It is difficult to ignore emotions when investing. It is even more challenging to achieve this aim in the current bull market, when sentiment among many investors is upbeat.
However, allowing emotions to rule investment decisions can be a dangerous situation. It may mean an investor fails to recognize potential threats to the companies they purchase or hold.
Instead, focusing on company fundamentals could lead to a more efficient capital allocation over the long run.
Positive emotions in a bull market
The improvement in investor sentiment over the past year has been extreme. Evidence of this can be seen in the S&P 500's 50% rise in that time, with many stocks now trading on high valuations relative to their historic averages.
In many cases, those rich valuations are being justified by earnings forecasts that are extremely optimistic. Today's upbeat investors seem to be pricing in a best-case scenario that leaves little or no margin of safety in case unexpected events occur that derail company performance.
Further evidence of dangerous levels of positive emotions among investors can be seen in the Volatility Index, or VIX. Its current level of 18 is around the same as it was prior to the 2020 stock market crash. However, economic uncertainty is now arguably significantly higher than it was at the start of 2020.
The potential for change
It is easy for the positive views of other investors to permeate your own standpoint in the current bull market. However, as last year's market crash showed, the outlook for stocks can change very quickly. Optimism among investors can quickly turn to fear. This has the potential to prompt a market correction, or even a bear market.
Therefore, it is imperative to invest capital based on fundamentals instead of emotions. By doing so, it is possible to identify overvalued stocks that could be negatively impacted to the greatest extent in the next bear market.
Using fundamentals also means companies with weak balance sheets or narrow economic moats can be avoided. In their place, fundamentally sound businesses that offer margins of safety in case of heightened market volatility can be purchased. They may offer a more favorable risk-reward opportunity in the long run.
A disciplined approach
One investor who has always sought to focus on fundamentals instead of emotions is Bill Ackman (Trades, Portfolio). As the Pershing Square Capital Management founder previously said:
"I'm not emotional about investments. Investing is something where you have to be purely rational and not let emotion affect your decision making - just the facts."
Clearly, it is difficult to ignore emotions in any market conditions. A simple way to help achieve this goal is to put in place an investment checklist. This can include a range of facts and figures such as company debt levels, interest coverage and valuation metrics that must be sufficiently analyzed prior to investment. They force an investor to consider fundamentals when making any decision regarding their portfolio.
Companies that do not meet the requirements listed in a checklist may prove to be unattractive. Avoiding them – even if they seem exciting or other investors are positive about them – may lead to a more productive use of capital in the long run.
Read more here:
- Peter Lynch: Buying Familiar Stocks Can Be Dangerous
- Warren Buffett: Asset-Light Businesses Offer the Best Results
- Howard Marks: Focus on the Present, Not the Future
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