Lauren Templeton and Scott Phillips, coauthors of Investing the Templeton Way, share their analysis of John Templeton’s advice for assessing one’s investing success. This is the second post on this topic; to read the first post, click here.
The time to reflect on your own investing methods is when you are most successful, not when you are making the most mistakes.
Nearly everyone can appreciate the counterintuitive nature of this advice, as it basically comes as a warning against the psychological pitfalls of success in investing versus failure. In fact, many experienced investors have likely seen a particular manager or fund obtain an outstanding short-term record, only to have performance falter shortly after that success is recognized and rewarded by additional assets under management or praise. It seems possible that Sir John’s advice is providing reference to what behavioral finance experts describe as overconfidence that results from mood and optimism.
Truth be told, much of Sir John’s investment advice and his consistent wisdom provided decades ago is now being formalized in a coincidental manner through the burgeoning field of behavioral finance. In sum, behavioral finance intersects the two disciplines of psychology and the financial markets in order to better understand the behavior and subsequent results of market participants.
What researchers have discovered in their cross-sectional studies in the relationship between investing and psychology is that human behavior plays an important role in the financial markets. Likewise, individual behavior plays a large determinant role in the investment returns achieved by practitioners of all stripes, from the top fund managers with all available resources to retail investors going it alone.
In a 2002 essay entitled Psychological Biases of Investors, professors Kent Baker and John Nofsinger describe the role of mood and optimism on investors in their selection of investments. As described by the professors, “People in a good mood make more optimistic judgments than people in a bad mood. Being in a bad mood makes investors more critical. This, in turn, helps them to engage in more detailed analytical activity.”
These findings tie back neatly to Sir John’s warning to successful investors, who are likely to let their guard down and become less analytically discerning in the wake of a successful run in the market. Importantly, Sir John’s advice provides a sharp lesson to investors that the time to be most vigilant over their holdings is when they feel best about them, rather than when they feel worst.