How to combat these 6 inner investing demons

By Larissa Fernand |  08-07-21 | 
 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

As stock investors consider the economic devastation of the pandemic, the human loss and the market’s relentless and bewildering climb, they are faced with conflicting emotions.

On the one hand, their portfolio is putting up some impressive returns. On the other, they are left to wonder what lies around the corner.

Sanjay Bakshi calls them the inner demons. The inner demons plant a thought into your mind, you interpret wrongly and then act on it. The thoughts are factual, but they have all the potential to blindside you.

Bakshi’s talent lies in laterally presenting seemingly non-related issues by delving into a deep repository of information. He is one of the best contemporary writers in finance and his thought-provoking narration has enthralled global audiences.

Here he identifies the demons and tells you how to combat them.

  • Demon: The market is very expensive.
  • Implication: That is a signal to sell this business.
  • Why it is wrong: Because your focus has shifted from the economics of the underlying business to the overall stock market.
  • Demon: The price of the stock has gone up phenomenally.
  • Implication: It can’t go up much more from here.
  • Why it is wrong: Because you have illogically anchored your decision to your purchasing cost, which is irrelevant.
  • Demon: The P/E multiple is extremely high. There are cheaper options available.
  • Implication: Time to sell and lower the P/E of the portfolio.
  • Why it is wrong: Because you will sell an outstanding business and replace it with a mediocre one.
  • Demon: It has become too big a position.
  • Implication: I must think about risk management.
  • Why it is wrong: Because real wealth is almost always lopsided and makes one worry about the other reality: wealth destruction also comes from over concentration.
  • Demon: The management made a capital allocation error / A slowdown in the industry is approaching.
  • Implication: Earnings will take a hit.
  • Why it is wrong: Because these thoughts will make you want to sell a stock due to apparent adverse developments, which in retrospect will turn out to be non-events over the long run.
  • Demon: You can’t go broke by taking a profit.
  • Implication: Sell.
  • Why it is wrong: Because this will also prevent you from ever seeing a 100 bagger.

So how must you combat this onslaught? By questioning your conviction. How do you question your conviction? Here goes…

Shift your gaze.

Shift your focus from the stock price to the performance of the underlying business. Instead of focusing on the paper profit, consider the potential value of the business 10 or 15 years down the road.

Consider three things: a) Businesses that can deliver growth without stretching balance sheets, b) without taking in more capital through the issuance of new equity shares, and c) where the quality of growth is excellent in terms of incremental returns on capital.

If it qualifies on these three fronts, it will increase per share value for its stockholders over the long term. That potential growth in value is sometimes mispriced by the market even if the stock has already appreciated significantly.

Question your anchor.

Investors tend to anchor to the cost they paid for an investment, which messes with their heads and prevents them from objectively reacting to new information.

Anchoring is the tendency to attach or anchor our thoughts to a reference points-though it may be illogical or irrelevant. Are you anchoring to your purchase price? Are you anchoring to historic P/E multiples? Are you anchoring your decision to ultra-conservative assumptions you employed when buying, despite seeing far better performance?

As Warren Buffett says, focus on the playing field, not the scoreboard. It is a mistake to base sell decisions by using the scoreboard as a guide: the current stock price, the current P/E multiple, or the percentage gain in the stock price in relation to the gains in some index or some other stocks or the investor’s purchasing price.

Revisit your goal.

The goal is not to book profits – that is the job of a trader. The goal of an investor is wealth creation.

Large amounts of money have been made by people who have sat on great businesses for long periods of time. Jumping in and out of stocks is risky as it can lead to foregone profits as the distribution of stock returns is such that it often follows the pareto pattern: 80% of the returns comes from 20% of the days in which the stock is held.

Reduce churn rate and if you must replace one idea with the another, the second must be significantly better than the first in terms of expected returns.

Don’t be quick to judge.

Some slippages must be tolerated. Some mis-allocation of capital decisions must be tolerated. Having some emotional attachment to a really good business is a good thing as it helps you resist the urge to take a profit and be more tolerant with minor mistakes.

By and large, you need to see if the business is delivering performance in line with your long-term projections. and what you envisaged. Equally important is to determine whether or not that performance is coming from variables envisaged and not some other factor. If the answer to that is overwhelmingly yes, then you could get pleasantly surprised as great businesses tend to do better than earlier envisaged.

To help determine if you should hold or sell a business that’s really working for you, use what I call as blue sky scenario. Basically, it implies that you should not use the same assumptions you used when you bought the stock. This is especially true when the business you bought into is doing far better than you had anticipated. Your model has to be adaptive. If the performance is far better (or worse) than you envisaged, you have to change the model unless the improvement (or deterioration is likely to be temporary).

Check your stress level.

Position sizing also has a lot to do with your personal stress level, where you get fearful of losing gains already made.

If the stock has risen to a point where it becomes to big part of portfolio and gives you sleepless nights, sell it down to the “sleeping point”. It's not just about making money, it is also about a living stress-free life. What’s the point of becoming so rich that you’re not unable to even sleep?

Pare down exposure in a bubble market, if you want to reduce your anxiety. The fear of losing unrealised gains is very, very painful.

Face the contradictions.

People hate contradictions. They make one uncomfortable.

You own a stock which is ridiculously cheap. The market, however, is not cheap. What should you do? Do you ignore the market or focus on the market and ignore the opportunity? Is there a way out of this contradiction? Conversely, the market is ridiculously expensive. Should you sell or focus on the individual stocks?

There’s no substitute for rigorous critical thinking. You cannot base your decisions on one parameter or benchmark; it must be evaluated from a variety of perspectives.

Remember this: You have no control over the behaviour of the market, but complete control over yours.

All the above information has been sourced from Sanjay Bakshi’s writings, interviews and presentations. You can follow him on Twitter.

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