Warren Buffett has pointed out on numerous occasions that successful investing is directly correlated to an investor's temperament. To paraphrase Buffett: Investors with ordinary intelligence will invariably outperform investors with much higher IQs, so long as they possess superior investing temperaments.
The aforementioned concept suggests that the key to investing success does not lie in one's intellect; rather it lies in one's ability to refrain from making emotionally based investing blunders. It seems that such things as humility, patience, calmness, perseverance and contentedness are the underpinnings of a successful investor. Could it be our personality — not our brainpower — is the main source of our investment prowess? A humbling notion indeed.
Overcoming one's personality and innate physiologic responses to stress is a difficult task to accomplish; however, it is a task that must be fulfilled if an investor hopes to achieve long-term success in the market. It should be the goal of every investor to plot out a strategy which allows them to minimize their destructive impulses well in advance of a real or perceived crisis. Having a crisis strategy in effect allows an investor to act calmly (even though his physiological responses may be telling him otherwise) during times of extreme market volatility.
Today's discussion does not apply to all investors. A small minority of investors are not predisposed to experience periods of extreme market panic or euphoria — neither are sociopaths or victims of certain types of head trauma, for that matter. That said, the vast majority of investors will not experience the enlightening "bump on the head" that provides them with anomalous investing clarity. For the rest of us, today's article will provide some simple suggestions that might prevent typical investors from sabotaging their long-term success.
Set Limit Buy Orders at Prices Below the Market
A favorite practice of Sir John Templeton was to set market orders on a wish list of stocks, well below their current market price. In doing so, Templeton was able to avoid making a decision on purchasing a stock when it fell out of bed. Most investors have trouble "pulling the trigger" on a stock purchase when it experiences a precipitous decline in its price per share. By making the decision beforehand, Templeton avoided the emotional anguish involved in purchasing a stock in free fall.
Make a Personal Commitment to Hold Stocks During Times of Market Collapses
In a recent interview on CNBC, Warren Buffett revealed that on three occasions he had suffered declines of at least 50% in the market value of his holdings. Fortunately for Buffett, he possesses the internal fortitude to hold on to his positions and purchase additional positions during periods of market turmoil.
I experienced precipitous declines in my stock portfolio, twice in approximately the last decade. The first period was in the summer of 2002 when the value of my holdings dropped around one third in the matter of several months. The second period was during the financial crisis of late 2008 and early 2009, when the market value of my holdings declined in excess of 50 percent.
During those periods, I never considered liquidating my overall position in equities. Instead, I used the opportunity which developed in late 2008 to swap my positions in my losing equities into excessively undervalued stocks (mostly net-nets with future earnings power) which were trading at absurd discounts to their balance sheet values. The brief window of opportunity not only provided me with a chance to increase the margin of safety in my portfolio, it also provided me with the opportunity to accrue favorable tax losses to carry forward against future capital gains. In essence, the losses were temporary but the benefits would be ongoing until their value was exhausted in the form of offsetting future taxes on capital gains.
On the surface, the value of a loss carryforward may not seem like much, but its underlying value can be substantial. Let's imagine in the midst of the financial crisis that the market value of an investor's stock portfolio shrivels from $2 million to $1 million. Let's further assume that the investor had no unrealized gains in his $2 million portfolio. The investor ponders the question of whether to hold all his undervalued positions or sell them for tax losses and immediately reinvest in equally undervalued equities.
Allow me to fast-forward several years later to examine the merits of each decision. Assume that both of the investor's portfolios tripled in value and now carry a $3 million market value. Suppose at this point in time, I wish to sell one of my holdings which has run up precipitously and now trades in excess of its intrinsic value. Being a sensible investor, I believe I should monetize my gain; therefore, I sell the security and recognize a capital gain of 500,000 dollars. Since I hold a loss carryforward of an equal amount, the entire gain is not subject to state or federal income taxes.
Now let's examine the tax ramifications of a similar stock in my original portfolio. If I choose to monetize an equally overvalued position, I will be subject to a sizable tax bill. For the sake of argument, say the tax liability is $100,000. That amount is equal to slightly over 3 percent of the entire value of my portfolio. Three percent may not appear to be a crippling blow, but the compounding effect of that tax setback can become enormous over time.
