How successful investors keep emotions in check

By Markets Covestor

People often ask what I think of the market. They want to know if it’s going up or down. While it may be fun to speculate, the question is like asking how well the Red Sox will do next season, or who will win the Presidential election in 2016.

Continue Reading Below

The answer is anyone’s guess.

Why do we insist on asking the question when the answer is unknowable? I think it is because asking about the direction of the market is really code for: am I going to be OK?

 

 

Enemy inside

Continue Reading Below

Is financial peace in the cards for me, or am I doomed to a future of fearfulness and worry? It is about wondering if your investing life will be successful, or not.

A successful investing life depends on two variables. The irony is that neither one of them has to do with the stock market’s direction in the months ahead, or even in the next several years for that matter.

The first variable involves things that can be measured such as your savings rate, the amount of money you already have, and how well that money is managed over time. Most people think this is the tough stuff but it’s not. You can always hire someone (like me!) to help.

The second variable is much harder because it can’t be delegated and it often requires that you act against your instincts. What really counts in investing, and it has nothing to do with numbers, is your own personal behavior.

When investor/teacher Benjamin Graham said years ago that “the investor’s chief problem—even his worst enemy—is likely to be himself,” he was referring to the fact most people are instinctively programmed to be terrible investors. And it has nothing to do with IQ.

 

Managing emotions

It is generally accepted people make decisions based on emotions and then justify them with facts. Most of us give too little credit to the role emotion plays in our life.

Think about your teenage years. Do you remember anything that happened that wasn’t tied to an emotion? No emotion no memory.

Emotions include our instinctive biases and can lead to various sorts of mistakes. Labelling an investment as “good” or “bad” based on its recent stock market performance is a mistake. Instead you should look at the performance, and the prospects relative to valuation, of the company’s underlying business.

Worrying when the markets decline and feeling good when they go up is another error. To paraphrase Sir John Templeton, the best time to worry about your investments is when they make you feel good. The most profitable time to invest, though counter-intuitive, is when your investments are making you nervous.

 

Cognitive trap

Other behavioral errors include obsessing over bad memories of previous market downturns and thinking luck, good or bad, plays no role in your success. Believing past performance predicts future success is also wrong because studies show it is the investment process that is most important.

I happen to believe the biggest investment mistake of all is not being patient. There are three reasons people make this mistake.

First, they do not fully understand or have confidence in what they own. Second, they cannot accept that stock prices are vastly more volatile than business trends.

Finally, they have not thought through the root of this volatility. All of this is anxiety-inducing and often leads to bad investment decisions such as selling low, or embracing strategies solely designed to lessen volatility.

 

Liquidity

Why are security prices so inherently volatile? In one word: liquidity. There is always a price for your security in the public markets. Constant price discovery allows you to sell pretty much any time and get paid within 3 days. The rub is that in the short run, you are at the mercy of market psychology.

Non-liquid assets such as investment properties or private businesses lack this constant price discovery. As a consequence, investors rely on appraised values to determine what their investment is worth. Many investors wrongfully think this valuation method somehow makes the asset less risky.

When it comes to the financial markets people often behave contrary to how they might act in their everyday affairs. Imagine going into a store and all the price tags have been removed.

Do you feel price ignorance is better than knowing what things cost? In the financial markets there is always a price tag. Volatility is simply the price you pay for always being able to see those price tags.

 

Brutal bear

The zeitgeist of a decade starts to reveal itself in the 4th or 5th year. Think ‘Roaring 20s’ or ‘Swinging 60s’or ‘Greed is Good 80s.’ Given we are at such a point in this decade, we may be at an important junction as the ‘teens’ takes shape and new trends are established.

If we are beginning to glimpse something which could come to define the ‘teens,’ it is innovation-driven deflation, a phenomenon that is not dissimilar to what happened in the latter part of the 19th century.

Innovation is the application of invention. Innovation-driven deflation is caused by the acceleration of this trend resulting in lower prices, wages and jobs.

Though it creates some winners, innovation-driven deflation can be destructive.

I mention this because collapsing oil prices, down nearly 50% in just a few months, could be an example of innovation-driven deflation, as both the supply of energy and the demand for energy have been greatly affected by recent innovations.

 

Energy

Just for oil, new drilling technologies have increased production by over five million barrels a day during the past five years, in the US alone.

