This is a special guest post by Jim Bergstrom.  Jim currently serves as Director of Investments for Indiana University Foundation, a $1.5 billion endowment.  Prior to joining IUF, he worked in private wealth management and institutional investment consulting.  He is a CFA charterholder and serves on the board of directors of CFA Society of Indianapolis. Jim recently authored a book titled Shangri-La Investing: A Common Sense Approach to Becoming a Better and Happier Investor, ( for the Kindle version, click here).  The book takes the reader on a fun journey using actual investment case studies, along with analogies tied to everyday situations. The ultimate goal is to demonstrate why people who fully understand and embrace the value investing framework can be better investors, with much less emotional stress during periods of volatility.

 

If you’re visiting Value Walk, presumably you have embraced the idea that value investing is the most probable path to long-term success in the financial markets.  But did you realize that one of the most important reasons for the success of value investors is that the value investing mindset equips them with the emotional stability and level-headedness to make smart decisions?  If success were solely determined by one’s ability to crunch numbers, interpret financial statements, and create an accurate model of discounted future cash flows, we could simply program a robot to handle our financial affairs.

 

Instead, in reality, the ultimate success of the buy and sell decisions we make (particularly those made during times of turbulence – whether for an individual company or for the market in general) often hinges on whether we can avoid the most common behavioral pitfalls associated with investing.

 

When I was asked to write a guest piece for Value Walk, I had a hard time choosing which Shangri-La analogy I wanted to expand upon.  In twenty-one chapters, there are countless analogies and case studies similar to the one you’re about to read, and eventually they all tie back together in the end to make the reader understand why value investing works – not just from a quantitative standpoint but also, just as critically, from an emotional standpoint.  Given the events of the past few months, it became pretty clear to me which direction I wanted to go.

 

One of the pervasive themes throughout Shangri-La Investing is that investors who have no idea what their investments are worth are subjecting themselves to complete, utter, and unnecessary misery.  Let’s dive deeper into this point here, since it’s particularly relevant given the volatility currently occurring in the markets.

 

Imagine I were to offer you the chance to play a game for a cost of $15 that has a potential total payoff of either $1, $5, $10, $20, or $50.  Here’s how the game works – you pay your $15 entry fee, and then I begin to cycle through the five different bills.  You can stop me at any time, and choose to walk away from the game with the bill I’m currently showing you.

 

This is a joke, right?  It’s the easiest game in the world – you give me $15, and just patiently wait until I show you the $50 bill.  You walk away with over 3x your investment.

 

Why is it so easy?  Because you know both the price (the $15 entry fee) and the value (the five different bills, ranging from $1 to $50) involved.  Do you panic when I show you the $5 bill, thinking that you’re going to be forced to lose ten bucks?  Nope.  Do you break into a cold sweat when the $1 bill comes out, fearful of a $14 loss?  No way!  Why?  Because you have confidence in both the price and the value of everything involved.

 

Let’s make it a little more interesting.  Since I’d lose most of my credibility as a financial expert if I were to allow you to mint a $35 gain off of me with no risk, I’m going to take away your largest advantage before allowing you to play.  Guess what that means?  You’re going to be blindfolded!

 

You’re still fully aware that the entry fee is $15.  You know the price.  But your mechanism for value discovery has been taken away.  You have absolutely no idea which of the five bills you’re being shown at each phase of the game.  It’s a total crapshoot – 60% of the time you’re going to wind up losing money.  Believe it or not, the game still has a positive expected return – over the very long run, you’ll win an average of $2.20 per game.  But still, this isn’t nearly as fun of a game when you’re blindfolded, is it?

 

Entirely too many investors today fall into one of two emotionally destructive camps.  First, many people subscribe to the popular theory that markets are efficient – that is, that the collective wisdom of millions of investors means that price and value are roughly equal.  Some of your investments are down 10-20% in price since June?  That must mean that the value of those investments has also dropped by double-digits.  Uh oh.  That’s not a good feeling.  These people are blindfolded, so to speak, in the sense that they accept price as a reasonable proxy for value, and are thus at the mercy of the collective decisions of other market participants.

 

Still other investors fall into the momentum or growth-at-any-price camps.  These people tend to focus on “price action” – if the price is rising, that must be positive confirmation that it’s still a good investment.  They care almost exclusively about price – and perversely, they may prefer an investment when price is high.  For these folks, value is either too hard to calculate, or it’s unimportant.  After all, a stock with a price of $25 and a value of $20 can still produce a fantastic 20% return in short order if the price goes to $30.  But when the price begins to fall, they have nothing to anchor to.  They can’t remain calm, because they’re wearing a proverbial blindfold – they have no idea what the value is of what they hold, so they’re prone to make emotionally charged, poor decisions.

 

There’s an enormous amount of macroeconomic uncertainty in today’s markets.  Everywhere you look, there are risks – European sovereign debt, the U.S. debt downgrade, corporate margins reverting to the mean, continued real estate weakness… you could literally go on for pages and pages.  So, how can you remain calm in the midst of this potential chaos?  By removing the blindfold, and only investing in durable, world-class businesses with prices significantly below conservative estimates of their intrinsic values.  For many, that will mean entrusting your capital to value managers who possess the advantage of being able to devote significant time and resources to the process of assembling a diversified portfolio of high-quality, discounted businesses.

 

It’s the most time-tested way to be a happier & better investor, particularly during turbulent times like those we’re currently living in.

 

If you enjoyed the above analogy and would like to see what one of the more expanded versions looks like, I’m happy to offer the opportunity to read a copy of the book’s opening chapter.  It’s entitled Patriots vs. Broncos, and given that the 2011 NFL season is starting later this week, I

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