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Stepan Lavrouk
Stepan Lavrouk
Articles (382) 

Joel Greenblatt: How to Handle the Emotional Aspects of Investing

Thinking like a business owner can help you stay sane

December 17, 2019

Joel Greenblatt (Trades, Portfolio) is notable for introducing retail investors to a simple mathematical approach to value investing. The essence of his "Magic Formula" is to simply buy the best-value companies in a given index, picking them on a purely quantitative basis. The idea is to take emotion out of the decision-making process, and to trust that, on average, the mathematics will work out in the investor’s favour.

While simple "Magic Formula" systems have shown some success, slightly outperforming the market during some periods, their efficacy has dipped in the years following the publication of Greenblatt’s "Little Book That Beats The Market" - perhaps in part because more people started using the formula, which eroded the edge over time.

As such, many value investors may feel like they have no choice but to introduce a certain amount of subjectivity into their decision-making process. Unfortunately, doing so also increases the role that psychology and emotion play. Here is what Greenblatt believes investors should do to handle the emotional aspects of investing.

Think of stocks like businesses

Like most value investors, Greenblatt believes that stocks should be treated as fractional ownership shares in real businesses. The fact that the stock market gives you daily fluctuation price quotations in your portfolio can create a false sense of risk when the quoted value begins to fall. At an event with the CFA Society, Greenblatt used the following example to describe the problem with this:

“If something happens in Greece, and you own a chain store in the Midwest - OK, are you going to sell it at half price the next day? You’re probably not even going to think about it, but in the stock market you’re going to get a much lower quote and you’ll think it’s relevant in some way.”

Greenblatt believes that thinking about stocks as businesses is not just useful - it’s essential to staying sane.

One more thought

I also think there is a further aspect to consider, which is how comfortable you personally are with fluctuations in the value of your portfolio. Generally speaking, the fewer stocks you own, the more your portfolio will fluctuate on a day-to-day basis.

Putting all of your money into a single stock is probably not the best idea; even if your research is flawless and incorporates all information perfectly, you are still putting yourself at the mercy of an unexpected event that might wipe you out. On the other hand, you are unlikely to be able to do any extensive research if you invest in 300 companies.

By my estimation, most active value investors have portfolios that range between 10 and 40 businesses. Where you fall within that range is likely to be a product of your own appetite for volatility. If you are someone who is comfortable with the idea of your net worth declining by 30% overnight, then by all means be more concentrated. If that seems like too much stress, then you will be better-served by being more diversified. Peace of mind is one of the most valuable commodities an investor can have.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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