Friday, August 9, 2013

Investing Series Part 4: Understanding Investor Psychology and Improve Your Investing Results

"The Investor's chief problem- and even his worst enemy- is likely to be himself" Ben Graham 

Ben Graham,Warren Buffett's mentor, is bang on when he reminds investors (both retail and institutional) that their worst enemy is likely to be themselves. In his influential book "The Intelligent Investor" , Graham spent many pages explaining that intelligent investing is mainly about following a disciplined approach and controlling your own emotions. In the book, he barely talked about the techniques of analyzing stocks or bonds but Warren Buffett considered it the best investing book ever written. Why? The answer lies in that even the smartest investors, with deep knowledge of finance and equity valuation, will often fall pray to their own emotions if they are not careful. This is why you see most investors (both beginners and experts) buy at market tops and sell at market bottoms. To succeed in investing, one must understand the emotions of greedy and fear, the driving forces behind stock prices for centuries. 

The Greed:

Naturally, people are greedy. Just think back to the roaring 1920s or the dot com boom in the late 1990s. Stock prices were just moving higher and more people rush into the stock market. As Sir John Templeton puts it, "Bull markets are born on pessimistic, grow on skepticism, mature on optimism and die on euphoria". As bull markets mature, the greed in investors are growing exponentially. Howard Marks explains that investors often rush to buy because of the fear of losing opportunities. Investors thought the risk lies not in the possibility of a loss but rather the possibility of not gaining 100% or even 1000%.

Investors must remember that mean reversion is a common theme in long term investing. If you experience some extraordinary good years, expect some bad years ahead.  As Buffett famously puts it:  "There should be a Newton fourth law: for investors as a whole, return DECREASES as motion INCREASES"; future returns are likely to be low when everyone is greedy. Newton was a brilliant scientist but a far less brilliant investor when he lost millions in the South Sea Bubble in the 1600s. 

There is also no free lunch in the world of investing. Dot com investors found that out when they saw the value of their holdings declined by 3/4 in less than a few months. If the prospects of making money is too easy, expect to lose money. For investors thinking that obvious industry growth should lead to good returns, keep this Graham quote in mind: "Obvious prospects for physical growth in a business does not translate to obvious profits for investors" (he was referring to the fact the airline industry in the 1950s grew rapidly, yet airline companies were losing hundreds of millions for shareholders as a whole) 

The Fear:

Fear is exactly the opposite of greed and it is the cause of violent bear markets. As prices keep declining, the fear grows exponentially within investors. All of a sudden, the fear of losing opportunities turns into the fear of losing all of one's capital. Return of capital becomes the key priority rather than seeking return on capital. Investors begin to sell their stocks no matter what the price is because they incorrectly extrapolate the short term price decline many years into the future and thought stock prices may drop to zero if they don't get out early enough. 

Intelligent investors will turn fear into opportunity. If prices drop, it means stocks are actually becoming cheaper rather than dangerous. Lower prices will result in higher margin of safety for investors. If you like the feeling when a laptop or handbag you want to buy is on sale for 50% of original price, why won't you like it when a stock you want to buy drops 50% during a bear market. As Graham would say: "Choose your stocks as you would buy groceries, not the way you would buy perfume"

Lessons to Remember for Life: 

  • Successful investing is about being a disciplined investor. Have strict rules based on your own investment philosophy and adhere to them strictly
  • Don't follow the crowd/herd and don't be afraid to be wrong in the short term. Remember, you are right if your analysis and research is correct. You are not wrong if the market is currently disagreeing with you. 
  • It may sound easy but following Buffett's advice of "Be fearful when others are greedy and be greedy when others are fearful" is often hard 
  • Investors often have short memories and often extrapolate short term trends many years into the future. Do learn some investing history because as Santayana would say, "those who do not remember the past are doomed to repeat it"


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