Mastering Your Emotions

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The Science of Hitting
Oct 03, 2012
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For the people who have been reading my articles for a while, youve probably caught on to the fact that most of the things I know about investing have come from the words of a few individuals with Warren, Charlie and James Montier topping the list. In a dated interview from (I seem to pick up another gem every time I read it), the interviewer asked Montier about why we are so terrible at predicting our emotions, to which he responded:

I wish I knew. However, all the evidence shows that we are truly appalling at predicting how we will act in the heat of the moment. On an up day in the market we tend to feel confident and happy, and are sure that we would buy more at a lower price. However, when that lower price arrives, we are caught like rabbits in the headlights. Learning to master your emotions is one of the most valuable things that investors can learn to do.

Learning to master your emotions first involves attempting to understand them: I believe we should look at empathy gaps. According to Websters dictionary, an empathy gap is a cognitive bias in which a person does not empathize or predict correctly how they will feel in the future. My favorite example of this (and one Ive often felt) is a hungry/full empathy gap: This is the idea that when youre starving you could eat a horse, yet an hour later after a small meal you dont think youll ever eat again.

As Montier notes, this usually works against us in investing as such: We know that we would love to buy a company, only if it got to the price we wanted (or to buy more in a company we already own). To our advantage, sometimes the stock will take a beating but then the talking heads start rambling, or the macro picture gets a bit grimmer, and suddenly youre closer to selling than buying. Heres a simple example: Who would like to buy Procter & Gamble (PG) for around 10x earnings? Many people (including myself) would say that they would be happy to buy P&G at 10x normalized earnings regardless of the macroeconomic environment and we all had the chance to in 2009; if youre like me, you didnt.

Recognizing that mistake isnt enough. What can I do to make sure that doesnt happen again? I think there are a couple of tools we can use to avoid letting the heat of the moment dictate our investment decisions:

1) Checklist I continue to be a big proponent of the implementation of a checklist; over time, mine has grown longer and longer as Ive added lessons learned from previous mistakes or grabbed from other value investors (with the most recent addition being the importance of having a competitively advantaged business that can reinvest retained earnings at an equally attractive rate of return or at least a management team that recognizes otherwise if thats the case). This is important for two reasons: First, Im all but assured to forget most of the stuff I dont write down, so for me, its a necessity. Second, a checklist forces you to go through the boring stuff like rewriting 10 years of financial data, assessing potential threats, etc. the homework that will help you avoid unnecessary errors and cause you to sit back for a minute and really think about the merits of this particular idea as a long-term investment.

2) Investment Journal In addition to the checklist, an investment journal is a great ex-post learning tool (writing articles on GuruFocus works as well). Theres no two ways about it you need some form of record to hold yourself to your investment thesis and force you to reassess your thinking if things do not play out as originally expected (for example, if Office Depot (ODP) and Office Max (OMX) dont announce material retail portfolio changes in the coming quarter, I will need to reassess my original assumptions on square footage reduction).

3) The Buy No Matter What List In an article earlier this year, I wrote the following: Legendary investor John Templeton had the best solution I know of: He would keep standing limit orders on stocks at prices well below the market that would force him to buy (meaning he must have had some liquidity on hand) if the stock cratered and hit that price... In Sir Johns own words, 'Invest at the point of maximum pessimism.' As one of the greatest investors of all time showed, its best to take your emotions out of the equation to do this successfully (coming from a man who had this to say on the day of the '87 crash 'let find stocks to buy').

Notice something critical: Sir John didnt keep a paper in his office he kept standing limit orders for the stocks that met his criteria. Now thats taking your emotions out of the equation! For the individual investor, a similar policy should be followed if you are going to simply keep a list, you must be positive that you would be a willing buyer at said price, and execute the order no matter what if you get the opportunity to. That will cause you to think twice about putting a company on the list that might not even exist a decade from now.

These three tools all share key features: They require analysis in the calm of the storm, and action (likely buying high-quality companies considering they made the Buy List) when the rest of the world is running around like a chicken with its head cut off. Most people who read this might say, Yeah, thats a pretty good idea, and go on their merry way. Only time will tell who among us has the intelligence to master their emotions and buy great companies for bargain bin prices when the rest of the investment community is falling victim to the latest and greatest scare on Wall Street.

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High-quality businesses for the long-term. In the words of Charlie Munger, my approach is \"patience followed by pretty aggressive conduct.\" I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.