I have discussed investment psychology in my recent article titled “The Lesson of Investors’ Psychology,” about the psychological mistakes that investors often make in their thinking and investing behaviours. In this article, I would like to focus on several important points in Howard Marks (Trades, Portfolio)’ recent memo: “On the Couch,” so that we can learn more from him to avoid mistakes in our investment analysis.
In his memo, Marks showed us his favourite sentence in a cartoon: “Everything that was good for the market yesterday is no good for it today.” Indeed, everyone knows that the Chinese overheating economy and excessive investment in fixed assets would lead to a hard landing and even recession. But it was only until last August that investors experienced the collapse of A-shares. The fear spread to the U.S., making it decline 11% in the week from Aug. 17 to 25. Marks wrote in his memo: “In 2015, we saw old problem get worse, new ones arise, and a general absence of anything to feel good about. The sense of hopelessness regarding problems like ISIS and runaway immigration is something investors handle particularly poorly. In August, the events in China sparked a revival of risk aversion and fear, with effects that carried around the world for a couple of weeks. And with the door opened to fearful interpretations, Pollyanna tolerance gave way to widespread negativism.”
Investors might find themselves in another classic cartoon that Marks mentioned “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher interest rates.”
The linear, one way thinking would make investors confused and hinder the ability to logically analyse the facts. Because of our own emotions, we hardly maintain a balance between both favourable and unfavourable developments.
Marks stresses on the common thinking mistake that I have personally encountered myself in the past. When a few of my positions declined in a price, it seemed very hard psychologically to accumulate more at a lower price. And when the price of a stock is going up a lot, I also psychologically tend to have a desire to own more of that stock. As Marks said, “Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning.”
In order to analyse the facts in the correct way, the key is to ask the right questions. Many people have asked Marks on what month the Fed would raise rates. His response was always: “I have no idea, and why do you care?” He didn’t think the timing of a rate increase was important. What really matters is how far the rates would go and how fast. According to Marks the right question to ask is: “How much will rates rise?" and “when the series of increases is over, will rates be high enough to meaningfully alter behaviour?”
In the memo, Marks shared what he learned 40 years ago about the three stages of a bull market:
- The first, when only a few insightful people suspect improvement might occur,
- The second, when most people accept that improvement is actually taking place,
- The third, when everyone concludes that things are sure to improve forever.
Between the first and the last phase, Marks wrote that there didn’t have to be a change in terms of fundamentals. It’s all about investors’ perspectives that make the difference. Of course, it would be great for investors to get in the first phase, and it's essential not to be in the last phase.
In conclusion, the bull and bear market can be determined by investors’ psychology without any significant changes in fundamentals. Thus, investors should rely on business operating fundamentals to determine the reasonableness of any positions, and try not to be influenced by the market sentiments.
