6 guidelines to be a smart equity investor

By Larissa Fernand |  01-11-19 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

The stock market is not your friend. In fact, it awakens a dangerous emotion: fear. Investors are prone to two opposing but equally debilitating fears.

When stocks are going up, we may find ourselves engulfed in the fear of missing out (which is so predominant in our society that we even have an acronym for it – FOMO). When the market actually declines, a very different fear pays us a visit–the fear of loss.

These two fears are not compatible with successful investing and have a zero-sum relationship with rational decisions. The more you are dominated by these fears, the less rational you are.

Staying rational is a very proactive, not a reactive, journey. Smart investors deliberately structure their lives and design the investment process to protect us from the toxicity of the market. The more you let the stock market into your life unguarded, the more room you create for fear – and the more your rationality slips from one toward zero.

So what can we do, as investors, to move toward maximum rationality?

Vitaliy Katsenelson, Chief Executive Officer at Investment Management Associates. has some advice. The suggestions he gives below have been sourced from various posts that appeared on his blog

1. Don’t constantly watch your portfolio.

Next time you notice the price of a stock you own moving up or down, think about the factors that may be influencing that move. Stocks are owned by people who have very different time horizons. You’ll have mutual funds and hedge funds whose clients often have the patience of 5-year-olds. They are getting in and out of stocks based solely on what they expect them to do in the next month or six months – a rounding error of a time period in the life of a company that lasts decades.

Some buyers and sellers are not even humans but computer algorithms that are reacting to variables that have little or nothing to do with fundamentals of the company you invested in – these players have a time horizon of milliseconds.

You will also have folks who are buying and selling a stock based on the pattern of its chart. Not that they don’t know what the company does; they will tell you they don’t care what it does. For them it’s just a chart with one squiggly line crossing another squiggly line.

Then there are folks who spend more time researching the next movie they are going to see than the stock they’re about to buy. Some of them buy a stock after reading a single article on the internet, while many others buy on the advice of their brilliant neighbor Joe, the orthodontist.

2. Remember: You’re an owner.

If you are a fundamental investor, you are not just buying stocks, you are buying fractional ownership in businesses.

You spend hundreds of hours on research, you read company financial reports; you talk to management, competitors, customers, suppliers. You build a financial model that looks years into the future to value a business, and also to predict what could kill it.

If after you’ve done all that, you still find yourself glued to the computer screen watching the price change tick by tick, you are basically giving credence to the idea that what a company is worth should be decided by algorithmic funds, the guy who reads charts but cannot even spell the name of your company, Joe the neighbour, and an ETF with the IQ of a Halloween pumpkin. (I don’t want to insult everyday pumpkins here.)

In short, the less time you spend looking at your portfolio, the more rational you are going to be.

3. Turn off the television.

Stock market movements throughout the day are completely random. The same actors that are influencing the up-and-down ticks of individual stocks–actors whose goals and time horizons may have nothing in common with yours–are driving market movements. I feel for TV producers who must provide a continuous narrative to explain this randomness.

Business TV presents additional dangers to your rationality: It reprogrammes you to think about the stock market as a game. In encouraging you to play that game, it puts you at risk of nullifying all the research you’ve done, as you let your time horizon dwindle from years to minutes.

It also threatens to strip from you the humility that is so needed in investing. Business TV guests who provide their opinions on stocks have to project an image of infallibility (the opposite of humility). Again, I sympathize with them – they are there to market themselves and their business, and thus they must project the image that they have an IQ of 200, holding forth on every possible topic.

You are never going to hear from them the words that are the essence of investing: “I don’t know.” Being unable to admit uncertainty is dangerous, because it may cause you to stop thinking about investing in terms of probabilities. If you start thinking that the future has only one path, you may ignore other paths and thus other risks in your portfolio construction. If you tell yourself that you’re an expert on every company, then your circle of competence has no boundaries and your overconfidence may take you to places (and into investments) where you have no place being.

Also, since “I don’t know” is not part of their vocabulary, business TV guests will confidently answer questions that should never be asked, such as “What will the economy and stock market do next?” If you have been investing long enough, it is hard not to develop opinions (hunches) about what the stock market and economy will do next. However, good money managers work diligently to extinguish these hunches from their investment process, because those hunches lack repeatability.

If you get the next leg of the stock market or economy right, that’s just dumb luck – nothing more and nothing less. Economic and stock market behavior, especially in the short term, are very random. God forbid your recent forecasting success goes to your head, because your ability to predict what will come next is not much different from your predicting the next card to be turned up in blackjack.

4. Be an investor, not a forecaster.

My colleagues and I used to identify with our self-proclaimed “I am a long-term investor” brethren. However, over time this phrase has morphed to mean “I am a buy-and-hold (and never sell) investor.”

Also, the term long-term investor, in our view, is a bit redundant, since there is no such thing as short-term investing in the stock market. If you are investing in stocks, then your time horizon should automatically be long-term; otherwise you are just a trader deceiving yourself into thinking that you’re an investor. However, investing is not just about the holding time horizon.

The analytical time horizon is just as important.

To us, being investors means having an attitude with which we look at stocks and process information. We buy businesses that happen to be listed on public exchanges, but our attitude toward them would not be much different if they were private. We view all news, be it quarterly guidance (whether it’s “great” or “disappointing”), upgrades or downgrades by analysts, or any headline crossing our screens in the context of one question: How does this impact the value of the business?

This perspective is liberating, because you start to process the news flow very differently. You develop a resistance to the distractions of the everyday news dump. Quarterly earnings stop being about “beating” or “missing” guidance. Ultimately, this simple question, “How does it impact the value of the business?” filters out 90% of the noise and puts us on a solid investment footing.

5. Focus on what you can control.

Timing the market is impossible. I don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random — as random as you guessing the next card on the blackjack table. In contrast, valuing companies is not random. In the long run stocks revert to their fair value.

If you assemble a portfolio of high-quality companies that are significantly undervalued, then you should do well in the long run. Yet in the short run you have little control over how the market will price your stocks.

6. Remember: This time it is not different.

That narrative (this time it is different) is used to justify buying overvalued stocks.

During the 1999 bubble, I vividly remember the “this time is different” argument. It was the New Economy vs. the Old Economy. The New was supposed to change or at least modify the rules of economic gravity. The economy was now supposed to grow at a much faster rate. In reality, economic growth in the U.S. over the past 20 years has not been any different than in the previous 20; in fact, it has been lower. From 1980 to 2000 the U.S. economy’s real growth was about 3% a year, while from 2000 to 2018 it has been about 2% a year.

Buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. It’s great to make money, but it is even more important not to lose it.

The market doesn’t need to collapse for us to be buyers. The market falls in love and out of love with specific sectors and stocks all the time.

Do note: Investment involves risk of loss

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