The Virtuous Investor: Rule 10
Laugh in the face of danger – keep a slogan for your encouragement
|Joachim Klement||Oct 16, 2019||4|
This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.
“It shall not profit meanly against all kind of temptation to have some certain sentences prepared and ready, specially those with which thou has felt thy mind to be moved and stirred vehemently.”
Erasmus of Rotterdam
The legendary value investor Ben Graham called the stock market a weighing machine that would take all the information about all the stocks in the world, and then weigh them through the interactions of investors in markets to determine a price for each stock. Unfortunately, stock markets and financial markets in general are not just weighing machines, they are also mood machines. As markets swing from bull to bear market and vice versa, the mood of investors swings in even bigger amplitudes from euphoria to despondency and back again. The chart below shows that often, these mood swings of investors can be more exaggerated than the actual swings in stock markets.
The stock market and mood swings of normal investors
The main problem with the stock market’s ability to impact the mood of investors is that we tend to become optimistic at the wrong point in time, namely after markets have gone up for a while. This is the time when trends have formed and matured, and investors want to jump onto a bandwagon that is already going at full speed.
Of course, no bull market lasts forever (not even the current one), and prices will eventually start to decline. At first, the decline will look like a correction since the nature of bull markets is that they have many intermittent corrections. Nobody can predict when a correction turns into a fully-fledged bear market. That’s why no investor should ever listen to people who claim they can time the market or predict the next bear market. They can’t. Nobody can. One can only prepare oneself for a bear market – whenever that may happen.
But most investors are woefully unprepared when a bear market strikes and as a result, they tend to panic – often at a very inopportune moment when prices have declined a lot. As a result of thee mood swings, normal investors tend to buy high and sell low and destroy performance by giving in to their emotions and trying to time the market.
Compare this behaviour to the mood swings of a value investor like Ben Graham or his student Warren Buffett. Value investors always insist on a margin of safety in their investments to ensure that even if their analysis of an asset is wrong or off the mark, they can still make money. Warren Buffett’s mood swings are almost a mirror image of the mood swings of a normal investor in a cycle. Because the margin of safety in investments is highest, when prices are low and low when prices are high, this focus on margin of safety means that value investors like Warren Buffett have a better chance than most investors of buying low and selling high. This does not mean that Warren Buffett tries to time the market. It just means that he only buys when there is significant upside to the price of an asset relative to its fair value.
Warren Buffett’s mood swings
The challenge with becoming a value investor is that it is going against our natural impulses as investors. Very few people have the necessary discipline to stick to a value investment strategy even if it underperforms for years (as it did since the last financial crisis).
But besides the normal investor and value investor, there is a third class of investor: the investors postulated by finance theory. Traditional finance theory assumes that investors have no mood swings at all and don’t get carried away by the ups and downs of markets. They are, supposedly like Mr. Spock of Star Trek (or Data of Star Trek: The Next Generation if you are part of my generation). They find the ups and downs of market a mere curiosity. And because they are unaffected by the ups and downs of markets, they simply buy an asset and then hold it for as long as possible.
Mr. Spock’s mood swings
Clearly, both Warren Buffett and Mr. Spock are more successful investors than the normal investor. But how can normal people like you and me influence their moods to become more like them?
Erasmus of Rotterdam recommends having a slogan at your disposal that you can recite when you feel exuberant or despondent. I have been using the most famous of these phrases of all time for many years and I have to say, it has helped me to stay invested, when markets declined precipitously and remain cautious when markets rose. It is, of course, the phrase recommended by President Abraham Lincoln in a famous anecdote:
“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!”
Abraham Lincoln. Address before the Wisconsin State Agricultural Society, 30 September 1859.
I have nothing to add, except to try it for yourself. If you look at your portfolio performance over the last ten years or so, it is likely to show significant gains. Now tell yourself, “this, too, shall pass away”. What does that trigger in you? Do you want to be more cautious going forward? If so, how can you reduce risks in your portfolio without limiting the ability to benefit from future upside too much?
Similarly, you might have some long-term investments in your portfolio that did not perform well at all and may even have incurred significant losses. Now recount to yourself, “this, too, shall pass away”. Do you still want to sell that asset? If so, why? Is there a fundamental case for the asset never to come back to where it once was? If not, then hang on in there and stay invested.
This little mantra has prevented me from making many an investment mistake in my life and if you constantly recite it to yourself while you look at your investment portfolio, I am pretty sure it can help you as well.