It’s a well-known precept of Warren Buffett (Trades, Portfolio)’s that investors should approach the business of buying stocks the same way they approach everything else - to wait until they are on sale and then load up. You wouldn’t hesitate to buy that car you’ve always wanted when it goes on sale - so why not stocks? If you had the opportunity to buy a good business for half price, why wouldn’t you?
Value investor Christopher Browne also takes this view. In his book, "The Little Book of Value Investing," he explains why most investors have such difficulty following this philosophy.
What is the problem?
The central problem for most investors is that they get swept up in the excitement of the stock market, as Browne explains:
“In the stock market, there is the irresistible excitement and lure of the hot stocks everyone is talking about at cocktail parties - the ones that are the darlings of the talking heads on cable stock market shows, and the financial newsletters tell us that we must own. It is the wave of the future! It is a new paradigm! People believe that they’ll miss a terrific opportunity if they don’t own these super exciting stocks...Everyone seems to think that they should buy stocks that are rising and sell those that are falling.”
This passage strikes at what I consider to be a key disconnect in how many retail investors view the market. For them, it is a source of entertainment, rather than a place to buy productive assets. Now I doubt that many people would admit to such a way of thinking. I would even say that most retail investors genuinely believe they have the right attitude toward investing.
But belief is not the same thing as fact, and the enduring popularity of financial media that sensationalizes things like earnings results is evidence that there is a large number of people out there that do view the market as entertainment.
To be fair, it is not just amateur investors that fall victim to these psychological biases and mental traps. Professionals, many of whom are paid large sums of money to manage client capital, also fall into this trap:
“It’s not just everyday, individual investors who fall prey to the herd mentality, it also happens to professional portfolio managers. If they own the same stocks that everyone else owns, they are unlikely to be fired if the stocks go down. After all, they won’t look quite so bad compared with their peers, who will also be down. This unique situation fosters a mindset that allows investors to be comfortable losing money as long as everyone else is losing money too.”
So there exists a perverse incentive that forces professional money managers to do the same thing that everyone around them is doing, even if that means underperforming. In their mind, it is far better to underperform than it is to run the risk of being seen as an unreliable pariah. This odd way of thinking is ultimately what leads investors to forget that they need to buy stocks when they are cheap, and become wary when they get expensive.
Read more here:
- Warren Buffett: If an Accountant Does Not Record Stock Options as an Expense, Do They Exist?
- Why Stock Market Returns Are, on Average, Higher at the End of the Year
- How Does an Initial Public Offering Actually Work?
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