To understand the market, we can see it as a hypothetical investor driven by panic, euphoria and apathy on any given day. Investing is a reaction to this mood. Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced. The more extreme the swing, the faster the reversal.
Stocks can be volatile, that is the nature of a market that allows the public to vote prices in, and you must remember that volatility is not just prices going down, but up as well, and this is where outperformance comes from.
There are only three things that can happen to a stock – it goes up, down, or stays the same. Should not be surprised when one of this happens; even Berkshire Hathaway has seen its stock price decline by 50% from top to bottom three times since the 1970s.
The fact of the matter is:
- Out of the top quartile (best-performing 25 percent) of managers over a recent decade, almost all of these top-performing managers (96 percent) spent at least one three-year period during that decade in the bottom half of the performance rankings.
- Even more telling, 79 percent spent at least three years in the bottom quartile (bottom 25 percent of managers) and a staggering 47 percent spent at least three years in the bottom 10 percent.
- In other words, even the best-performing managers go through long periods of significant underperformance.
Fighting market psychology
I remember when I started investing the same six months that the US got downgraded for the first time from AAA to AA and the Eurozone crisis was in full force. I remember we made 16% a couple of months and went back to our initial capital and we lost 2%. That was within the first six to eight months. The companies I’m dealing with weren’t even small companies. We’re talking about blue chips like Microsoft and Dell, these are great companies. These are the biggest companies in the US.
That’s when I really learned the habit of — you’re going to be greedy when times are bad and cautious when people are buying heads over heels. What kept me sane throughout all these years is simply that you need to assess operating position of the firm and not the stock prices.
Investing is a long-term strategy, but people react to short-term signals all the time because of how the system is set-up to allow for ease of trade. Though it is a huge advantage to have access to the market every day, you don’t need to react to (if you are not paid based on trading activity).
In a severe recession, all asset prices fall and the ones with the most liquidity tend to be sold off first. So instead of reacting with panic, exploit it – recessions and cheap prices are one of the best times to invest.
Also, never assess the success of the portfolio from one stock. Unfortunately, we are the best people at fooling ourselves. We fool ourselves all the time. If your stock that goes up 1,000%, you think suddenly you’re a genius. Unfortunately, you can’t eat the return from one stock. It doesn’t matter if you make a hundred percent from one stock if everything else went to zero. You need to assess your entire portfolio.
Never invest money you need in five years’ time. Sometimes you never know. You run into a crisis like 2008/09. Things do happen, s#!+ happens. You always want to give yourself a buffer period. If you think you need money next year, next six months, do yourself a favor: Don’t say you’re investing in the long run, you’re not.
So to summarize, the 4 strategies to overcome the effects of market psychology:
- Build a reflective habit of being greedy when times are bad, and to be far more cautious when people are buying heads over heels
- Assess the operating positions of firms (fundamentals), not their stock prices
- Avoiding leveraged industries will help you not to lose sleep
- Never assess the success of your portfolio from one It doesn’t matter if you make a hundred percent from one stock if everything else goes to zero