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Protecting Yourself Against Fear

February 22, 2013 | About:

When I looked today at Hewlett Packard’s (NYSE:HPQ) three-month, 40% run, I became physically ill. Then, remembering that I had only myself to blame, I punched myself in the leg for good measure. Why, you ask? Because three months ago I sold HP near its lowest point in 15 years. It was not the size of the mistake that frustrated me – it was a small position – but that I succumbed to the fear and made a rare emotion-based sell decision.

Like nearly all of us here at GuruFocus, I consider myself a value investor. And as a value investor, I pride myself on my ability to withstand pain and to make cold, calculated decisions based on rational analysis. But over the course of 24 hours in November 2012, I was my own worst enemy, and I ignored Benjamin Graham’s timeless advice, “Be greedy when others are fearful.” I sold HP when the whole world was pessimistic.

As I lick my wounds and attempt to recover from the embarrassment, I switch back into cold, calculating value investor mode. I ask myself, “What is there to prevent Fear from one day wiping out a good chunk of my portfolio?” I make a checklist to reinforce my self-discipline, but I quickly realize that while necessary, a checklist is not a comprehensive solution. Value investors – especially those with concentrated positions – must survive many years of decisions to make it to the finish line with good results. And in a concentrated portfolio, each decision carries greater weight. This renders ordinarily disciplined value investors vulnerable to “black swan” events of our own making – fear-based decisions that permanently damage a portfolio painstakingly built over a lifetime. (If you have not read Nassim Taleb’s works on probability and “black swans,” I strongly recommend it.)

For most of us here at GuruFocus, a realization is in order. No matter how disciplined we become, fear will eventually get the better of us, and we will make a bad, bad decision. Our checklists will go ignored. Some unknown trigger will convince us that the checklist doesn’t apply this time. Fear is a merciless son-of-a-gun, and he will find a way to make even the most disciplined among us stumble. (What was my fear “trigger?" Seth Klarman reduced his HPQ position. All my analysis went out the window, and I rushed to follow him to the exit.) My formerly disciplined investing strategy was revealed to have a serious decision-making weakness.

In “Fooled by Randomness,” Taleb writes, “I consider myself as prone to foolishness as anyone I know, in spite of my profession and the time spent building my expertise on the subject. But here is the exception; I know that I am very, very weak on that score.”

And so armed with this realization, how do we mitigate the risk that we will eventually make a very bad fear-based decision? I propose three possible solutions.

  1. We could team up with a partner (e.g. Buffett and Munger) and make joint, unanimous decisions. That seems to be an effective strategy, though it’s a bit impractical for most individual investors.
  2. We could put a significant chunk of our portfolio in an index fund; if we make bad decisions on individual investments, the index fund should theoretically be able to weather the storm, and we will recover. But let’s face it – most of us are convinced we can beat the irrational Mr. Market over the long-term, and the idea of resigning ourselves to index funds is quite distasteful. Besides, what’s to stop fear from convincing us to sell the index fund and go to cash at the worst possible moment?
  3. We hire a master value investor with a proven track record to become responsible for a portion of our portfolio. By assigning, say, one-third of the portfolio to the master investor, we protect ourselves from the possibility that sometime over the next 30 to 50 years we act irrationally and suffer a permanent capital loss due to our emotional decisions. If we are willing to pay this master investor a 1 percent annual fee, we should have a number of good options. One merely has to search Morningstar or GuruFocus to find a good fund manager. If a self-induced “black swan” event does occur, we still have the funds managed by the master value investor; we can pick up the pieces and carry on.
There is much to like about option No. 3. It is less prone to emotional sell decisions due to the time and effort required to sell a mutual fund. (I cannot simply log-in to my trading account and place a sell order, as I can with stocks.) Also, it allows the individual investor to choose a fund manager with a proven ability to remain disciplined when the rest of the world panics. Fortunately we can look to the Great Recession to evaluate our fund manager candidates.

As we are now entering the final week of February 2013, I feel obliged to suggest Bruce Berkowitz and the Fairholme Fund (FAIRX) before the fund closes its doors to new investors on Feb. 28. Bruce Berkowitz, the GuruFocus 2012 Investor of the Year, possesses a remarkable ability to base his decisions on rational analysis and to ignore the “noise” that so often leads to fear-based thinking. (I must admit, I seriously doubted Bruce Berkowitz when he allowed himself to be photographed with his manicured poodle in 2010. But then I realized, “Hey, that’s exactly what you want from a guy whose motto is ‘Ignore the Crowd.’”) Berkowitz has demonstrated discipline in both good times and bad, as evidenced by this Fairholme presentation comparing the fund’s cash position to market valuation.

