their eating habits and what caused people to eat more or less.

They found people ate less when they used chopsticks or smaller plates. They ate more when they used forks and larger plates. Thinner people surveyed the buffet before diving in and picking out the most appetizing foods while the heavier eaters grabbed a little bit of everything.

People who sat closer to the buffet ate more food, while people who sat in chairs facing away from the buffet line consumed fewer calories.

There are obvious investment parallels here.

Some investors need smaller portion sizes and broader diversification. Sometimes you need to face your chair away from the buffet so you’re not focused on short-term performance or the returns of other investors who have different goals and time horizons than you.

It might not seem optimal to someone with the willpower to stay the course, but some investors need a behavioral escape hatch. If a 10% allocation to a strategy allows you to stick with the other 90% that’s more long-term in nature, that’s a win to me.

I know plenty of investors who have the ability to follow a portfolio come hell or high water. They don’t need any behavioral enhancements. They can sit on their hands and do nothing during a bear market and don’t act on FOMO during a bull market.

These investors do exist and they can optimize their portfolio as much as humanly possible.

I also know plenty of investors who don’t have the ability to ride out the storms or completely set-it-and-forget-it.

These investors might need to turn down the risk dial or incorporate other strategies to keep them on course.

It really comes down to knowing your weaknesses as an investor.

For individuals, that means know thyself. For advisors, it means know thy client.

You can’t help someone invest their money if you don’t understand how they behave when making money decisions.

We touched on this question on this week’s Ask the Compound:

Wes Gray from Alpha Architect joined me on the show this week to discuss questions about the best places to live for tax purposes, owning T-bills without the high taxes and how to best diversify value stocks.

Further Reading:
Buy & Hold vs. Fear & Greed