In periods of market volatility, one thing we as investors have to keep an eye on more than anything else is the tendency for psychological biases to creep into our decision-making process.
A large body of research shows that humans are far more susceptible to pain and losses than anything else. This is especially important for investors. Losing money can be far more painful psychologically than making money. This psychological pain can drive us to make irrational decisions, which we may not necessarily have made in rising markets.
There are plenty of psychological biases and tendencies that can influence decisions as a result of this underlying pain factor, and one of them is the tendency for investors to freeze and double down on losing positions.
Don't let the market influence decisions
One of the most misunderstood pieces of advice in fiance is Warren Buffett (Trades, Portfolio)'s statement that during market drawdowns, the best strategy for investors is to do nothing, but this is only part of the story. Buffett has also said there are only two reasons why he would sell a stock, to raise money for other investments or if something has changed.
Considering the current macroeconomic outlook, I would say the outlook for many companies has changed dramatically over the past couple of months. Therefore, it may make sense for investors to review their ideas in some cases. If nothing has changed, then holding on will be the best course of action.
However, in this process, we also need to avoid another psychological bias, which is, as Charlie Munger (Trades, Portfolio) has described, the bias of pounding ideas into one's mind.
Psychology of human misjudgment
Below is an exerpt from Munger's June 1995 speech, titled "The Psychology of Human Misjudgment."
"This is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won...
Well what I’m saying here is that the human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in. The human mind has a big tendency of the same sort."
Put simply, we as investors just cannot shut ourselves away and hope everything will turn out alright. We need to be constantly challenging our ideas and principles in the ever-changing and developing business world. Just because a company was successful 20 years ago does not mean it will be successful for the next 20 years. There will always be challenges and opportunities to overcome and take advantage of.
If we as investors do not acknowledge this, we will be left behind and may be caught off guard by changes in the world that we have failed to recognize and build into valuation models.
It is vitally important that investors do not pound existing ideas into their heads and ignore any changes in the outside environment. This will lead to mistakes, especially in a fast-changing economic environment.
I'm not saying investors should go out and sell all of their stocks immediately. It will depend on a business-by-business basis. As Buffett said, the time to sell is when something has changed. If nothing has changed, the company still has a competitive advantage, is not going to be threatened by rising interest rates and is unlikely to see a significant drop in demand for its products in a depressed economic environment, then nothing has changed and there is no need to sell.
However, if a business has a lot of debt maturing in the next few years, has large capital spending obligations, or is losing customers, it could be time to break down the idea and see if it really deserves to maintain a place in the portfolio.
