Legendary investor Warren Buffett — the chairman and CEO of Berkshire Hathaway — was once asked what is more important to become a successful investor: intelligence or discipline? His answer may come as a surprise to some. 

“Stocks go up and down, there is no game where the odds are in your favor. But to win at this game, and most people can’t, you need discipline to form your own opinions and the right temperament, which is more important than IQ,” according to Buffett.

Why Is Discipline so Critical to an Investor?

Investing in the stock market can easily become an emotional task in the absence of a disciplined investment strategy. To prevent emotions from driving investment decisions, an investor needs to integrate discipline into their investment strategy. Discipline provides consistency, which is essential to outperform the market over a longer period of time.

Let’s understand discipline in the context of stock markets by using a simple example.

Assume that you have decided to create a portfolio based on a single metric of the price-to-earnings ratio (P/E) and a valuation time frame of six months. Let's also assume you have decided to limit it to the five smallest P/E ratio stocks from the S&P 500 Index, at the time they distribute their second quarter dividends. As a result, stock X was added to your portfolio as one of the five stocks. Six months later, the stock is now trading at a higher P/E ratio and hence does not make it to your list. This is where an investor will face an emotional versus factual dilemma.

Having gained significantly, an investor might want to stay in the trade hoping for more returns. That’s how human emotion often functions. However, this is precisely the emotional decision which has to be overridden by data, suggesting that stock X is no longer among the five smallest P/E stocks. Acting on the data-driven suggestion is an example of discipline.

The market is often a reflection of the aggregated emotional reactions of an entire population. The short term movements in stock prices or the broader markets are often comparable to an impulsive action. An investor should ask themselves how a bull/bear run impacts his or her investments and then make decisions based on data and facts.

Bull runs often lure people to jump in, hoping to benefit from a market rise, while a bearish market trend could lead to a sell-off.  These kinds of extreme market conditions can lead to people abandoning their investment strategy. A test of discipline is the ability to stick to your investment strategy even in the most extreme and tempting of market conditions.

Warren Buffett's Investing Discipline 

A great example of market discipline comes from the "Oracle of Omaha," Warren Buffett. Mr. Buffett set out the following rules as his personal investment principles:

  • Invest in companies you thoroughly understand.
  • Invest in a company only if you are convinced it is good. Don’t come to a conclusion based on what others say. Read the facts and conclude for yourself. Can’t come to a conclusion? Move on until you find something you understand and are convinced about.
  • Invest in companies that lie in your circle of competence.

A test of the Oracle’s discipline was the dotcom bubble of the late 1990’s. He decided to avoid investing in technology companies which he did not understand, even as these tech names helped create billions of dollars overnight. He was being called "old world" and many went on to question his principles of investing. Buffett eventually had the last laugh, with the stock market crashing in 2000, fueled by the technology stocks.

Warren Buffett’s discipline of avoiding things he didn't understand — even when everybody around him was picking them up — paid off in the end. Discipline did prove to be an ally in his case, strengthening his rules of investment even further.

Here is an example which numerically captures the advantage of discipline in an investment strategy.

Systematic Investment Plans (SIPs) are a popular way of investing in stock markets for people who have regular monthly surplus income. We look at returns for two investors, the first one being disciplined and who did not miss investing $1,000 into an S&P 500 Index fund every month for the last 10 years. The other does not invest in stocks when the markets signals bearish trends. We assume that in the second case, the investor places $1,000 into bank fixed deposits at a one percent interest rate.

The table below summarizes the two investment strategies and their results.

Investment amount ($):

1,000

Investment frequency:

Monthly

Time period of evaluation:

10 years

Return on Bank FD’s

1%

Returns

Total Investment Face value ($)

Market Value of investments ($)

Absolute returns

S&P indexed portfolio return (A):

121,000

189,392

56.52%

Avoiding monthly investments after a drop in price (B):

121,000

164,286

35.77%

The difference in the two portfolios is significant, with the constant SIP portfolio returning $25,106 more on a total investment face value of $121,000. The constant SIP portfolio returned 56.52 percent against 35.77 percent for the portfolio with fixed deposit investments in bad months.

The Bottom Line

It is clear that discipline in the stock market does pay off, and Warren Buffett is a great example of what discipline can bring to an investment strategy. In conclusion, discipline ranks near the very top of skills required to be a successful investor.

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