Monthly Archives: September 2014

To Err is Human?

The Wall Street Journal did it again.  This weekend, Morgan Housel wrote an article bashing the individual investor.  His motivation in penning “The Three Mistakes Investors Make Over and Over Again” was no doubt to help individual investors from making these mistakes over and over again.  Yet at its heart, this article, and myriads just like it, do little to educate the investor (if they did, would we really be told how to avoid the mistakes we make over and over?), and probably just hurt people’s feelings.  In the name of full disclosure, I am equally guilty of trying to “educate” people about the capital markets.  I too probably tick off as many people as I help with my writings.  Still, there seems to be some underlying truth to the notion that we as humans are hard-wired in such a way that prevents us from naturally succeeding as investors on our own.

Let’s take a quick look at Mr. Housel’s three mistakes and please allow me to offer my perspective on them.

#1 – Incorrectly predicting your future emotions.  He writes “Too many investors are confident they will be greedy when others are fearful.  None assume they will be the fearful ones, even though somebody has to be, by definition.”  The stock market action in 2008 and early 2009 tested everyone’s resolve to be greedy when others were fearful.  All one has to do is recall the dominant feeling of those dark days – were you rubbing your hands together like McScrooge surveying a new pile of gold or were you worrying about losing all of your wealth?  I must say that I met very few people during that time who were not fearful.  When the market goes down, especially when it goes down a lot, it is NORMAL to feel fear.  Some may argue that selling when you are fearful is a NORMAL thing to do (lots of people did it back then), but I would argue that it is the worst thing you can do when you are fearful. Now that the climax of fear is well in the past, I am on the lookout for an abundance of greed.  The American Association of Individual Investors (AAII) sentiment survey is perhaps the best individual investment survey out there and suggests now that investor sentiment is somewhere in the middle – not too bearish (like in early 2009) and not too bullish (like in 1999).

#2 – Failing to realize how common volatility is.  He writes, “If you don’t understand how normal [there’s that word again – ed.] big market moves really are, you are more likely to think that a pullback is something unusual that requires attention and action.  It often doesn’t.”  I would add that most people don’t understand what volatility means. The mathematical definition deals with distribution of stock price fluctuation over time.  The great Howard Marks in a recent essay perfectly defined volatility – “… the possibility of permanent loss.”  People don’t fear stock volatility when prices are rising. They even might be able to hang in there during a mild and short correction.  What they truly fear is permanent loss.  I spoke to many rational people back in the 2008 and 2009 who truly believed that the stock market (or at least their portfolios) would go to ZERO, that they would lose ALL OF THEIR MONEY. Why would otherwise intelligent, well-adjusted and mature people feel this way?   Because they are NORMAL!  Owning a stock is unlike owning anything else.  Even if you can fully appreciate that a stock represents ownership in a real company (something that still feels very theoretical), you can’t hold it, you can’t see it, you can’t stick it in your basement with your doomsday supplies…  To most of us, it’s a bit ethereal – a number on a page, a ticker symbol on a website, a name without a face…  Yet, stocks are real, and have rewarded investors with the highest average return of any asset class over the years.  But their price volatility is common.

#3 – Trying to forecast what stocks will do next. He writes, “No matter how bad forecasts are, investors come back for more.”  He quotes Alan Greenspan, “We really can’t forecast all that well, and yet we pretend that we can.  But we really can’t.”  He quotes a 2005 study from Dresdner Kleinwort that looked at an aggregate of professional forecasts, “Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.”  He goes on to suggest that a world without accurate forecasts need not be a scary place.  The legendary investor Benjamin Graham spoke often about the “margin of safety,” something that will help the investor weather the rough spots in the market.  He suggested that having a margin of safety in one’s investments would render “… unnecessary an accurate estimate of the future.”  Long-time readers of this blog will know that I am not a fan of forecasts.  I spend most of my time trying to measure value and discover undervalued stocks.  This is what Benjamin Graham did.  It’s what all value investors do.  It is not a NORMAL way to look at the world.  It requires a personality with a contrarian bent.  In my research, I am aware of what the Wall Street experts are saying and forecasting, but rarely do I let their opinions influence mine.  I say this not out of arrogance and with any sense of superiority, but simply due to the reality that so much of what I hear and see out there is of no use or consequence to how I approach the investment decision making process.

Mr. Housel ends his piece with a hopeful homily, “You have no control over what the market will do next. You have complete control over how you react to whatever it does.”  I suggest that he’s totally correct, unless you are NORMAL, in which case you are likely to 1) incorrectly predict your future emotions, 2) fail to realize how common volatility is and 3) try to forecast what stocks will do next…

My advice to NORMAL people is to find someone less NORMAL than you (like a value investor) to construct a portfolio that will serve you well in good times as well as bad, and will help you reach your long-term financial goals.  In other words, don’t try this at home – it’s a lot harder than it looks…