Imagine you’re at the shopping mall and a sign in the window of your favorite store reads, “30% Off All Items!” Have you ever thought to yourself, “I should develop a feeling of excitement and enter the store”? Probably not. We’re just happy to see the sale, so we enter the store and begin browsing.
Now imagine the sign reads, “All Items 30% More Expensive!” Why wouldn’t this sign get us excited? Because we want the best deal we can get, and when prices increase we’re not getting the same deal anymore.
Ironically, though, this is how most people invest. When stock prices increase, people get excited and want to buy. And when stock prices decline, people get depressed and want to sell. Unfortunately, this won’t generate long-term success. However, there is a solution.
Carlson Capital's Double Black Diamond Fund posted a return of 3.3% net of fees in August, according to a copy of the fund's letter, which ValueWalk has been able to review. Q3 2021 hedge fund letters, conferences and more Following this performance, for the year to the end of August, the fund has produced a Read More
By understanding how our emotions influence our investing decisions, we can create policies and procedures to mitigate their influence, which will enable us to make successful investments.
This Is Your Brain
Let’s go back to the mall. Why do we enter a store when they’re having a sale? Because our brains have an automatic firing mechanism (specifically, in the basal ganglia system) that generates excitement. Our excitement may not even be recognized at the conscious level, but it leads us to react. And these reactions are governed by the prefrontal cortex, which manages goal-directed behavior.
Similarly, when investors see stock prices increase, their basal ganglia system produces excitement. And who doesn’t want more of a good thing? So, the investor buys more stock, only now he’s paying a higher price and probably increasing his risk.
Thankfully I’m an outlier. I get excited when I see stock prices decline. Why? Because as a portfolio manager, I want to buy stock in companies when they’re on sale; this is how I’ve generated the returns I have.
To be clear, I’m not saying, “Just buy a stock after it declines.” To invest successfully you must first understand the difference between price and value. Then, you need policies and procedures so you can capitalize on opportunities when they become available.
Price Isn’t Value
According to Warren Buffett, “Price is what you pay and value is what you get.” It’s important to understand the gargantuan difference here — a company’s stock price doesn’t necessarily represent the long-term value of the company. For example, 10 years ago you could have bought Apple ($AAPL) stock for $12. Did this represent the long-term value of Apple (which you can buy as of this writing at $117 per share, a whopping 875% higher)? Of course not. Then why didn’t more investment professionals buy Apple?
The reason is most money managers see a stock’s price decline and their amygdala (the part of the brain that manages fear) fires off an emotion that tells their prefrontal cortex, “I’m afraid we’re losing money, you better do something.” So, the manager sells the stock and a loss is incurred. However, there is a solution to making irrational investments based on emotion.
Policies And Procedures: Mitigating The Influence Of Emotions
Our policies and procedures for our buy-and-sell decisions, risk mitigation and portfolio management have been the differentiator for Global Return. This is because our policies and procures are a roadmap for how we make decisions – our policies tell us what to do and our procedures tell us how to do it. Think of them as “the rules for investing.”
For example, one of our policies is to buy stock in a company when it’s trading below our adjusted book value and generating sufficient cash flow to sustain operations. These opportunities arise when the market sentiment of a company is unnecessarily negative, which we saw happen earlier this year with a company we were following. The market was so negative on this company that the stock kept declining until ultimately it traded below our adjusted book value. Yet, the company was still generating ample cash flow to sustain operations.
Clearly, the stock price did not reflect the value of the company — I bought the tangible assets at $0.65 cents on the dollar and got the cash-flowing business for free. Despite the emotional discomfort of buying a stock loathed by the market, we adhered to our policies and procedures and bought the company. Today, the stock is up 70%.
In this example, the selling shareholders didn’t recognize the difference between the stock price and the value of the company; they just made an emotional decision and sold the stock. Can you imagine standing in front of your favorite store and saying, “No way am I going inside — they’re having a 90% off sale!”?
Establishing Policies And Procedures: A Roadmap To Success
Whether establishing policies and procedures for your personal investments or your organization, you need to know your mid- and long-range goals because these dictate the investment strategies you should select.
Importantly, your strategies need to suit your personality. The reason for this should be obvious: Our brains create emotions that dictate how we react. And if you select a strategy that isn’t aligned with your personality, you’ll have negative emotions that lead to irrational decisions and losses. As an example, shorting stocks is a strategy some people use to make money. However, my personality is too risk-averse for this so I created a simple rule: We don’t short stocks.
After identifying your strategies, then develop your policies and procedures to implement them. At Global Return, we have many policies but the two most important outline when we buy and sell a stock and how we mitigate risk. For investors without any policies, begin by establishing these basic rules.
Our experiences and returns show that policies and procedures are crucial for successful investing. So, whether at your favorite store or in the stock market, if you want a good deal for your money, consider establishing a set of rules to control your emotions and manage your buy-and-sell decisions.
Article by Elliot Trexler Originally at Forbes