How to be a successful investor

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(MoneyWatch) Among the requirements for achieving your financial goals are:

  • The knowledge needed to develop an investment plan; integrate it into an overall estate, tax, and risk management (insurance of all types) plan; and then provide the ongoing care and maintenance that is required
  • Math skills that go well beyond simple arithmetic
  • The ability to determine the appropriate asset allocation, one that provides the greatest odds of achieving your financial goals while not taking more risk than you have the ability, willingness, or need to take
  • A strong knowledge of financial history

However, having these skills (or working with a financial advisor who does) is only a prerequisite for success. They won't serve you well if you don't have the patience and discipline required. As Warren Buffett has noted, "The most important quality for an investor is temperament, not intellect."

Unless you can achieve your financial goals while limiting your investments to the safest investment-grade bonds (something very few can do), your must accept that you and your portfolio will face many "stress tests." Economic crises happen with great frequency. Over the past 40 years, investors have been confronted with more than 15 major crises, or about one every 2.5 years. And if you're like most investors, it's unlikely you can recall even the majority of them -- because they were resolved fairly quickly, though success didn't seem so clear at the time. And which investors fared the best? Those who had the patience and discipline to stay the course.

The value premium (value stocks have outperformed growth stocks) has been well documented in the academic literature. Not only has it been large and highly persistent, but it has existed in almost all developed markets (with the exception of Japan) and most emerging markets as well. However, the past five years have seen value perform poorly. This has led many investors to abandon their well-thought-out plans.

From 1927 through 2011, the annual average value premium was 4.7 percent. However, from 2007 through 2011, the value premium was negative in four of the five years, with the annual average premium being negative 3.7 percent. And it has continued to be negative in 2012, testing investor patience and discipline.

But this type performance should have been anticipated. If there weren't long periods of negative performance, there would be no risk and no value premium. The only thing unexpected is the timing of the underperformance, which we can't predict as there are no investors with clear crystal balls. Those investors who knew their financial history would have known that we had experienced similar periods in the past, all occurring during periods of financial crises. The literature demonstrates such periods is just when you should expect the risks of value companies to appear.

  • 1927-31, the value premium was negative four of five years. The annual average premium was negative 6.2 percent, much worse than it has been in the past five years.
  • 1937-39, the value premium was negative all three years. The annual average premium was negative 7.9 percent.
  • 1978-80, the value premium was negative all three years. The annual average premium was negative 7.2 percent.
  • 1989-91, the value premium was negative all three years. The annual average premium was a still worse negative 8.3 percent.

Clearly, these periods were difficult for value investors. That's the nature of risk. If you want to seek the higher returns of risky assets, you must accept that there will be periods, even long ones, when you will experience negative outcomes. And there can be no guarantee that even over the long term you will be rewarded for taking risk. If that was the case, there would be no risk. The premiums would be free lunches. That stocks are safe if your horizon is long enough is just another of the many falsehoods believed by many investors. The following are just two examples:

  • On June 1, the Japanese TOPIX Index (similar to the Russell 3000) closed at a 28-year low!
  • For the 40-year period 1969-2008, U.S. small growth stocks (Fama-French index) returned 5.1 percent, underperforming totally riskless one-month Treasury bills which returned 5.9 percent. (During the same period the Fama-French small value index returned 11.6 percent, and the Fama-French large growth and value indexes returned 7.8 percent and 9.6 percent, respectively.)

How you react during crises will determine the likelihood of successfully achieving your goals. Unfortunately, most investors, even those who use their heads to develop investment plans, allow their stomachs to take over during crises. And stomachs don't make good investment decisions. They cause us to overreact to the noise of the moment. We succumb to the mistake of recency -- the tendency to give too much weight to recent experience and ignore long-term historical evidence. Fear sets in, and panic takes over as the controlling emotion. And we lose the discipline and patience that's required to be a successful investor.

The bottom line is that while the necessary conditions to be a successful investor are that you have the knowledge of financial history and the math skills to develop a well-thought out financial plan, those conditions aren't sufficient. You also need to have the right temperament. Asking yourself, and honestly answering, these questions will help determine if you have what it takes to be a successful investor:

  • Do I have the temperament and the emotional discipline needed to adhere to a plan in the face of the many crises I will almost certainly face?
  • Am I confident that I have the fortitude to withstand a severe drop in the value of my portfolio without panicking?
  • Will I be able to rebalance back to my target allocations (keeping my head while most others are losing theirs), buying more stocks when the light at the end of the tunnel seems to be a truck coming the other way?

As you consider the answers, think back to how you felt and acted after the events of September 11, 2001, and during the financial crisis that began in 2007. Experience demonstrates that fear often leads to paralysis, or even worse, panicked selling and the abandonment of well-developed plans. When subjected to the pain of a bear market, even knowledgeable investors often fail to do the right thing because they allow emotions to take over, overriding what the brain knows is the right thing to do.

This results in what my colleague Carl Richards calls "the behavior gap." The term is used to describe the failure of investors to earn the same return as that earned by the very funds in which they invest. Ask yourself: Have I always done the right thing? Have my returns matched those of my investments?

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.