I think the most interesting part of the investment industry is the psychology involved, and I’m always looking for new ways to communicate about this. Investors who follow market-timing disciplines know how difficult it is to overcome the psychological hurdles. It’s especially challenging to ignore the media's constant advice to pursue short-term results and trends, while the media advocates long-term investing. You can rarely pick up a financial magazine these days without reading cover headlines promising to tell you which mutual funds or stocks you should be buying RIGHT NOW.

This pop psychology may be good for selling magazines. But it doesn’t serve long-term investors very well. So I was particularly interested in an article I discovered in Sound Mind Investing, a newsletter with a Christian orientation. (Sound Mind Investing, $59 per year, 502-426-7420, PO Box 7420, Louisville, KY 40252-0128). With permission, we are reprinting a shortened version of the article, which was written by Austin Pryor, a former market-timer. I think he is right on target.

PUTTING AWAY CHILDISH THINGS:
INVESTING BY REASON
RATHER THAN EMOTIONS

by Austin Pryor

"When I was a child, I spoke as a child, I understood as a child, I thought as a child: but when I became a man, I put away childish things."
1 Corinthians 13:10

Unlike the Apostle Paul, long after I reached adulthood, I find I am still learning how to put away childish thoughts and behavior – including those in the area of investing. And I suspect many other investors are as well. For example, when children are caught doing something wrong, don't they tend to shift the blame? In the same way, investors can get into a stock or fund that they know is high risk, and if it turns out badly, act as if someone else was responsible! ("My broker talked me into this.") Or how about the way kids act impulsively on the emotions of the moment? Don't investors frequently buy or sell in the same spontaneous manner?

This kind of behavior came to mind as I read of investor's reactions to the dramatic market swings in recent months. One Wall Street Journal article included the story of a grocery store executive who had a lifelong habit of investing only in bank CDs. I was struck by his childlike reactions – my observations are enclosed in brackets: "I got fed up (anger) with making 3 percent while everyone else I know (peer pressure) was making 8 percent to 9 percent (envy) in bond mutual funds. I felt like I wasn't a smart (feeling of inferiority) investor." When his bond funds dropped in value, he sold half his holdings and is debating whether to sell the rest. "How can bonds lose money in a month's time (short-term thinking)? Why should I sit there (impatience) while I'm losing money in these funds every day?" Did he understand the risks of his new investments or have any long-term commitment to them? Apparently not. Too often, we make decisions of emotions rather than decisions of reason.

We are focused on short-term satisfaction rather than on long-term objectives. Against all reasonable expectations, we seem to somehow expect to astutely select the cream of the investment crop, ride our holdings to the crest of a glorious bull market, and then wisely take our profits. We're living, like children, in a fantasy world, and when our fantasies don't come true, we often react with bitter disappointment, anger or fear.

OUR SUBCONSCIOUS PURSUIT OF MARKET-TIMING

Nowhere is this more evident than in our preoccupation with market-timing. Ironically, this emphasis on timing, which one would think is intended to help us make better investing decisions, usually has the opposite effect because it develops within us a "trading" versus an "investing" mentality. And let there be no doubt: it is very difficult to make consistently profitable short-term trading decisions.

PROFITABLE MARKET-TIMING MODELS
HAVE BEEN DEVELOPED...

Because "buying low and selling high" is every investor's dream, market-timing can sound an alluring call. But is it just another investing fantasy? Superstar investors like Peter Lynch, John Templeton, and Warren Buffet don't even attempt it. The Harvard Business Review called it "folly," and Money magazine frequently ridicules it. Why are these knowledgeable observers lined up against it? They say it's too difficult to be done on a consistently profitable basis, and that newsletter writers have grossly exaggerated its value in order to sell more newsletters.

