Investor emotions have fluctuated wildly in 2020. The widespread fear caused by Covid-19 in the first quarter has ultimately given way to boundless optimism in recent months.
The Volatility Index (VIX) provides a neat snapshot of this change, where a lower figure represents greater investor optimism. It started the year at a figure of 12, increased to 83 in mid-March and has now declined to just 22 in spite of an uncertain outlook for 2021.
In my view, emotions are a distraction for investors. They serve no useful purpose, and yet can have a hugely negative impact on portfolio returns. For instance, they may lead to a lack of consideration for risk in a rising stock market. Equally, they may lead to indecisiveness in a bear market when buying opportunities are widespread.
Therefore, learning to ignore them – in bull markets and bear markets alike – may be a major step in your investment success.
Ignoring emotions via a value investing strategy
In my opinion, one of the simplest means of successfully ignoring emotions is to have an investment strategy that does not use them. An obvious example of such a plan is a value investing approach that uses company fundamentals to assess the quality of a firm.
For instance, ratios such as a company's return on invested capital (ROIC) can be used to assess the size of its economic moat. Equally, a firm's debt-to-equity ratio and other similar measures can provide guidance on its financial strength. Together, and alongside other company fundamentals, a picture can be built of a company's quality and value in any market conditions.
A value investing approach does not use economic forecasts, investor sentiment or gut feeling as an indicator of when to buy or sell. Instead, it involves buying a quality stock that trades at a discount to what it appears to be worth, or selling it if it trades at a premium to its intrinsic value. As a result, it can be a simple and effective means of guarding against the unhelpful influence of emotions.
Application in today's stock market environment
Baupost Group co-founder Seth Klarman (Trades, Portfolio) is a proponent of value investing. He has previously discussed why emotions do not form any part of his investment process:
"Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgement, they respond to market forces not with blind emotion but with calculated reason. Successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones. Indeed, the very way an investor views the market and its price fluctuations is a key factor in his or her ultimate investment success or failure."
I think that Klarman's comments are particularly relevant in today's investing environment. The S&P 500 has risen 65% since its March lows. This has contributed to improving market sentiment that has caused many investors to become extremely bullish about company forecasts. The end result could be that some stocks are overvalued.
This situation could mean that value investing has significant appeal for a long-term investor. They may be able to sell today's overvalued stocks and either purchase undervalued shares, or else bide their time via cash holdings until a more attractive range of buying opportunities comes along.
Read more here:
- Warren Buffett: Don't Worry About Politics or the Economy
- Lessons on Change From Warren Buffett's 1986 Letter to Shareholders
- Howard Marks: A Bear Market Is Never Far Away
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