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Rupert Hargreaves
Rupert Hargreaves
Articles (1263)  | Author's Website |

Seth Klarman on Rational Thinking in Times of Market Stress

Klarman's thoughts from 2008

April 03, 2020

In times of market stress and volatility, it is very easy to become irrational. Investors must try and avoid becoming irrational at all costs, especially when markets are falling. Irrationality can push you to make silly investment decisions, which can have serious repercussions.

In most cases, these silly decisions can be easily avoided. The trick is to remain rational. The question is, how do investors remain rational in these uncertain times?

Seth Klarman (Trades, Portfolio) spoke about this very topic in a 2008 issue of Outstanding Investor Digest (OID):

"Remaining rational is easier said than done... While investors will obviously achieve the best result by remaining rational thinkers at all times, this is easier said than done. In the financial markets, emotion often takes over, and greed and fear come to dominate investor behavior...

Even those who are aware of this, who expect always to invest rationally and to be able to resist their own greedy temptations and panicky reactions, cannot always carry through on their plans.

It's easy to blink when bargains become far better bargains. Top-down or momentum investors – especially if leveraged – are at a loss when confronting the unexpected. Should they hang on and risk ruin, or capitulate and lock in painful losses? Even those with the benefit of a value investing roadmap – which ensures a fundamental, long term-oriented approach to investing, a disciplined pursuit of bargains and an imperative to view the market as an irrational creator of opportunity – may blink when faced with the unexpected."

Klarman went on to explain that he and the rest of the investment team at Baupost have tried to develop some strategies for maintaining rational thinking at all times. Specifically, Klarman told the OID:

"One of our strategies for maintaining rational thinking at all times is to attempt to avoid the extreme stresses that lead to poor decision-making. We have often described our techniques for accomplishing this: willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity and avoidance of recourse leverage, among others. Even the most conservative investors can become paralyzed by large losses, whether due to mistakes, premature judgments or the effects of leverage."

This last point is particularly vital. Taking losses is never easy for any investor, but it is essential to make sure that you do not let these losses drive decision-making, because doing so can have serious repercussions:

"If losses impair your future decision-making, then the cost of a mistake is not just the loss from that investment alone, but the impact which that loss may have on the future chain of events. If a loss freezes you from taking full advantage of a great opportunity, or pressures you to make it a smaller position than it should or would otherwise be, then the cost of a loss may be far greater than the initial loss itself."

This advice from 2008 is just as valuable today as it was when Klarman first gave the interview.

To avoid irrational decisions, it is essential to be prepared, have a plan and stick to it. If you are unfortunate enough to be caught up in a downturn or losing position, it is vital to keep a cool head and make sure losses don't impair your future decision-making.

If losses are allowed to invade and influence your thoughts, they can prevent you from taking advantage of great opportunities or pressure you to make further ill-judged decisions.

Disclosure: The author owns no share mentioned.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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