As emotional human beings, we tend to be our own worst enemy when it comes to making investment decisions. Keep these three pointers in mind so that you do not slip up.
Uncertainty is not risk.
Seth Klarman is one of the world’s most astute investors at the helm of one of the largest hedge funds in the world.
He believes that risk is not inherent in an investment; it is always relative to the price paid.
Indeed, when great uncertainty - such as in the fall of 2008 - drives securities prices to especially low levels, they often become less risky investments.
The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers.
In 2007, the general sentiment was that prices will keep rising. That was the time to hold back since equities were at all-time highs. But individuals were getting caught up in the euphoria.
In 2008, when the market hit rock bottom, it was a great time to plunge back into equities. But individuals were running (away) as fast as they could.
Price is perhaps the single most important criterion in sound investment decision making. Every security or asset is a "buy" at one price, a “hold” at a higher price, and a "sell" at some still higher price. Yet most investors prefer what is performing well to what has recently lagged, often regardless of price.
The risk lies in investor behaviour.
Investment guru Howard Marks, in one of his memos, explains to readers why they can invest in the best of companies (or a great mutual fund) and have a bad experience, or invest in the worst and have a good experience.
He believes that most of the risk in investing comes from the behaviour of investors.
Consider this. Economies rise and fall quite moderately. Companies see their profits fluctuate much more because of operating and financial leverage. But market gyrations make the former look mild. Why do the prices of stocks rise and fall much more than profits? The answer lies in the dramatic ups and downs in investor psychology.
There are no checks on the swings of investor psychology. Investors get crazily bullish and imagine no limits on prosperity, growth and appreciation. At other times, they get despondent and conclude that the “worst case” scenario they prepared for isn’t negative enough.
A too-high price can make something risky. A too-low price can make it safe.
Naturally, it's naive to assume that price is the only factor at play. Deterioration of an asset can cause a loss, as can its failure to produce expected profits. But, all other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this is simple: No asset is so good that it can’t be bid up to the point where it’s overpriced and thus dangerous. And few assets are so bad that they can’t become underpriced and thus safe. Since humans set security prices, it’s their behaviour that creates most of the risk in investing.
Over a long period of time, the risk in equity is nullified.
Even if you are not a stock picker but invest in funds, you would do well to heed his advice. Don’t panic and sell when the markets fall or get into the market only when it is on a run. By doing that you defeat yourself.
It’s difficult to ignore your emotions completely but the statistics prove that stock performances over time tend to improve and come back. If you’d been fully invested in debt between 2000 and 2003, you might have been rubbing your hands with glee as you watched equities tumble amid the bursting of the tech bubble. But that same portfolio today would have substantially underperformed a mixed stocks and bond portfolio, even taking into account the stock market crash of 2008.
When investor Jean Marie Eveillard was asked to describe the characteristics of a good analyst at a presentation, his response was “the capacity to suffer”. Money manager Thomas Russo picked it up and popularised it.
A smart investor must have the ability to suffer though periods of bad performance. If your fund manager is sticking to his investment style, there would be periods when his portfolio is terribly out of favour relative to the forces that are driving the market at the time. You will be able to stay the course if you have the ability to suffer.
You can do that if you invest for the long haul and have a strong thesis as to why you have invested in that fund in the first place.
