Passionflower, useful in anger management. Photo: PumpkinSky. Source: Wikimedia
In the short-run stocks are driven by our emotions. A company’s stock may be up 4% one day and down 7% the next, based on a of couple analysts’ comments. But has the fundamental value changed that much in 48 hours? Probably not. John Maynard Keynes once noted that the market can be a beauty contest, where judges don’t choose who they think is the best-looking contestant, but the one they think the other judges will choose.
But a company’s true value comes from inside: its sales, cashflow, and operating results, not the vagaries of the market. In the long run, it’s earnings, not emotions, that determine what a firm is worth. Still, the market’s wiggles and jiggles get us amped up or depressed—and encourage us to do foolish things. So how do we take emotions out of investing?
One way is to set up automatic systems. Buy into the market on a regular basis. Rebalance a portfolio when it gets out of line. Back in 2000, it was tough to sell stocks and buy bonds – stocks had been so strong, and bonds were boring. Conversely, it was even harder to sell safe bonds and buy stocks in 2009. But if you took both of those actions, a balanced portfolio outperformed an all-stock portfolio over the 20 years from 1995 to 2015, with a lot less risk.
The famous investor Sir John Templeton used to set triggers for himself well below the market: automatic orders that would force him to buy. Wise as he was, he knew that he would rationalize not buying when the market came down to his level. Another investor doesn’t bother to learn the names of the companies he owns. He doesn’t want to be influenced by their “stories” when it comes time to sell. The rational reason to own an asset is to make money. They’re not friends; they’re not family. If they won’t make you money, get rid of them.
It’s a paradox: the market acts irrationally, but rewards rationality. Ben Graham said he had a partner named Mr. Market, a moody fellow who suffers from episodes of mania and depression. He wouldn’t listen to his partner, but he would sometimes take what Mr. Market was offering cheaply, and later sell to him what he was obsessed with owning. This approach enabled Graham – and other classic value investors – to be immensely successful.
Ben Graham. Source: Wikimedia
Graham also once said that in the short run the market is a voting machine, counting dollars but not sense. But in the long run it’s a weighing machine, measuring operating performance. Because stories may entertain us, but they don’t make us money.
Douglas R. Tengdin, CFA