While the Fairholme Fund is only one of many sound strategies, investors would do well to consider leaving themselves the option of investing in Fairholme later by opening an account now. It may not open again.

Regardless of how we choose to protect our portfolios from fear-based thinking, the critical step is to acknowledge the likelihood that fear will eventually cause even the disciplined investor to stumble. As Taleb says, what differentiates the intelligent investor from everyone else is that we recognize this weakness. We must protect ourselves accordingly.

About the author:

I am a private investor with a focus on stocks and real estate. I enjoy reading about the investment philosophies of the value "greats." My strategies are closest to those of Joel Greenblatt and Mohnish Pabrai. I believe strongly that individual investors help themselves and the community by subjecting their thoughts and analysis to peer review.

Rating: 3.5/5 (8 votes)


William.b.thomson - 4 years ago    Report SPAM

Thanks for the article. I think, however, that you could have proposed a fourth option. That option is to live with the fact that occasionally your emotions will get the better of you. I am a long term investor having started in 1976. I have read everything and tried everything. I am financially secure by most people's standards. And yet .... and yet, I will make at least one major blunder, sometimes several, a year that are the result of my emotions getting the better of me.

What is much more important than worrying about selling when you shouldn't have is not selling when you should. Remember the golden rule about not losing money. There is no shame in a small loss taken in the heat of battle. There is a great shame in losing your shirt.

As I frequently say, I want my first purchase to be wrong. I want the stock to go down after I buy it. Sometimes the stock goes down so fast and so hard that I question my judgment and don't buy more. I go back and revisit my original thesis. If there is new evidence that I should panic, then so be it. What if I miss read the new evidence? So be it. We make our decisions on the basis of our best judgment of the information at hand. Opportunities missed are a heck of a lot better than crippling losses.

Learn from your lessons but don't dwell on them.
Mocheng premium member - 4 years ago
Well, you wouldn't be writing this article if HPQ is $7 dollars today. So don't be too harsh on yourself.

Not everyone can control their emotions especially when they see 15% drop in a day.

If you have done enough research and really believe in the company, then I suggest you ignore paying too much attention to the stock market daily. Go out take a walk in the park, or do something fun. That can help you with immediate emotional decisions.

Henniker82 - 4 years ago    Report SPAM

Thanks for the feedback -- it is good to hear the perspective of a value investor who's been in the game 35+ years, in good times and bad. By now you must know yourself quite well when it comes to emotions and decision-making. I especially agree with your point about the risk of permanent capital loss from a decision NOT to sell.

One point I hoped to make clear in the article is the importance of establishing some sort of safeguard against the possibility that one's entire net worth is impacted by a brief period of emotional decisions in an otherwise stellar career. 99.9% of the weeks in a 30 year career we can be on our game performing good, rational analysis. But that one week when we are weak...it can devastate a portfolio if we do not enact some safeguards.


Henniker82 - 4 years ago    Report SPAM

Very true -- I would probably not be writing if HPQ had cratered. And we should evaluate our decision-making process, not individual outcomes. I think what was most unsettling was learning that there are conditions that will cause me to act out of fear. A chink in the armor when I didn't realize there was one. It sure wasn't the drop in price -- I'd wager that most everyone here has experienced a huge single-day drop. Ordinarily we live for sell-off days like that. But it was knowing that my self-discipline has the potential to break in certain conditions.

All the best,

20punches - 4 years ago    Report SPAM
I used to make those "fear-based" sell decisions back in the days when my analysis was shallow and when excessive noise from media and social network detracted my attention greatly.

Based on my experience, the best way, and definitely not an easy way, to cope with fear is by conducting thorough analysis and by building up you latticework over time. If you've done your research and if you have confidence in your analysis, instead of "selling" when the stock is under pressure, you should be adding on to your positions because now you are getting a better bargain price than your original purchase price. I've had stocks in portfolio dropping 30% right after earnings (Gentex Corporation last year) and the fear was wide spread. But I've spent 100+ hours researching Gentex before I made my first purchase decision and when it dropped to below $15, I know it's "excessive fear" that's driving the price, not the fundamentals of the business and I used the opportunity to double down on my positions.

Your other solutions are all viable as well. But in my opinion, to achieve superior return, you have to do thorough analysis and you have to figure out whether the selling is legitimate ( are the fundamentals of business deteriorating or it is because of fear).

And keep in mind that there are many reasons that guru investors trim their positions. Sometimes a position has just become too large for the portfolio, sometimes they are just making disciplined sales and other times there may be better opportunities.