Assume that I am merely a competent investor who is able to average a return on investment of 10 percent a year. By virtue of the Rule of 72, I will be able to double my money in slightly over seven years. In seven years the tax liability results in an overall portfolio shortfall of around $200,000 assuming that I keep the capital invested; in less than 15 years it becomes a $400,000 shortfall. In slightly over 20 years, the effect of that uninvested $100,000 tax liability is now approaching $1 million. Such is the nature of the loss of the original tax liability when compounding at annualized rate of merely 10 percent.
Now that I have completed that brief diversion, let me return to my original point about not selling in the face of market drops. Most investors, who monetize their stock holdings during precipitous market sell offs, do so with the intent of preserving capital while fully intending to reenter after "the market bottoms." At least that is their intellectual justification for selling out of their position.
If an investor/speculator sells early enough, no real damage is done so long as the timid investor does sit in cash for an extended period. The problem lies in the reality that most investors are extremely poor market timers; they tend to sell when the emotion of holding on to dropping indices or equities becomes emotionally untenable. In other words, they tend to sell out after the market has dropped extensively. Additionally, as the market eventually bottoms and begins its upward ascent, the "market timers" are extremely reluctant to reassume their long positions. Most of these timid investors do not reenter their long positions until the market indices have risen sharply, generally to a point that is far above the level where they jettisoned their positions.
The fate of the temperamental market timer invariably damages the rate of return on his long-term holdings. Similar to scratching a nagging rash, the temporary feeling of relief is not commensurate to the long-term damage that results from yielding to temptation.
Politics, Economics and Investing Rarely Mix Well Together
The market collapse which began in the fall of 2008 was a perfect example of how political views helped inflame the temperament of certain investors. When you combine a severe drop in equity prices with extremely negative political rhetoric in regard to the future of the U.S. economy, the stage is set for irrational selling by many investors.
Politics and economic theories are hopeless intertwined; if they become the focal point of an investor's perception of the ultimate future gains or losses in his portfolio, then the investor is doomed to failure. The average investor is well served to ignore his current perceptions in regard to the economy while focusing upon the merits of the businesses in which he invests. That advice goes in spades when it comes to politics. Political ideologies have little correlation with economic results and zero correlation with investment returns. However, if you paid any heed to opinions expressed on the various investment message boards in early 2009, you would have realized that the aforementioned statement was a minority opinion.
Make a Resolve Not to Buy or Sell Stocks on Impulse
As I get older, I buy and sell fewer stocks and I require a much longer research period before I make an investment. Most consumers conduct a detailed study before they make any major purchase; however, when it comes to purchasing an equity, the investor frequently does not want to be bored with the details. If an investor finds that he spends more time on his hobbies than researching his stock purchases, he should limit himself to investment in index funds.
Find a Relaxation Technique Which Facilitates Investing Success
Bill Gross practices yoga. Ray Dalio swears by transcendental meditation. Those are just two examples of how successful money managers reduce their stress and employ techniques that facilitate the correct investing temperament.
Personally, I find that regular exercise on a treadmill or an elliptical provides me with the proper investing attitude. Not only does the practice help me relax, it also stimulates my mental processes. Many times I find myself mentally writing articles when I exercise. It also aides me in understanding business models or conceptualizing the merits or risks involved in company.
Most investors believe that their ultimate success is a result of their intellectual prowess. In reality, investment success is a direct function of temperament or more specifically, one's ability to avoid fatal investment flaws. Most investment flaws are a result of emotion-based decisions which result from impetuous personalities. Limiting impulsive investment behavior is far more important than understanding the intricacies of the market or absorbing the business model of a complex company.
The ordinary investor, who resists his impulses to buy on leverage when the market is rising and sell on fear when it begins to tank, is almost certain to outperform his more gifted counterpart who falls prey to his emotions. Investing is largely a game of inaction rather than a game of reaction; in the long run it becomes a battle of attrition where the spoils go to the most patient players. The survivors are the participants who innately possessed the proper temperament or the ones who learned to control their destructive impulses.
I leave you with a quote from Dr. Martin Luther King: "The ultimate measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy." Simply substitute the word "investor" for "man" and the quote applies perfectly to investing.