The stock market is a device for transferring money from the impatient to the patientWarren Buffett
What is Pain?
Everyone experiences pain from time to time. People often view pain as an indication of mechanical damage to an area of the body similar to the damage done to a part of a larger machine. Using this logic, if something “hurts” it always indicates “harm”, and therefore painful activities should be avoided. This isn’t necessarily the case.
Humans are complex organisms and can adapt to almost anything. Recent research has shown the experience of pain is complex and is related to the perception of threat and the need for protection rather than active tissue damage.
The perception of pain can be influenced by numerous “biopsychosocial” factors and the expression of pain can be met with a low level of fear where the individual has high self-efficacy and allow for recovery.
Or if they instead catastrophize their experience of pain and have a high level of fear, they will have a low self-efficacy. This can cause them to avoid the pain and could inhibit recovery.
With this in mind, we can view pain as not always as bad (harmful), rather as discomfort we all occasionally must deal with.
Pain in Investing
For many, investing can be seen as a “painful” experience, because you often expose a portion of your portfolio to investments that experience market volatility. When investing you must determine if the pain you are experiencing is indicating harm (damage) or is to be tolerated.
All investing involves risk, often when investing for the long-term you must expose a portion of your portfolio that will be exposed to the volatility of the market. The pain of market volatility may “hurt” but is not “harmful” and should be viewed as a fee you pay when investing in these types of assets.
A Potential Issue with Active Investment Strategies
Active investments’ offer the potential for outperformance relative to their benchmarks. Future outperformance is uncertain and underperformance relative to a benchmark is always a possibility. The use of active management depends on experience, talent, cost, and patience.
When implementing an active investment strategy, there will inevitably be periods where it underperforms its benchmark. The duration and magnitude of the underperformance cannot be known in advance.
This “active-risk” exposes you to a new kind of “pain” and you must ask yourself if the pain you are experiencing is normal or is there actual harm being done?
How to Manage Active-Risk
How much active-risk you are willing to accept should be determined in advance of implementing any active investment strategy. You must ask:
- How much relative underperformance you are willing to accept?
- How long will you allow any underperformance to be sustained?
This way you are not making decisions based on emotions but on pre-determined guidelines.
These pre-determined guidelines help to prevent you from making decisions based on emotions during the inevitable periods of underperformance.
Investing is painful enough on its own. Active management exposes you to a different type of risk and potentially increases the pain you experience. Investing is a means of reaching a desired future state.
It should be used as a way to maintain a certain level of wealth, with the possibility to incrementally increase it over time. Everything has a cost, even if it not currently apparent. There is no risk-free return.
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