In The Intelligent Investor, often regarded as the bible of investing, economist Benjamin Graham offers a reflection on how human emotions can impact investment decisions, especially when fear or greed takes over and leads us to act at the wrong time. Graham emphasizes that, despite the objectivity financial analysis can provide for making investment decisions, the main obstacle to achieving optimal returns is not the market itself but our own behavior.
In this context, a new concept emerges that might seem unusual but becomes clearer throughout this article: a contract with yourself. This idea involves investors committing to themselves to remain calm during market volatility and resist emotional impulses. By doing so, they not only strengthen self-control but also establish clear foundations for their strategies, even when tempted to act impulsively.
Human behavior and Its impact on returns
One of the most representative concepts of this phenomenon is the “behavior gap,” which Benjamin Graham also references in his work. This gap highlights the difference between the returns investment funds report in their official documents (time-weighted returns) and the actual returns investors experience, which are often lower due to emotional decisions (money-weighted returns). Interestingly, studies reveal that investors typically don’t lose money because of market fluctuations but because of how they react to them. Investors often earn annual returns worse than the funds they invest in due to a tendency to sell when the market falls and buy when it rises.
Similarly, Graham stresses that the goal of investing isn’t to outperform the average but to earn enough to meet our own needs. Success should be measured by whether we’ve created a financial plan and behavioral discipline capable of helping us achieve our goals.
The impact of the behavior gap is significant, especially over the long term, as differences in returns can become substantial. This behavior not only affects immediate gains but can also distort perceptions of the market, making it appear more volatile and unpredictable than it truly is. The real profitability of an investment lies in thoroughly analyzing our choices, staying calm, and sticking to our strategy, even in times of uncertainty.
The contract as a tool to combat the behavior gap
Now that we understand the concept of making a contract with yourself, it’s essential to explore how to apply it to our investment strategy. This idea has already been implemented by some investment platforms, which encourage investors to sign a legal document outlining principles to follow during periods of stress or uncertainty. For example, since 2019, Indexa Capital has offered investors the option to sign a “contract with yourself,” committing not to withdraw funds during market downturns.
The purpose of this contract is to provide investors with self-confidence and an emotional reminder to stay calm when challenges arise during market fluctuations. Additionally, it serves as a “behavioral anchor,” a concept from behavioral psychology that refers to decision-making based on initial information. The first piece of information we receive tends to be internalized and becomes anchored in our thinking. Relating this to investing, reading your own contract during moments of doubt caused by market fluctuations allows you to confront the rational thoughts of your calm self with the emotions of your crisis-driven self. This contrast can discourage decisions misaligned with long-term goals.
Thus, the contract isn’t just a legal document but a personal commitment with significant psychological impact. By signing an official commitment, investors reinforce a long-term mindset crucial for avoiding emotional reactions. In this case, Indexa’s data shows that most clients who signed this contract maintained their investments during downturns, with only 6.5% of withdrawals from 2019 to June 2024 (335 clients out of 5,142).
Ultimately, human behavior has a profound impact on investment returns, and as Benjamin Graham aptly demonstrates, emotions can be the greatest enemy of profitability. The idea of signing a contract with yourself might seem simple or even trivial, but Indexa Capital’s example shows it makes sense and can be a valuable tool for avoiding the trap of our own nerves.
This type of emotional and rational commitment can make the difference between a successful investment and one filled with regrets. In the end, successful investing isn’t just about understanding markets but also about understanding and controlling our psychology. It involves knowing ourselves well enough to recognize our risk tolerance and level of self-control when fear limits our ability to invest wisely and achieve the best possible returns.
