How Delayed Gratification Improves Investment Performance

Forbes

We live in a different world than we did just a decade or so ago. Instead of taking a few hours out of your day to go grocery shopping, you can now have them delivered in the same amount of time. With just a few clicks, you can book your entire vacation online. When buying a car, you can avoid the time and hassle of multiple trips to dealers by buying it online. You can even buy and sell stocks instantly and commission-free without talking to a stockbroker.

Unquestionably, having nearly everything you want at your fingertips is enormously convenient and efficient, but at what cost?

Humans Are Wired For Short-Term Gratification

With the advent of technology in the form of smartphones, social media, and on-demand services on the internet, people have become addicted to instant gratification. Studies show that instant gratification often triggers dopamine release in the brain, a neurotransmitter associated with pleasure and reward. The same instant result can be achieved through activities such as exercise, yoga, walking in nature, or playing with a pet. When people experience this rush, they are more inclined to pursue similar experiences.

The need for instant gratification without regard for the future is a deeply ingrained survival instinct forged over thousands of years by ancestors whose biggest concern was where their next meal would come from. So, to take the short-term view when making financial decisions is instinctive for many, even though it could be damaging in the long run. Therefore, to make sound decisions with a long-term view requires a deliberate thought process that runs counter to our nature.

That “present bias”—the phenomenon in which a person would rather focus on immediate benefits and costs—works against investors in several ways:

The Urge To Chase Returns

Some investors seek instant gratification by chasing performance, jumping from one stock or fund to another, hoping to land on a “market winner.” However, focusing on stocks that have been run up in value exposes you to more downside risk. Also, just because a fund manager is performing well this year doesn’t mean they will perform as well next year. According to S&P Global, less than half of top-performing fund managers repeated their top performances over a 10-year period.

Fearing Losses More Than Enjoying Gains

Human nature makes many investors prone to “loss aversion,” especially during periods of extreme market volatility. Scientific studies show that, for many people, the fear of losing money has a significantly greater psychological impact than the joy of reaping gains. That instinct can drive investors who can’t bear the thought of losing money to flee the market, turning what typically turns out to be a temporary decline in portfolio value into a permanent loss of capital, inevitably hurting their long-term investment performance.

Following The Herd

People who fear the possibility of being left behind tend to find comfort in numbers. When they see big moves in the market—either up or down—they tend to look to others for inspiration on how they should react. The herd mentality in investing is why we experience stock market crashes—everyone following the herd over the cliff. The herd instincts of investors have led to the biggest asset bubbles in history (i.e., the dot-com bubble of 1990 and the housing bubble of 2008), first driving asset prices up to unsustainable levels and then following them down when the bubble bursts.

Short-Term Investing Orientation Hurts Returns

Few people can predict which way a stock or market will move with a degree of certainty that could produce consistent, positive results. According to a DALBAR study, investors underperformed the market over a 20-year period, earning a 7.13% annualized return versus an average 10.65% return by the S&P 500 index—a substantial gap. As outlined by this article, this substantial gap could be explained in part by investors attempting to time the market, and making short-term moves to increase returns or prevent losses.

It’s not any better for active funds managed by professional investment managers who actively trade stocks in the short term with the primary objective of outperforming the S&P 500. Through 2022, less than one-fourth of active funds were able to beat the S&P 500 over the trailing half-decade. The S&P 500 earned an average annualized rate of return of 7.51% during that period.

Using A Sound Investment Strategy To Overcome Human Nature

Considering that historical perspective, investors must overcome the instinctual preference for short-term gratification because it rarely pays off. It helps if they work with a quality financial advisor who can help them develop a sound, long-term investment strategy based on their specific goals, priorities, and preferences.

It also helps if they invest in high-quality, well-managed companies with a track record of generating positive free cash flow and a high return on invested capital (ROIC). These companies, particularly those with global brands and dominant market positions, have the capacity to reinvest a portion of their cash flow back into the company to grow it while generating a high return on invested cash. When companies can do this consistently, it has the effect of compounding shareholders’ wealth. They are also more resistant to economic headwinds such as inflation and recessions.

Even at a moderate rate of growth of, say, 4%, a company with the ability to add just 1% annually to earnings growth combined with a free cash flow yield of 5% should be able to compound their growth at a rate of around 10% in good times and bad. With that level of growth compounding investor returns over time, there’s no need to time the market or speculate.

Investors Must Overcome Instincts To Make Sound Investment Decisions

Our natural biases and instincts are potent forces that can work against us when making critical financial and investment decisions, often triggering emotions that lead to costly mistakes. The counter to emotionally based decisions is a well-conceived investment strategy that keeps you focused on your objectives and your ambitions for a good life in the future.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Sincerely

Jonathan Dash,
Founder and President
Email: info@dashinvestments.com

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.