The ancient Stoic philosophers introduced me to an idea they called “premeditatio malorum”—the premeditation of evils.
It’s a practice that involves considering some of the worst things that can possibly happen to you, as a way of immunising yourself against them. To many, this concept might seem somewhat odd and quite grim, but if the Stoic philosophy appeals as much to you as it does to me, you can see the value in it.
In fact, the idea of premeditatio malorum is rooted in our religious and cultural traditions. From the ancient Bhutanese folk saying “to be a happy person, one must contemplate death five times daily” to the writings of St. John Climacus (“The remembrance of death, like all other blessings, is a gift of God”), spiritual wisdom reminds us to keep in our minds that our time on earth is temporary and fleeting.
Paradoxically, this practice can actually make us happier.
Remembering that you could lose your job makes you appreciate those administrative tasks you can’t stand. Being thankful for your health and the use of your limbs makes it hard to complain about all that yard work you need to get done. And recalling the mortality of your loved ones will have you treasuring every routine moment with them, and hugging them a little tighter.
It’s a useful practice.
Now we’re going to apply it to your investment portfolio.
At the start of almost any financial advisory relationship, you will work through a questionnaire that outlines your attitude towards risk. “How would you react if your portfolio fell 20%?” is a common question, for example. And “I would hold on or buy more” is a common answer.
The thing is, you have no idea how you would react in that scenario, because it’s presented in such an abstract and soulless way.
In more vivid and personal terms, one might phrase it as follows:
You have worked your whole life and have finally sold your business for $10 million, after tax. You are ecstatic but also worried about what the future holds. You’ve never had responsibility for so much wealth, and you’re not sure if you’re handling it correctly. You hire an advisor recommended by your brother-in-law because he seems knowledgeable. Shortly after he deploys your cash, the market begins to decline. Your $10 million is now $9.5 million. “Don’t worry,” says your brother-in-law’s advisor, “this is a healthy correction.” This does not feel healthy at all, but you assume he’s an expert and you trust him. After a brief respite, the market suffers another violent selloff. The newspapers begin talking about a big recession… maybe even another Great Depression scenario. The financial news is filled with talking heads in fancy suits telling you to raise cash and head for the hills. Your $10 million is now $8 million, only a few months after investing. At this rate, your life’s work will be vaporized in a couple of years. You demand another meeting with your brother-in-law’s advisor, who tells you, “This is a healthy correction,” and offers to switch you into a lower-risk fund, maybe to rebalance into bonds. What do you do?
If your answer to this scenario is “hold on or buy more,” you’re a more trusting and patient client than I would ever be.
Premeditatio malorum is about anticipating these events in advance.
That’s a nice portfolio you got there… would you still feel as confident in it if it was down 20% tomorrow?
Why conviction is important
Research firm Dalbar conducts a well-known survey that tracks the difference between market returns and those returns actually experienced by investors. The results are often striking. For example, in 2018 they noted that the average balanced fund portfolio returned 6.8% per year over the twenty-year period from 1998 to 2017. During the same period, the average investor in those same funds experienced a return of 2.6%.
How is that possible? Because investors buy when prices are high and the news is positive, and sell when prices are low and the news is negative. In doing so, they ensure they will earn poor returns.
Many advisors use this data to prove to clients that they should stop trying to time the markets and instead stick to their investment plan. This is true.
But what if part of the problem causing this was a mismatch between the investor and their portfolio?
What if part of the reason they were selling is because they never really believed in their investment strategy to begin with?
A well-known example is that of Ken Heebner’s CGM Focus Fund, the best-performing mutual fund of the first decade of the 2000s. The ten-year annualized return was an impressive 18.2%. In 2007 alone, the fund was up 80%, attracting $2.6 billion of assets the following year.
And then… the housing crash. The mortgage and banking crisis. The Great Recession. Immediately following a huge inflow of investor dollars, the fund declined 48%.
The money came in when the numbers were hot. But the investors didn’t have conviction in Heebner or his strategy. They were just chasing returns. And so despite the fund having the best returns of any fund in the decade, investors performed horribly. According to Morningstar, the average investor in CGM Focus experienced a loss of 11% annually over the same time period that the manager made 18% per year.
A more recent example of this phenomenon are the terrible returns experienced by investors in the famous ‘ARK Innovation Fund’. I’ve talked about that enough and won’t revisit it here.
These are great examples of why it’s important to avoid chasing returns. Know why you’re making an investment. Understand the strategy and have conviction in it. Because if you’re just chasing returns, you’re going to bail when things get rough.
Premeditatio malorum is important because it’s a way to test for conviction. And conviction is the key to investing successfully through downturns.
The long-term trend in the markets, as in the economy, is up. Believing this is a necessary prerequisite to investing in stocks. We all know what we need to do when the market corrects. When we’re facing a recession scenario, or a financial crisis. When everyone else is panicking and selling. We need to buy.
But human nature tells us that we’ll feel so much more comfortable running with the herd. And if the herd is selling, we also want to sell.
We will sell, even though we know it’s the wrong thing to do in the long run, because it will alleviate our pain in the short run.
So what do we need in order to prevent ourselves from selling at the bottom? I’ll take it a step further—what do we need in order to buy more at the bottom?
The magic ingredient is conviction. Conviction means that you have a firm belief in what you own or in the strategy being implemented by your money manager. It means that you won’t be tempted to sell when the market drops temporarily, no matter how violent the selloff. In fact, it means that when that happens, you’ll actually be tempted to buy more.
I’m not talking about blind faith. I’m talking about having a solid understanding of what you own. Confidence backed by objective facts, not predictions of what other investors will do.
Geoff Saab is the author of Low Risk Rules: A Wealth Preservation Manifesto, and writes a free newsletter at lowriskrules.substack.com.
