The individual investor
Great investors see opportunity
The title of this post summarizes an entire investment philosophy. It describes an investment process. It describes the personal qualities needed to be a successful investor. It captures a key psychological insight.
I kid you not. Let’s ask Warren Buffett to sum it up for us: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Another way of putting this is that great investors see opportunity where others see peril.
In this post I propose to dig into the idea of investing when others are fearful and explain how it really works.
Preliminaries
A couple of preliminary points. First, we have to distinguish between individual stocks and the general market. The price of individual stocks can get depressed below fair value for a host of reasons unconnected with the overall market.
A typical situation occurs when a company makes a major capital investment for future growth. Management might guide analysts and investors to lower earnings in the short term with warm statements about future prospects down the road. The reaction of many analysts is that they put a hold on the stock until there is better ‘visibility’ around future earnings. The price of the stock gets depressed. This is often a wonderful time to buy the stock.
One can ask whether the sentiment that depressed this stock price on guidance for lower earnings in the short term is fear or some sense of peril. The sentiment is certainly one of risk aversion. It certainly underscores the fact that Mr. Market doesn’t like to invest unless everything looks rosy through their short-term glasses.
As I say, bargains appear in the stock market all the time, not just in risky economic times. My post The joy of higher return with no more risk offers some twenty reasons. The common thread with these stocks is that other investors are reluctant to invest in them for some reason.
This is why investing in individual stocks rather than index funds or ETFs is superior. Investing in individual stocks we try to buy shares at a price less than fair value. This gives us a Margin of Safety, as Benjamin Graham and Warren Buffett put it. Trying to put a fair value on the aggregate constituents of an index is essentially impossible. It involves market timing which is a sure way to lose money. Valuing an individual stock is a more doable proposition. You can compare its price with your best information as to the intrinsic value of stock.
Bull and bear markets happen. It is possible to use depressed prices in the overall market to take on positions in individual stocks. What caused the bear market doesn’t really matter. I’ll discuss this later in this post.
The second preliminary point is that investing when others are fearful is not a matter of simply being courageous in face of peril. In fact, the greatest danger with this or any other style of investing is being supremely confident i.e., over-confident. The wise investor stays within their circle of competence and knows the circle’s bounds. Investors need to understand the business they are investing in.
So, with that intro, let’s get into the idea of investing in face of peril. And in this post, I will focus on investing in bear markets. My earlier post deals with things that cause the prices of individual stocks to be depressed.
Developed instincts
The novice investor has a lot of instincts about how to invest. One of the challenges of investing is that many of our instincts are dead wrong. Experience in investing teaches which instincts are wrong and which are right. Flipping dead wrong instincts to new or different instincts is tough.
To buy when all about you are fearful is a developed instinct. It is contrary to our usual instinct, our usual mentality, especially our instinct is to do what most everybody is doing. Our usual instinct is to buy when things are going well. This is wrong.
Lightbulb moment
My current philosophy of buying stocks has evolved over the years and continues to evolve. I never studied finance or economics. I started with the rudimentary understanding that the economy goes in cycles with strong economic times followed by recessions. From my early reading I also saw that the stock market also goes in cycles, bull and bear markets. My instinct was that these cycles would go together.
In late 1990 there was an official declaration that Canada was in a recession. Media and pundits had been discussing the onset of a recession for months. The stock market was down. As events unfolded, I saw that late 1990 was an ideal time to put new money into the stock market. This was something of a lightbulb moment for me. The pundits, investors and the stock market were in a funk.
The idea that an official declaration that the economy is in a recession might be a good time to buy is counter intuitive. What I learned from that experience is that there is no necessary connection between the economy and the stock market. My current learned intuition is that I largely ignore the economy and the outlook for the economy in making investment decision.
What existed in late 1990 was a general feeling of fear amongst investors about the economic outlook. The stock market had been going down for some time.
March 2020
With the onset of Covid fear gripped the stock market. I was actively Tweeting during the spring of 2020.
Two of my Tweets capture my investment response to Covid.
“My plan which I have followed for decades is to largely ignore volatility and make purchase and sale decisions based on sound investing principles. The only volatility that gets special treatment is true bubbles, of which only 4 in last 100 years.
“Crowbar on tracks, fragility? Don’t underestimate human adaptability and resilience. It’s quite a bit different than 2008 when banks and big parts of the financial system were truly fragile.
I sold a couple of stocks in the spring of 2020, for example a company that made aeroplane engines and a company that made public transit vehicles (end markets extensively impacted by Covid), and bought a couple of others, for example two tech stocks that had gotten beaten down in price to less than fair value. I was able to buy with a good margin of safety.
Risks in the stock market were actually reduced in the spring of 2020. How so?
Risks when markets are down
Benjamin Graham explains it quite clearly. A representative of a savings-and-loan company came to Benjamin Graham with several questions. “The first question he asked me was “Don’t you think that common stocks now are less safe than before because of the decline in the market?” That hit me between the eyes. Here were financial people who could seriously consider stocks less safe because they have declined in price than they were after they had advanced in price. “(Graham, The Intelligent Investor, fourth revised edition. 1963) p.10
The point very simply is that stocks in general and any given stock are no riskier when priced as bargains, and probably less risky. I ask the reader to ponder whether stocks were more or less risky in January 2009 at the depths of the Financial Crisis bear market? The answer is that they were less risky. The same was true in the spring of 2020 when Covid became a pandemic.
It has been argued that seeking better returns by buying value is associated with higher risk because higher value appears in risky economic times. Such simplistic thinking ignores the insights of Benjamin Graham, Warren Buffett, John Templeton and Philip Fisher about buying with a margin of safety and buying at a time of maximum pessimism. These investing greats are correct because they have demonstrated that their approach works in the real world.
Conclusion
When we get the right pitch (a superb company at a bargain price) we can largely ignore the welter of news and views about the stock market at large. It doesn’t matter if the crowd is cheering wildly or in distress. Pundits are constantly talking about the outlook for the market or the economy. The level of the S&P 500 is analyzed based on historic Price/Earnings ratios and the current CAPE ratio. This is simply distracting. The larger market and the economy are both complex and confusing. How are we to know how the business cycle will unfold in the next three to five years? What we can focus on is the opportunity presented by the purchase of an individual stock. This is a much more manageable assessment.
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Readers wishing to dig into some of the different corners of the world of risk might take a look at the Motherlode Chapter 4. Risk and Uncertainty
That chapter contains the following Sections:
4.12 A 1 in 1,000 chance of permanent loss
4.14 Risk/reward trade-off assumption
4.16 Are higher rewards from lower risk possible?
4.17 Risks when markets are down
4.18 Risks when markets are up
4.20 Conclusion regarding risk and uncertainty
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Other posts on investment psychology
This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction. This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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