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The Science of Hitting
The Science of Hitting
Articles (495) 

Governing Your Emotional Pendulum

Some thoughts on avoiding emotional decision making

June 07, 2018 | About:

I recently reread an old interview with Alice Schroeder, the author of the Warren Buffett (Trades, Portfolio) biography "The Snowball." It’s an interesting interview, and you should check it out if you haven’t seen it before. There are a number of gems in it that are worthy of discussion, but there’s one section in particular that I want to focus on in this article (bold added for emphasis):

“My one really difficult experience as an analyst was at PaineWebber during the dotcom bubble. It was like bullishness was a drug poured into the New York City water supply. Everyone believed. The idea that investment banking pressure was solely responsible for the Internet bubble has been overplayed…. We drank the Kool-Aid just like everybody else. People think Wall Street was cynical; there was less cynicism than history has recorded…

Somehow, Warren was able to ignore the whole thing. People sometimes speculate that he is emotionless, and I’m frequently asked if he is autistic. He’s certainly not emotionless, but his emotional pendulum swings in a very narrow arc... While he does use rules to make decisions, it’s key that he’s detached and not temperamentally excitable to begin with.”

For whatever reason, reading that response made me think about Tesla (TSLA). For anybody involved in the financial community on Twitter, you’ve undoubtedly noticed that this company is a topic of frequent discussion. It’s a situation where the longs and shorts both seem completely committed to the conclusions they’ve drawn about the company (and its CEO, Elon Musk).

If you asked people on either side of the trade what the future holds for Tesla, and how certain they are about that conclusion, I bet many of them would proclaim a very high degree of confidence in their predictions for the next few years. If nothing else, their conviction is impressive.

Which side is correct is irrelevant. Just think about the disproportionate amount of time and effort these people are spending on this one company. At this point, for those that have been involved in this fight for years, it’s probably as much about pride (being right) as it is about making a smart investment decision. They simply can’t ignore the chance to stay involved in this battle.

There’s something else about Tesla (and companies like it) that makes it difficult to keep your emotions in check. The reality for Tesla is that perception matters. That’s the case because the company is reliant – or at least has been historically – on capital markets to fund its business. Whether you’re long or short, short-term moves in the wrong direction are double trouble.

That’s not the case for investors in PepsiCo (PEP). It really doesn’t matter where the stock trades in the next 12 to 24 months; in fact, a lower share price would be beneficial for long-term shareholders because the company will continue buying billions of dollars worth of stock on the open market.

That’s not the case for Tesla. If the stock fell to $50 or jumped to $500 tomorrow, that would be a meaningful development that has real implications for the business. Said differently, a business that depends on the kindness of strangers has to worry about fluctuations in investor sentiment. That’s a risk that’s difficult, or impossible, to handicap. Its relevance will range from immaterial to quite important depending on the current state of investor sentiment.

I don’t want to push this idea too far, but I think it has some merit. If you own conservatively financed businesses, changes in investor sentiment are less worrisome than they are if you own a business that will likely need to raise additional capital in the near future. By the way, business issues from changes in investor sentiment don’t always start at the company level. Look no further than what happened to General Electric (GE) when access to commercial paper dried up in 2008.

For someone like myself, this is a nonstarter. I don’t like the risks associated with capital providers suddenly becoming more demanding (or refusing to provide capital at any price). I experienced that to a certain degree with my investment in J.C. Penney (JCP). For what it's worth, I found that experience extremely uncomfortable. It put me in a state where acting rationally, as opposed to making emotional decisions, was more difficult.

Over time, Warren Buffett has typically invested in high-quality businesses with conservative financing. In the cases where he has engaged with businesses that relied on the kindness of strangers (particularly during periods of distress), he was the stranger.

I may be overstating the role security selection has played on Buffett's temperment. Maybe someone like him has an innate ability to act less emotionally to market volatility than the average investor. Even if that’s the case, I think there are some steps we can take to put ourselves into situations where we are less likely to make emotional decisions.

For one, I think you can minimize this risk by focusing on conservatively financed businesses that you’re comfortable owning for the long term, even if they operate at leverage ratios below what analysts or other industry participants consider “optimal.”

Second, I think you should do your own research (due diligence) as opposed to relying on other people’s conclusions.

Finally, I think a good rule of thumb is to stay away from the battleground stocks that are always in the press – particularly if the future of the business is overly dependent on investor sentiment. I can promise you that there are plenty of investment opportunities beyond Tesla and Netflix (NFLX). With these simple steps, I think you can meaningfully narrow the arc of your emotional pendulum.

Disclosure: Long PEP and GE.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (7 votes)



Dr. Paul Price
Dr. Paul Price - 7 months ago    Report SPAM

GE sounds exactly like the kind of stock you recommend avoiding.

Fluidityinglass premium member - 7 months ago

Great read and perspectives on several levels...And great Buffet advantage reminder...never heard it said as eloquently as you did above. Thanks again.

"In the cases where he has engaged with businesses that relied on the kindness of strangers (particularly during periods of distress), he was the stranger."

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Dr. Paul,

Of the ideas I've shared above, I think this one is the most important - "You should do your own research (due diligence) as opposed to relying on other people’s conclusions."

I've done the work on GE, and decided to buy some. Time will tell if that was a mistake. I would note that I have not bought more as the price declined. So take what you will from that decision.

If you have any specific thoughts on the company, I'm happy to discuss them. Thanks for the comment!

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Fluiditityinglass - Thanks for the kind words! I'm glad you enjoyed it.

Stephenbaker - 7 months ago    Report SPAM

Good thoughts. I am looking at GE. Disagree with Dr. Price, completely. Forget about all the commentary, history, recent (and current) issues and focus solely on the core businesses and newly formed management. Look out several years and try to get comfortable with the trajectory of revenues and earnings. Whether the dividend is reduced again or not is irrelevant. Not quite ready to buy just yet but getting more comfortable with this one.

Batbeer2 premium member - 7 months ago

@SoH thanks for sharing your thoughts. Worth reading. As always.

You say: Maybe someone like him has an innate ability to act less emotionally to market volatility than the average investor.

Perhaps it is not about acting less emotionally but about controlling emotions. There is a difference. You know you can (within limits) invoke emotions within yourself. As an example you could choose to watch the movie "The Devil wears Prada" and you know you are probably going to feel more cheerful. Or you go watch "Boy In The Striped Pyjamas" and you expect to feel a bit more tearful. But anyone who watches either of those movies and comes out believing they are about clothes is not neccesarily a superior investor.

In short, there are things you can do that will make you feel like a ripening teenager at a beauty pageant when the market is down 50%. One of them is making sure you have excess cash.

Maybe it's coincidental but Berkshire is sitting on heaps of excess cash.

@ Paul Price Who is recommending stocks here? All I see are some guys sharing their thoughts.

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Stephen - Good points. Thanks for the comment.

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

BatBeer - Interesting thoughts (as always). Thanks for sharing!

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