“You have to inoculate yourself against regret.” – Daniel Kahneman
About ten years ago, I was sitting in a conference room discussing stock ideas with a group of investors. The stock I presented had a good business model, competitive position, and management team. The valuation seemed reasonable, too.
But when asked if I’d buy the stock today, I hesitated.
“What if the stock falls 20% right after we buy it?” I worried to myself, “I’ll look foolish.”
Another investor sensed my timidity and inexperience and gave me the best advice I could have received at that stage of my career. “This is a decision-making business,” he said, “You can’t be afraid to make a call.”
It’s never easy to part with hard-earned capital to make an investment with an uncertain outcome. This is true whether you are making the decision on your own or with a financial advisor.
Even if we knew beforehand that all of our investment decisions would have positive results, that wouldn’t be satisfactory. If every other investor similarly had guaranteed positive outcomes, our expected returns would diminish toward Treasury bill rates.
Put another way, when it comes to stock investing, you need to get comfortable with uncertainty. That’s especially true if you hope to earn above-average returns.
Ah, but what if the investment doesn’t work out? The pain of a permanent loss of capital can wipe away any joy received from gains elsewhere. Indeed, behavioral economists have found that humans are typically 2 to 2.5 times as averse to losses versus similar gains. In more practical terms, we feel the pain of losing a $100 bill more than the joy of finding a $100 bill on the street.
All of this can be tied back to basic human instinct. Back in our hunter-gatherer days, losing half of your tribe’s food supply was a real crisis. Adding 50% to your food supply was a nice bonus, but not a life-or-death matter. While loss aversion helped our species survive, it is detrimental to us as modern-day investors.
What can we do?
The fear of regret and loss has kept many investors – and I’m certainly included in this group – from making important investment decisions. Though we’re biologically hard-wired to think and feel this way, there are some tactics we can employ to work through these forces.
Limit price & performance checking. The longer I invest, the more I’m convinced that the worst thing a long-term investor can do is frequently check his or her performance. Checking performance invites in additional biases such as confirmation bias, hindsight bias, and yes, loss aversion. As Credit Suisse’s Michael Mauboussin put it, “prices can go from being a source of information to a source of influence.”1
Let’s say you invest in a business and its quarterly report shows strong fundamental improvement, but it missed the market’s even higher expectations. The stock falls 5%. You see this drop on CNBC and you think, “Oh no, what have I done?” You start to stress out, looking for ways to get back to even. This only compounds the problem. Conversely, if a stock you buy shoots up 10%, you may get a false impression that you’re a new investing guru. You start to make more aggressive bets as a result of this overconfidence.
To the extent possible, limit the frequency of your visits to your brokerage site, scanning real-time prices, and consuming financial media.
Have a 24-hour cooling off period. If you are feeling strong emotions – either delight or despair – before you make an investment decision, take a step back. Go for a run or a walk. Meditate. Sleep on it. Consult your advisor. Do whatever it takes to let the emotion subside.
Yes, while you delay your decision, the investment value could fall further. Over the course of an investing career, however, the benefits of waiting and making calm decisions far outweigh additional losses “saved” from panicked decision making.
Have an alternative benchmark. Investors often compare their returns versus a broad market like the S&P 500. There’s nothing wrong with that. On a year-to-year basis, though, what drives performance in that index will likely differ from your strategy.
If you’re a growth investor, you’ll probably lose to the market when value outperforms, and vice versa. If you’re unaware of these market currents, you might hastily change your investment approach, thinking you’re doing something wrong.
An alternative benchmark should be related to the business fundamentals of the stocks in your portfolio. For example, if you’re a dividend-focused investor, you might say you want to achieve 6% to 8% annual dividend growth. This way, even if your style is out of favor relative to an index in a given year, you can take comfort in your approach if your portfolio generated, say, 9% annual dividend growth.
The common themes of these approaches are to distance yourself from emotional decision making and focus instead on underlying business fundamentals.
To be an investor is to be a decision maker. The better we understand ourselves and why we make the decisions we do, the better chance we have of realizing satisfactory returns on our investments.
Stay patient, stay focused.
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1 Mauboussin, Michael; Callahan, Dan; Majd, Darius, “Thirty Years: Reflections on the Ten Attributes of Great Investors” (2016)
Todd Wenning is a Research Analyst with Johnson Investment Counsel (“Johnson”).
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