Christopher Davis is a portfolio manager at Davis Advisors, a US-based investment management firm. This article was originally published on Morningstar’s U.S. and Australia websites.
If the brain is the most important organ for successful investing, the stomach may well be the second as reason and judgment can easily be distorted by fear and other emotions. Over 65 years and three generations of investing, our family has seen this occur again and again.
While common sense would dictate that buying stocks when prices are low is better than buying when prices are high, investors often do the opposite. Falling prices make investors fearful and soaring prices make them greedy.
In essence, healthy investor behaviour means being disciplined, patient and unemotional. This requires having the temperament and discipline to invest, especially when prices are low. In contrast, unhealthy investor behaviour typically leads to selling during periods of great pessimism (most recently in the depths of the financial crisis) and leaping in at the top of bubbles (for example, into tech stocks during the internet boom or into real estate during the housing bubble).
Such emotional decisions can wipe out years of gains achieved through compounding.
Here are three specific lessons to keep in mind:
1) Disregard short-term market and economic forecasts
Amazingly, investors often rely on interest-rate forecasts and stock-market predictions despite overwhelming evidence that these have little or no value in predicting stock price moves.
For example, we tracked the average interest-rate forecast from The Wall Street Journal's surveys of economists from December 1982 to December 2013. This average forecast was then compared to the actual direction of interest rates. The result? Overall, the economists' forecasts were wrong in 40 of the 63 time periods – 63% of the time!
To build long-term wealth, investors must disregard such forecasts.
2) Do not chase the latest hot-performing investment category or asset class and do not try to time the market
Again and again we see investors flock to managers and strategies that have recently done the best, only to be disappointed when those same managers go through the periods of underperformance that so often follow such hot streaks.
For example, over the last few years, passive, index-oriented investment strategies have delivered strong returns as the correlations within the stock market between individual stocks and their sectors have been quite high. As a result, investors have poured money into these passive strategies.
We believe the investment landscape may be changing, however, and we may once again be entering a stock-picker's market where success will depend on a professional portfolio manager using discipline and judgment to separate good businesses from the bad.
Even though active management may not be in fashion at the moment, we do not intend to change an investment strategy that has served us well for decades or give up the ability to use judgment rather than formulas in managing our clients' savings.
3) Invest systematically
Investors who want the growth potential of equities but may be too concerned about a market correction to begin investing should consider a systematic investment plan.
Systematic investing involves investing money in equal amounts at regular intervals, regardless of the market environment. For example, an investor with $10,000 to invest in stocks may choose to invest $1,250 every three months over a two-year stretch.
A systematic investment strategy has three key benefits.
1) It removes the emotion that can adversely affect the timing of investment decisions.
2) It means investors automatically purchase more shares during periods of uncertainty when prices are low and fewer shares during periods of euphoria when prices are high.
3) It capitalises on market volatility because more shares are automatically purchased at lower prices when the market drops.
The biggest contributors to investment success:
We believe the three biggest drivers of our long-term outperformance are perspective, discipline and alignment with our investors.
We never forget stocks represent ownership interests in real underlying businesses. As a result, we focus steadfastly on the durability and long-term growth of the businesses we own rather than their fluctuating stock prices.
If we are right about the business fundamentals, then time and the power of compounding will work to our advantage in building wealth over the long term.
We recognise the growth of the underlying business can be amplified if the business is bought at a bargain price. As a result, a strong valuation discipline is a central tenet of our investment philosophy.
This discipline also serves to reduce risk by providing a "margin of safety" in our purchase price as a buffer against inherent uncertainties and gives us the staying power to weather occasional but inevitable economic storms.
We have always believed in eating our own cooking. Our firm's employees, board of directors and their families have more than US$2 billion invested side by side with our clients. This alignment means that in addition to thinking about the upside potential of any investment, we also think about the downside.
As fellow investors, we are also motivated to maintain a relentless focus on research and results while avoiding the conflicts that can arise when portfolio managers invest their own money differently than their clients' money.
