The problem of our emotions

In his book, 'The Big Secret for the Small Investor’, Joel Greenblatt wrote that the best-performing stock mutual fund of the last decade earned more than 18% annually. This is impressive since the market, as measured by the S&P 500, was down close to 1% per year between 2000 and 2009. Yet the average investor in the same fund lost 11% per year over those ten years. How is that possible?

After every period in which the fund did poorly, investors ran for the exits, and after every period in which the fund did well, investors piled in. The average investor lost money in the best-performing fund by buying and selling the fund at just the wrong times. Investors seem to forget that even the best-performing fund managers go through long periods of significant underperformance.

Our emotions and our behaviour are under the continuous influences of the media and, of course, of other people. Emotions are simply a wrong guide to base investment decisions. Where money is concerned, emotions regularly overcome rationality. This can also be seen in the market as stocks go up and down for no reason other than fear, greed, hope or despair.

To avoid your emotions influencing your investment decisions, you should invest using a strict, standardized process, a proven system which you can rely on that removes emotions from the decision-making process. Think of this system as the process or procedure that a doctor needs to follow when performing an operation. It does not guarantee success, but the procedure has proven its reliability over time and has a high probability of success.

The need to focus on the investment process with the highest probability of success rather than the outcome is critical when investing. This is because investment outcomes are probability-based, and even if they have a high probability of success, there is still a chance that they will be negative. However, only if you invest using a system with a high probability of market-beating returns over the long term do you have a high probability of being a successful investor.

And this is exactly what we would like to do with this paper. Determine exactly what factors you should use when selecting your investments to give you the highest probability of substantially outperforming the market. To do this, we looked at factors based on historical financial data to see how effectively each factor generated market outperformance. We did this using a computer database that can quickly and accurately process or screen many companies, but more importantly, a computer has no emotions. Once you have identified what factors have a probability of outperforming the market, you can add them to the computerised stock screener to generate the names of companies that meet these factors. This list is an excellent starting point for selecting market-beating investment ideas.