We have talked a bit about the mechanics of investing and some of the rules to follow while investing. However, an often overlooked aspect of successful investing is the emotional and behavioral aspect. It is one thing to know that you should have a buy and hold attitude through thick or thin, but it is another thing entirely to continue to hold your stocks while financial news anchors are panicking as the market crashes, and you watch your portfolio decline in quoted value. While many espouse the buy and hold mentality, I suspect that far fewer apply it successfully.
This behavioral-emotional aspect is also in my opinion why there will always be a value stock premium as measured by Fama and French. Value can, for example, underperform for long periods of time in good markets when growth stocks are hot. It has been shown that value stocks tend to outperform because they hold their value better when everything else is headed down. It is exceedingly difficult for most people to watch their growth stock investing neighbors get much “richer” than them year after year. The first year you might dismiss this as luck. The next year, you may start to get a little annoyed. By year 5 or 6 of watching everyone else do better, you are ready to give up and go all in on extremely overpriced growth stocks or the latest fad. All you manage to do is hit the very top of the market and lose a lot right as it all comes crashing down. Your neighbors, by the way, lose too when it comes crashing down. Then everyone discovers that the wealth they thought they had was an illusion. Meanwhile, value stocks keep chugging along. However, to capitalize on this value, you have to either endure some psychological pain as illustrated above, or you must have the type of temperament that is impervious to it. The value premium isn’t going away because many people cannot tolerate this for extended periods of time.
In order to guard against these scenarios where emotion and bad habits defeat you, it helps to set up your behavioral systems to reward the practice of good behaviors. You need to have a very clear investment policy that outlines several scenarios and how you will act in each case: What happens if the market rockets upwards? What happens if it crashes? What happens if it bores you to death and goes nowhere for 10 years? You become what you think about and practice regularly, so you need to be careful to structure your world to practice good investing. Stop comparing yourself to others, and focus on making the best decisions that you can based on the data, and make sure you track the right data.
For example, many people like to track their lifetime annualized return, or their annualized return over the past 1 year, 5 years, etc. However, this can drive some bad behaviors. If you look and you see that others are earning higher rates of return, you may be tempted to chase after them. If you see your rate of return dipping, you may be tempted to take action, when letting things sit is a better strategy. There is a lot of noise in the market, and it can be difficult to tell if you are truly outperforming on this measure until 20-30 years have passed. I really think that tracking this measure and caring so much about it can be detrimental to your future wealth.
A better way that encourages buying and holding of value, and one which I personally practice, is to instead track free cash flow averaged over the last 3 or 5 year period for my portfolio. You want to try to build a portfolio with the most free cash flow you can buy for the money, after all. The free cash flow averaged over a reasonable number of years will change more slowly than your 1 year market return. During a market crash, you will see your high quality stocks picked from your Star List still chugging along pumping out free cash flow while everyone else is panicking in the streets. They will be busy thinking about how the market now suddenly quotes their portfolio at half the value it was at yesterday. In the meantime, you will still be looking at the fact that your portfolio has had no hiccups in free cash flow, money that is rightfully yours whether returned to you as a dividend, or reinvested on your behalf by the company to create even more free cash flow. You won’t be worried about what happens in 1 year or 5 years, confident that eventually the market will have to realize the value of your portfolio of stocks based on the free cash flow it generates. If it doesn’t, then you will be more than happy to reinvest and accumulate enormous wealth in a short period of time, regardless of whether the market ever decides to quote your stock at high or low prices.
This practice actually mimics how wealthy dynasties viewed their riches in centuries past. They would say something like – our estate supports an income of 100,000 pounds. They didn’t talk about the value of all the lands and businesses they owned. Why would they? They would never sell these and give up the future wealth generating capacity. It didn’t matter to them what someone else would pay for them. They viewed their assets and investments as valuable for the long term ability to generate profits and income. This led to success over many generations.
I have been advocating on this blog that you buy the absolute highest quality companies with durable and sustainable returns on capital at the best values you can buy them. You first put together your Star List of companies as a kind of shopping list, and then you monitor this list for the best values on a price to free cash flow basis. An underappreciated aspect of this kind of investing is that it drives the right behaviors and evokes the right emotions in you as an investor to be able to stay the course and buy and hold. If you have a collection of the most stable companies in the world that continue to crank out free cash flow and dividends regardless of what is happening in the markets, you will be less apt to panic when everyone else does during a crash. When you put together a group of investments that you should almost never have to think about selling, selling starts to disappear from your mind as an option to be considered, and you start to practice buy and hold even more strongly. You stop trying to think about “capturing” that gain with a sale.
One of the reasons why I avoid “cigar butt” and net-net types of value investing, is that they are temporary situational investments. You have to decide when to sell them, and they can also certainly get into big financial troubles during market panics when liquidity dries up. You are essentially training yourself to sell often and be on guard for selling in the case that something goes south. To me the best kind of value investing is high quality value investing. Remember, you become what you practice every day so be wary about adopting strategies that make you practice selling your stocks.
Emotional proclivities are varied amongst investors, so only you know what your emotional tendencies are. You must be brutally honest with yourself and understand these tendencies, because you need to tailor your investment strategies and how you measure success to what you are like as an investor. If you constantly worry about everything and have relatively little financial knowledge, then you may have to accept market returns with index investing. You may also have to accept lower returns by adding in treasury bonds to reduce portfolio volatility until you can sleep at night. Over 20 year periods and longer, treasury bonds have always lost relative to the US stock market. But that is of no use if you are the type to panic in a market crash because you have low knowledge and a tendency towards high anxiety. In that case, you would do well to accept the lower, more stable returns that allow you to buy and hold.
I think the best investors understand not only the markets and financials of stocks, but also they understand themselves extremely well. Do not ignore your own emotional and behavioral tendencies as you invest, or you will almost certainly underperform. Take a long hard look at yourself under the microscope and figure out what you need to drive the behaviors that the best investors practice.
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