Seth Klarman (Trades, Portfolio) was once asked what his biggest fear was as an investor. Here is what he said:
“For years, when someone asked me what my biggest fear was as an investor in managing my portfolio, my answer was that it was buying too soon on the way down from often very overvalued levels. I knew a market collapse was possible. And sometimes, I imagined that I was back in the 1930s after the market had peaked the year before and then dropped 30%. Surely, there would’ve been some tempting bargains then. And just as surely, you’d have been crushed by the market’s subsequent plunge over the next three years – down to below 20% of 1929 levels. A fall from 70 to 20, and from 100 to 20, would feel almost exactly the same by the time you hit 20. Sometimes being too early becomes indistinguishable from being wrong.
Of course, getting in too soon as the market falls involves great risk for all investors, including value investors. Certainly, when a few securities start to get cheap even as the bull market continues, a value-starved investor will step up and buy them. Soon enough, many of these prove to be no bargain at all, as the flaws that caused them to be rejected by the bulls become more glaringly apparent when the world gets worse.
After a stock market has dropped 30%, there’s no way to tell how much further it might have to go. It’d be silly to expect every bear market to turn into the Great Depression, but it would be equally wrong to expect that a fall from overvalued to more fairly valued couldn’t badly overshoot on the downside.”
When I first read that a few years ago, it didn’t resonate with me very well. Of course I was very ignorant and inexperienced back then. But over the years, I’ve come to appreciate that fear more and more. Klarman talked about being too early because of the market turn. I’d add that even during a bull market, investors often buy individual stocks too early on the way down from a very overvalued level.
But the key question is how can we deal with this fear? Why do we buy too early, and how can we minimize this risk?
There are a lot of reasons why we tend to buy too early, but the most powerful one in my opinion is the combination of a few human psychological biases that Charlie Munger (Trades, Portfolio) laid out in his Harvard speech:
- Bias from contrast-caused distortions of sensation, perception and cognition.
- Bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.
- Bias from the non-mathematical nature of the human brain in its natural state as it deal with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list.
- Bias from over-influence by extra-vivid evidence
When a stock drops 30% from 100 to 70, it’s a big contrast. The stock price and the recent financials are available easily. The drop is very vivid. If it’s a stock of a company that other gurus own at higher prices, you want to take advantage of it and not miss out. I’ve been in this type of situation many times in my investment career, and boy, did I make some mistakes.
Now let me pause here and ask you to think about a past mistake you made, which involves the lollapalooza effect above. I want to you to relive that experience as detailed as possible and pay special attention to each step that led to that mistake. Then find a current example of a stock that you are thinking about buying because it has dropped so much and many gurus owned it at much higher prices (for example Valeant) (VRX, Financial).
More on this subject in my next article.
