We human inhabitants of the 21st century like to think of ourselves as sophisticated, rational actors. Alert to nuance, loaded (perhaps flooded) with information, we believe that when adversity is present we will act calmly and intelligently. We flatter ourselves. At the back of our brains is a frightened animal. When danger is perceived, that animal part of our brains takes charge. Psychologists tell us that flight from danger is probably the earliest and most deeply seated of the various types of behaviour by which animals react to conditions which threaten their existence or their integrity. Quite simply, when danger is perceived, we are predisposed to take action. If you are standing around on the savanna and a lion (or a bear) appears, doing nothing is probably a bad choice. When that frightened animal part of us is connected to the stock market, we get events like those now unfolding.
John Maynard Keynes knew this. In 1936 he wrote:
Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities
In spite of what Keynes wrote, when I studied economics forty-five years ago, the standard models of behaviour were based on emotionless, highly informed and highly rational participants in the economy. No animal brain motivates behaviour in these admirable and predictable folks. They think before acting, assess risk and reward and always do the sensible thing. The behavioural economists, arriving in the past twenty years, labelled these mostly mythical fellows as “econs”, and noted that econs, far from being the norm, are at best, scarce.
I believe that our job as portfolio managers is to act, as much as we can, like an econ, and as little as we can, like a scared animal. This belief is based on experience and our understanding of how markets work.
We cannot time the market. We don’t think anyone can. We buy stocks after analysis and careful consideration. We are fully aware the market may not agree with us for quite some time. We can point to endless examples of stocks that were unloved until someone with deep pockets recognized their value.
We don’t sell stocks after we buy them simply because the market does not like them. The market is best viewed as a popularity contest in the short run, and we don’t pick stocks based on popularity. In the long run the market does recognize value. We have seen it time after time in our portfolio holdings over the past 18 years. The most important skill for an investor (at least our kind of investor) is to learn to ignore short term market fluctuations and concentrate on the important information – how is the company actually performing, what are its prospects, is the valuation cheap, reasonable or expensive. If we believe that the fundamentals have not changed we will never sell a stock based only on its popularity or unpopularity.
Sometimes we have the opportunity to buy more of stocks we like at a lower price when they are unpopular, and this is obviously a good thing when not taken to extremes. We construct and maintain diversified portfolios and this takes priority over acting in an undisciplined way, even if we think it is opportunistic. This is the best protection against the erosion of capital. Having 3% of a portfolio in a stock that goes down 20% is tolerable. Having 10% or 15% in that one holding may not be. As Warren Buffet, the great investor has taught us, job #1 is not losing money.
Since we do not market-time, we value the discipline of diversification over the lure of going bargain hunting. We do recognize that sometimes we are wrong, and that not every pick works out. We don’t want to make what I call the Nortel Error – mistaking a lower price as good value, and buying a stock as it falls, and falls, and falls.
This is our core philosophy, our investing DNA. It has served our investors well over 18 years.