Lastly but equally important, "margin of safety." If you often find yourself trapped in "fear based" selling situations, you may want to reconsider the way you calculate your margin of safety and how much margin of safety you need before making a purchase decision.
tim bug
Tim bug - 4 years ago    Report SPAM
Hi, good article. I am curious about your analysis of HPQ if you said you should not have sold it when it hit its lowest in years. What was your thesis? Thanks!
Denggi - 4 years ago    Report SPAM

Yes, I am interested to know your thesis too. What has validated the thesis other than the stock price going up recently?
Bob_in_Maryland - 4 years ago    Report SPAM

This discussion lends itself to a diary entry that Barton Biggs made, regarding the "Madness of Crowds"; which can be found in the book DIARY OF A HEDGEHOG. Mr. Biggs reflected on the "collective wisdom" of crowds and made references to prominent thinkers. He then offered commentary on "tacit knowledge" which he characterized as "intuitive" and "instinctive". He stated that tacit knowledge is valuable because it reflects "deep life experience", dispersed from the collective lives of human beings.He really puts it together when he refers to the stock market theory which envisions price mechanism as a "single number" where the representation of ALL FEAR [emphasis mine] and judgement takes "representation". If an investor fails to acknowledge this; that acknowledgement can be rewarding. He recommended reading James Surowiecki and THE WISDOM OF THE CROWDS; closing his diary entry by characterizing the stock market as a "wise and foreseeking, old, thing". Then he knocks it out of the park by offering this insight:"Mr. Market" is wise not on the "little things" but is possession of "tacit insight" into the "ebb and flow of great events". Knocked me out. Now, when I regard a single security, I make sure that regard is given to the markets "fascination" with the tangential as well; and as the security is held (added to, or subtracted from) that regard only intensifies. So this perspective can offer a certain guidance on the "buy; sell; hold" paradigm in which we so ardently engage.

By the way, I hesitated to remark upon this citation because it was so powerfully constructed. Only reading it in its' totality provides the basis for significant context. Hopeful that mentioning gives it justice. It is so germane to this discussion.

BEL-AIR - 4 years ago    Report SPAM
One way I protect myself from fear, is by being diversified lots, this way I am not fearful if one stock keeps going down after I bought it.

Also by not buying full positions right away and always have the dry powder to add more if it is down alot from our original buy point as long as the fundamentals did not change also helps me alot.

Funny how we hope for fear so we can get some stock for cheaper, yet if we ourselves buy it at a cheaper price and it keeps going down fast and hard even the value investors get scared to death as well at times, I know it has happens to me, specifically when I used strategies years ago like trading and something kept going down after I had bought.

I guess it is safe to assume then that the markets will always be inefficient due to this fear that us humans experience, if you think about it if there was not this fear that happens to us humans value investing would never work for us..

Good article and some great points as well.

AlbertaSunwapta - 4 years ago    Report SPAM
But what is HP worth today?

Just because it has moved quite a bit doesn't mean that the market has it right. You bought thinking that other people had it wrong on the price and then changed your mind and decided that you were wrong and they were right, so you sold. You now believe they are right again in driving the price around again.

You're letting the market's short term movements define your sense of success or failure - both fear and now regret, both without any solid anchoring by a good sense of the company's intrinsic value.

Moreover, there's a good reason Buffett avoids many technology companies, despite his close relationships with many tech company founders.
Batbeer2 premium member - 4 years ago
>> 99.9% of the weeks in a 30 year career we can be on our game performing good, rational analysis. But that one week when we are weak...it can devastate a portfolio if we do not enact some safeguards.

One way to deal with that problem is to not touch your portfolio 90% of the weeks. Just trade once a quarter and you're there. Spend the other weeks on research. Your bad week may come when you're 350 years into your career. A week spent on research will never ruin your portfolio.

Think about it; assume the guy you're trading against tomorrow uses that approach. How do you fancy your chances? That guy could be you.

Thanks for an interesting article.
AlbertaSunwapta - 4 years ago    Report SPAM
^ That and put a portion of one's portfolio into indexed funds. If you prove to be a good value investor your gains on the non-indexed portion will soon far outstrip the indexed share and any deleterious effect on your overall standard of living and well being from indexing will be negligible.

As for years of investing. As one approaches retirement, that experience is increasingly placed at odds with the prospect of having to live solely on the proceeds of investing. From my experience, one's sense of downside risk gets heightened. Differentiating between panic and prudence is sometimes only possible in hindsight. :-)
ComLP - 4 years ago    Report SPAM
Nice points batbeer2!

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