Robert Arnott: Leave Emotions Out of Investing

Posted on December 26, 2012 at 5:29 AM PDT by

We’ve written a lot in the past about the importance of emotion-free investing. Now one of the top investors on Wall Street, Robert Arnott, is saying the same: If you can manage to check your feelings at the door, you’ll be much better off.

Arnott is chairman and CEO of Research Affiliates, a California asset manager he founded in 2002. It manages $113 billion today from its Newport Beach headquarters. Arnott is widely published on the topic of portfolio management and asset allocation and is frequently quoted in the financial press.

emotions out of investing

The folks at The Motley Fool spoke to Arnott and asked an incredibly direct question, especially of a money manager who makes a living picking stocks. Simply enough, they wondered, should investors bother with trying to select individual stocks in hopes that they might outperform.

Now, most money managers would immediately begin to “talk their book.” You’ve seen this before. Interview the gold bug, and you’ll get an earful about gold. Talk to the value guy and, you bet, it’s time to buy value plays. And on and on.

Arnott does make the case that stock picking is possible, even a reasonable pursuit, for the ordinary investor.

Then he does an interesting about-face: You won’t lose picking the wrong stocks, he argues. You’ll lose because you’re a human being with emotions:

Emotion will discourage us from doing what’s feared and loathed in the market, and that’s where the biggest opportunities are. So since most people are emotional, I would say most people should index, and that doesn’t mean cap weighting.

Arnott goes on to recommend buying a broadly diversified portfolio, one that includes domestic and foreign stocks and bonds, as well as alternative investments such as commodities and real estate.

(Note: Arnott’s firm pioneered a type of indexing known as fundamental indexing, based on the investment prospects of a firm, as compared to indexing by market capitalization, which is simply by size. He wrote a book about it.)

You might find it surprising to hear a stock picker advising people to buy indexes, but Arnott is absolutely right. One of the craziest risks ordinary investors take every day is concentration risk.

Sometimes it’s because they own too much of their own company’s shares. Or they jump on a “bandwagon stock” and ride it into the sky, only to crash to earth at exactly the wrong moment.

Indexes offer the retirement investor a decent shot at avoiding concentration risk — thus diminishing emotional attachment — by owning hundreds or even thousands of companies at once. A few dozen firms could implode and it would hardly make a dent in your long-term outcome.

Likewise, rebalancing, as Arnott maintains, is crucial to building wealth. The reason why, again, is your emotions. It can be alarmingly easy to believe that one part of your portfolio will rise without a halt, never to revert to the mean.

But experience shows that this just isn’t so. It takes nerve to sell part of a winning hand and to use that cash to buy the “losers” in your allocation, which is rebalancing in a nutshell. Most people don’t have that kind of willpower.

Getting your emotions out of investing

Nevertheless, rebalancing helps you to see the forest for the trees and make choices in a timely manner, ultimately supporting the goal of safety and growth over time. Compounding is what builds a retirement, not an outlier stock or all-in bet on a single asset class at “the right moment.”

Finally, an important point about diversification: When Arnott talks about diversification, he really does mean owning at least small holdings in hard assets such as commodities and real estate, something you can achieve with exchange-traded funds (ETFs) at minimal cost and fairly low risk.

Yes, owning the S&P 500 is more “diversified” than owning five or 10 common stocks, but true diversification across asset classes allows you to rebalance in those wild moments when markets sharply diverge. And they will, in time.

That’s powerful investment, and it can be done with very little risk of emotions getting in the way.