Investing is not a battle against the markets; it’s a battle against yourself. The best way to measure your investment risk is to go stand in front of the nearest mirror. Stare into it, and think long and hard about whether you’ve tested your assumptions. What’s the probability that you’ve analyzed an investment correctly? What’s your past record of getting it right? What will you do if your analysis turns out to be wrong? And how will you fight the urge to panic at the wrong time? – Jason Zweig
In a recent blog post, the Wall Street Journal’s Jason Zweig republished a response he first gave to an investor’s query about risk in 1999, just before the bursting of the dotcom bubble. The broad thrust of the piece is that investment risk lies less in how your investments behave than in how you as an investor behave.
He breaks the risks that really matter into two key considerations:
- Do you understand a given investment as well as you think you do?
- Have you correctly anticipated how you’ll react if this analysis turns out to be wrong?
The impact of the psychological factors on investors’ actions is something we’ve written about many times before. We believe the key points of these discussions are worth revisiting in the current investment climate in which momentum investing and following the herd has had such conspicuous success.
Analysis of the cognitive biases that particularly affect the actions of investors produces three main culprits:
1. Investment myopia
Human nature tends to give more credence to things that have happened recently and emphasises a few memorable cases rather than looking at longer periods or examining the full data set. In the stock market, this means that intellectually lazy investors tend to make decisions based on the recent past, making it easier to allocate capital to shares that are running even when these are trading at nosebleed valuations. And when these continue to run even higher, they become even harder to ignore.
Stocks that have done well in the last year or two are seen as ‘safe’ investments that will continue to do well – cue SABMiller, Naspers and BAT to name but three. At the same time companies that are remembered for their recent significant declines including resources and cyclicals – are doomed by most investors to be companies that will never ever recover, irrespective of the circumstances.
This happens despite the cycle playing itself out in stock markets over and over again, where today’s winners become tomorrow’s losers and today’s losers go on to get their day in the sun.
2. Fear of losing money
Investors fear losing money much more than they enjoy gaining the same amount and register loss of money in a way that is similar to the experience of pain. So they tend to attach painful associations to stocks that have fallen in price, have underperformed or that appear risky instead of being able to analyse their intrinsic value in an unbiased way and understand their realistic prospects. This same fear also prompts us to sell out of a good company if the share falls further after we’ve bought it – turning a temporary decrease in our holding into a permanent loss of capital.
3. Fear of missing out
FOMO in the stock market is apparent when we don’t buy a stock that proceeds to go up. It makes it easier to follow the herd and buy into a popular stock despite obvious overvaluation.
The personal risk of going against the stream is often too high: people and asset managers get into trouble and get fired for being wrong on their own, but not for being wrong as part of a group.
The upside of these emotional biases for long term value investors like RECM is that the short-term market inefficiencies create significant discrepancies between stock prices and intrinsic value that provide great opportunities. But only if one we can identify and exploit them while keeping our own emotional biases in check.
How we make sure we understand our investments
In returning to the two risks highlighted in Zweig’s article, we attempt to address the first through a rigorous approach to fundamental bottom-up analysis of a company and its management that generates a defensible estimate of the company’s intrinsic value. The thesis behind each investment idea is defended against robust interrogation from the rest of the investment team, including the senior portfolio managers.
We do not attempt to forecast stock prices, market indicators, the timing of market corrections or the inevitable exhaustion of galloping bulls. Instead we focus on the difference between the current market price of the stock of a company and our estimate of the intrinsic value of the company.
Our investment process is built on understanding and adjusting these cognitive biases
On the second point – how we guard against our human biases – we’ve set up a sensible and consistent investment process to help us steer clear of the emotional noise in the markets. Rather than fixating too much on rear-view measures of performance, we prefer to focus on our target of delivering the best long-term real returns to our clients.
How do we know we’re right about any particular investment? The truth is that we don’t, and we never assume we’ve got it 100% right – we have enough experience in the markets to understand that no-one ever gets it right all the time. Instead we build in a number of factors to protect us against the impact of the inevitable mistakes that will occur from time to time.
- maintaining a diversified portfolio of assets across investment ideas, sectors and geographies.
- insisting on a generous margin of safety in our investments – that is the quantum of the difference between the current price of a share and its conservatively estimated intrinsic value.
- scaling the size of our holdings in a particular idea according to the size of the margin of safety.
- continually reassessing, interrogating and debating our positions against the universe of opportunities.
- sometimes we buy a stock and it falls – if we believe our investment thesis remains intact we buy more. And we scale out of investments as the price rises and the margin of safety decreases, regardless of the market’s view on the underlying momentum in the share.
While we’ve built and refined our investment philosophy to be robust, we remain conscious of the intrinsic cognitive biases inherent to investing.
Zweig concludes his post by inviting readers to decide for themselves whether his 2009 response applies to 2015. We believe it does. While the causes of large stock market declines get given different labels after the fact – the Dotcom Bubble, the commodity SuperCycle story, the Global Financial Crisis – the underlying reason for the falls in stock prices is always the same: assets that people felt ‘safe’ paying too much for become less expensive.