Enter Mark Hulbert, respected publisher of The Hulbert Financial Digest. For more than 15 years, Hulbert's work has served as a kind of Consumer Reports of the investment newsletter field. Over time, his research, performance statistics, and writing has gained wide acceptance in the industry. In addition to his own newsletter, he writes a regular column for Forbes that covers the investment newsletter scene. What has Mark Hulbert's 15 years of tracking newsletter recommendations taught him about market-timing? In his words, "It is an undeniable fact that some newsletters have beaten a buy-and-hold approach with their timing... The proportion of timing newsletters which have beaten the market is significant and can't be explained away as just luck... One goal is to beat the market -- to do better than simply buying and holding. But the other goal, which is far less widely recognized, is to reduce risk. Whatever else one might say about the market-timing newsletters, this is a goal on which they can, and have, delivered... More than half of the market-timing newsletters beat the market on a risk-adjusted basis in each of three time periods measured. This is a very impressive achievement."

Hulbert's findings are in line with my own experience -- that market-timing can indeed reduce risk while improving returns; however, it's not as easy as some would have you believe and it's often mentally and emotionally exhausting. I gained this insight the old-fashioned way -- I earned it.

In 1978, a close friend and I decided to launch an investment advisory service based solely on market-timing. We were one of the early entries in what eventually became a crowded field. During periods of market weakness, we performed exceedingly well for our clients due to our ability to sell out and move quickly into money market funds. When the eventual rallies occurred, we were nimble enough to get back in and enjoy most (but not all) of the ride up. Our strategy generated returns which saw our average managed account more than triple in value during our first five years of operations. It was during this period that our performance earned us our top 5 percent ranking among investment advisors nationwide.

...BUT FAITHFULLY EXECUTING A MARKET TIMING STRATEGY CAN BE REALLY HARD

Our "glory days" faded during the bull market of the mid-1980s. Market-timing doesn't work well in bull markets (as even its supporters will admit) because the occasional moves out of the market eventually prove unnecessary, and you often find yourself buying back in at higher prices. Investors become impatient with these miscues. The summer of 1987 still stands out in my memory as one of the worst periods of my professional life.

In April with the Dow around 2300, we had sold all stock funds and put our clients 100% into money market funds. We did this because we felt the environment had become one of high risk. As the Dow made new highs over the summer months (and everybody seemed to "know" it was going to 3000), we began losing clients to other firms who didn't share our concerns about risk. These clients simply didn't want to miss out on what appeared to be a profit-making opportunity. Eventually, the October crash took the market down to the 1700 level and vindicated our caution, although our conservatism did look foolish for awhile.

DON'T TRY THIS AT HOME, BOYS AND GIRLS

The point of relating this bit of personal history is simply to illustrate the difficulty that most investors have in faithfully staying with a market-timing strategy. Our clients began to let their emotions guide their investment decision-making. Although they had every reason to trust our judgment -- based on our track record and their own experiences with us -- they found it very difficult to ignore the media hoopla and the influence of family, friends, and co-workers.

Successful market-timing demands enormous self-control, more than most people are conditioned to give. It often requires stifling our natural greed and staying out of the market even though it keeps moving higher. Or overcoming our fears and remaining in the market when pessimism abounds.

MAKING IT EASIER TO DO THE RIGHT THING

Look at it this way: self-discipline is the ability to do the right thing at the right time every time. By the "right" thing, I don't mean always making the most profitable decision. That's impossible. Rather, I mean the right thing is to ignore the distractions of news events and well-intentioned advice and stay with your plan. In other words, to make decisions of reason rather than decisions of emotion.

This is more difficult than it sounds because the markets don't always offer positive reinforcement. In the short run, you can lose money following your plan or you can make money deviating from it. When that happens, "good" behavior is penalized and "bad" behavior is rewarded. It weakens your commitment to following your strategy. If this continues, it isn't long before you're back where you started -- making every decision on a what-seems-best-at-the-moment basis. Unless you have a rare and natural gift for investing, that's the last place you want to be. Your plan, like other boundaries in life, is there for your protection."

Great job Austin!