Natural gas volumes have soared at a similar rate while since 2011 the cost of alternative energy generation has plummeted.

On the demand side, technology has enabled consumers of energy to become more efficient. Companies generally need less energy to produce more stuff.

 

Blue chips

It is anyone’s guess as to where oil prices are headed and analysts making oil price predictions have one thing in common: they are ‘anchoring.’

This is a behavioral investment mistake that relies on subjective reference points such as the cost of production or the price at which the Saudis will decrease production.

We sometimes forget oil is a commodity like any other and ultimately the old adage will prevail: the cure for low prices will be low prices.

This means production will eventually drop due to bankruptcies among the less efficient, financially weak companies, and less investment by the survivors.

The good news for oil investors is this process will ultimately set the stage for higher prices. The bad news is it could take years.

Based on what worked after a similar period of dropping oil prices in 1986, the way to invest in the industry now is to own only the strongest firms. These firms typically pay attractive dividends and should follow oil stocks higher if prices rebound.

 

Royal Dutch Shell

If things remain depressed they could be in a position to buy energy assets on the cheap. Paradoxically, lower prices may result in higher dividends for the strong firms because they will spend less on capital investments.

In my opinion, a good example of a strong firm that is in the Core International portfolio is Royal Dutch Shell (RDS/A).

The broad lesson of innovation-driven deflation is to own the industry leaders with the greatest financial strength and most efficient business models. If this trend hits other industries, apart from segments of technology that have dealt with deflation for decades, then boring and blue-chip might become the new sexy.

Dividends take on a greater role as investors look to stocks to help them meet income objectives. Real growth, though less common, obviously now becomes even more valuable.

 

Different this time

The US stock market is currently expensive and is likely to become even more so. We are three months into the third year of the US Presidential cycle and history is on our side: since 1896, the market has gained an average of 15%, rising 80% of the time, during the third year of a President’s term.

For all other years combined the stock market rose by 4.4% on average, according to Mark Hulbert, editor of the Hulbert Financial Digest.

Right now the US economy shows little signs of excess and all indications point to an economy that continues to chug along. Clearly, falling oil prices will put more money into the hands of consumers.

This is important because since World War II the market peaks on average 7 1⁄2 months before the economy peaks. In other words, a bet that we’re headed for a bear market implies a recession will begin next summer.

 

Fed policy

Meanwhile interest rates continue to be favorable. Even if the Federal Reserve begins to raise interest rates, based on data collected since the end of WWII, the S&P 500 will not peak for another two years. The shortest time period between an interest rate hike and a market high was in 1961 when the market took ten months to top out.

So to be pessimistic on US stocks in the coming months through September, you need to believe we are entering into a recession and that this time is different: interest rates and politics do not matter.

In the US, the best opportunities in the stock market include companies perceived to be boring and pay high dividends out of their cash earnings. Also attractive are high quality growth stocks valued less expensively than the general market.

Perhaps it is the ubiquity of ETFs, but nowadays many of these great companies are cheaper than mediocre ones. Great companies are defined as consistently and highly profitable ones that have been able to grow their earnings per share at a high rate for a long time.

 

National Presto

An example of a boring American company in the portfolio that pays a high dividend is National Presto Industries (NPK), a quirky conglomerate that makes small appliances, adult diapers and low tech armaments.

The company is run by Maryjo Cohen, a 30% stakeholder, and has no debt and excess cash. Valuation is low and we particularly like the fact National Presto pays a variable annual cash dividend that could average 7% or more in the years ahead, keeping in mind that dividends reflect past performance and there is no guarantee they will continue to be paid.

Great companies with strong financials and 10-year growth rates above 10%, but at discounts to the stock market, include firms like Deere & Co. (DE), The Gap (GPS), Gilead (GILD), and IBM.

In Asia, particularly Singapore, as well as in “old” Europe opportunities to acquire and hold suitable securities at good prices are vastly greater than here in the US.

Common sense tells us that this situation, where the US is overvalued relative to history and almost everywhere else is not, will not last forever.







Like what you read?

Subscribe to our once-weekly email newsletter and get the best posts delivered to you in one convenient place, to browse at your leisure:

Photo Credit: Allan Ajifo via Flickr Creative Commons

DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.