There are many components to a successful investing strategy. Perhaps none is more important than the psychological aspect of investing. The price of any asset at any given time is the summation of the participant’s willingness to pay a particular price. Psychology rules price direction and understanding how psychology moves prices swings allows an investor to understand and grasp potential future price movements. Approaching the psychology of a market with a great deal of skepticism is perhaps the most powerful risk management tool we have in our investment toolkit. You can’t always understand how other investors are thinking, but a hefty skepticism of crowd behavior will help you avoid potential pitfalls.
Despite one of the most difficult investing/trading environments of all time I have had a great deal of success navigating the market over the last few years. A combination of good risk management and hard work has resulted in high risk adjusted returns and high absolute returns throughout my career. One of the most important components of my approach to good risk management has been a hefty dose of skepticism with regards to all things stock market related. I am often mistaken as a permabear (even though I have been incredibly bullish at points over the last few years) because I often talk down data as it appears at face value, but I believe being skeptical is one of the key components of a good investment strategy. This doesn’t mean that data is always wrong as it’s presented, but you should always delve deeper into your research and come to your own conclusions rather than the conclusions of others or even worse, the conclusions of the crowd.
In the novel “Ugly Americans” Dean Carney, the American hedge fund manager who dominated the Japanese derivatives markets in the 90’s, had a rule about being skeptical of markets:
“Don’t ever take anything at face value. Because face value is the biggest lie of any market. Nothing is ever priced at its true worth.”
Regular readers know I am no proponent of the efficient market hypothesis. In fact, I believe the market is highly inefficient due to the severe inefficiencies of the psychology of its participants. Taking the market at face value is almost always a recipe for disaster. As Jesse Livermore said, “the market is designed to fool most of the people most of the time.” Taking the market at face value is a recipe to be fooled most of the time.
Being a skeptic often involves going against the crowd. Earnings look “better than expected”? Well, maybe they’re not actually that strong after all. The economy is in a full blown recovery? What if it’s not? I described the bandwagon effect in “Why you likely trade like a loser”:
6. The bandwagon effect: the tendency to think it must be right because everyone else is doing it – a thought process guaranteed to get you in when it’s obvious and get you out when it’s obvious. Put another way, it has you buying at the top and selling at the bottom.
As I said earlier, when everyone is thinking the same, someone isn’t thinking. Learn to go against the crowd. And when the boat feels like it’s tipping to one side, jump off or consider moving to the other side.
Being a skeptic is a powerful risk management tool. It’s not always easy to sit idly while the market rips higher or exuberance runs wild on Wall Street, but being skeptical of the market will almost always ensure that you avoid the devastating pitfalls that hinder so many investor’s portfolios.
In short: do your own research and always approach other investor’s conclusions with a heavy dose of skepticism.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.