When I looked today at Hewlett Packard’s (NYSE:HPQ) three-month, 40% run, I became physically ill. Then, remembering that I had only myself to blame, I punched myself in the leg for good measure. Why, you ask? Because three months ago I sold HP near its lowest point in 15 years. It was not the size of the mistake that frustrated me – it was a small position – but that I succumbed to the fear and made a rare emotion-based sell decision.
Like nearly all of us here at GuruFocus, I consider myself a value investor. And as a value investor, I pride myself on my ability to withstand pain and to make cold, calculated decisions based on rational analysis. But over the course of 24 hours in November 2012, I was my own worst enemy, and I ignored Benjamin Graham’s timeless advice, “Be greedy when others are fearful.” I sold HP when the whole world was pessimistic.
As I lick my wounds and attempt to recover from the embarrassment, I switch back into cold, calculating value investor mode. I ask myself, “What is there to prevent Fear from one day wiping out a good chunk of my portfolio?” I make a checklist to reinforce my self-discipline, but I quickly realize that while necessary, a checklist is not a comprehensive solution. Value investors – especially those with concentrated positions – must survive many years of decisions to make it to the finish line with good results. And in a concentrated portfolio, each decision carries greater weight. This renders ordinarily disciplined value investors vulnerable to “black swan” events of our own making – fear-based decisions that permanently damage a portfolio painstakingly built over a lifetime. (If you have not read Nassim Taleb’s works on probability and “black swans,” I strongly recommend it.)
For most of us here at GuruFocus, a realization is in order. No matter how disciplined we become, fear will eventually get the better of us, and we will make a bad, bad decision. Our checklists will go ignored. Some unknown trigger will convince us that the checklist doesn’t apply this time. Fear is a merciless son-of-a-gun, and he will find a way to make even the most disciplined among us stumble. (What was my fear “trigger?" Seth Klarman reduced his HPQ position. All my analysis went out the window, and I rushed to follow him to the exit.) My formerly disciplined investing strategy was revealed to have a serious decision-making weakness.
In “Fooled by Randomness,” Taleb writes, “I consider myself as prone to foolishness as anyone I know, in spite of my profession and the time spent building my expertise on the subject. But here is the exception; I know that I am very, very weak on that score.”
And so armed with this realization, how do we mitigate the risk that we will eventually make a very bad fear-based decision? I propose three possible solutions.
- We could team up with a partner (e.g. Buffett and Munger) and make joint, unanimous decisions. That seems to be an effective strategy, though it’s a bit impractical for most individual investors.
- We could put a significant chunk of our portfolio in an index fund; if we make bad decisions on individual investments, the index fund should theoretically be able to weather the storm, and we will recover. But let’s face it – most of us are convinced we can beat the irrational Mr. Market over the long-term, and the idea of resigning ourselves to index funds is quite distasteful. Besides, what’s to stop fear from convincing us to sell the index fund and go to cash at the worst possible moment?
- We hire a master value investor with a proven track record to become responsible for a portion of our portfolio. By assigning, say, one-third of the portfolio to the master investor, we protect ourselves from the possibility that sometime over the next 30 to 50 years we act irrationally and suffer a permanent capital loss due to our emotional decisions. If we are willing to pay this master investor a 1 percent annual fee, we should have a number of good options. One merely has to search Morningstar or GuruFocus to find a good fund manager. If a self-induced “black swan” event does occur, we still have the funds managed by the master value investor; we can pick up the pieces and carry on.
As we are now entering the final week of February 2013, I feel obliged to suggest Bruce Berkowitz and the Fairholme Fund (FAIRX) before the fund closes its doors to new investors on Feb. 28. Bruce Berkowitz, the GuruFocus 2012 Investor of the Year, possesses a remarkable ability to base his decisions on rational analysis and to ignore the “noise” that so often leads to fear-based thinking. (I must admit, I seriously doubted Bruce Berkowitz when he allowed himself to be photographed with his manicured poodle in 2010. But then I realized, “Hey, that’s exactly what you want from a guy whose motto is ‘Ignore the Crowd.’”) Berkowitz has demonstrated discipline in both good times and bad, as evidenced by this Fairholme presentation comparing the fund’s cash position to market valuation.
While the Fairholme Fund is only one of many sound strategies, investors would do well to consider leaving themselves the option of investing in Fairholme later by opening an account now. It may not open again.
Regardless of how we choose to protect our portfolios from fear-based thinking, the critical step is to acknowledge the likelihood that fear will eventually cause even the disciplined investor to stumble. As Taleb says, what differentiates the intelligent investor from everyone else is that we recognize this weakness. We must protect ourselves accordingly.