Markets

Discipline Is Necessary for Investment Success

By Larry Swedroe

Updated on: November 30, 2009 / 2:55 PM EST / MoneyWatch

Warren Buffett once said, "The most important quality for an investor is temperament, not intellect." The evidence from research on investor returns versus investment returns demonstrates that your worst enemy can be your emotions:

During bull markets, it's greed and envy.
During bear markets, it's fear and panic.

The inability to control these emotions can cause you to earn returns persistently below the returns of the funds you own. This outcome results from investing via the rear view mirror, buying (high) after periods of good performance and selling (low) after periods of poor performance.

One key to being a disciplined investor is to understand that bear markets are both inevitable and unpredictable as to their timing, length and depth. Another key is to know that the world is never really as dark as it appears to be during a bear market. Knowledgeable investors know bear markets are accompanied by countercyclical policy actions. And the stock market is a leading economic indicator, anticipating that such actions will be taken. That's the reason for the clichÃ© that you make the greatest returns during tough economic times, it's just that you don't know it at the time.

It's also why while Buffett advises against market timing efforts, he advised that if you can't resist the temptation, you "should be greedy when others are fearful." Buffett also stated: "The most common cause of low prices is pessimism. We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces."

The latest bear market, the worst since the Great Depression, certainly tested investors. After falling 37 percent in 2008, the S&P 500 Index fell another 25 percent at the beginning of the year, producing a total loss of about 53 percent, until beginning one of the greatest bull runs ever on March 10, 2009. Only those investors who were able control their emotions and ignore the noise of the market were around to enjoy the rally.

Discipline is equally important during bull markets. Just as the world is never as dark as it seems during bear markets, it's never as bright as it seems in bull markets.

Successful investors are disciplined:

They have a written investment policy statement that includes a rebalancing table.
They maintain discipline by adhering to their plan.
They sell stocks during bull markets, not because they're bearish, but because equities have now exceeded their maximum allocation.
They buy stocks during bear markets, not because they're bullish, but because equities have fallen below their minimum allocation.

By fighting off their emotions, those with the discipline to rebalance end up buying when prices are relatively low (and expected returns are high) and selling when prices are relatively high (and expected returns are low). They act as if they're fearful when others are greedy and greedy when others are foolish. In other words, they act like Warren Buffett.