Don’t confuse good markets with good investments
By David Haggard, CFA®, CFP
When inexperienced people decide to trade in the stock market, they tend to make three mistakes:
They buy what they know, or what they feel and believe they know, often a popular, well-respected brand.
They become masters of rationalizing unsubstantiated decisions: “Look how well it has performed in the last five years.”
They don’t understand risk, so they ignore it.
Let’s imagine a family considering buying stock in a well-known Fortune 500 company. Over the years this has been a solid investment. It has grown steadily, earned a AAA rating and avoided excess debt. Great company, great brand, easy to consider it a winner by any measure.
So what’s the problem?
They are looking at this investment from the outside (its brand, its image, its past performance) and ignoring the effects of the current market. If the company’s stock is trading at 50 times earnings (an all-time high), it’s still a great company. It’s just not a good investment at that time.
How do you avoid this mistake? Look at the company from the inside, that is, its financial profile. Put aside the brand image or even what the company makes. What do the financials look like? Let’s say your due diligence leads you to conclude that its share price should be $100, but it’s trading at $300. At that level it’s not a good buy; at $50 a share it’s a great buy.
When you find out the company makes inexpensive paper products, you won’t care. The numbers, not the image, will guide you to a smart investment decision.
The lesson is simple: Follow the math, not the narrative. In a recent article, I wrote about the fallacy of buyers’ expectations, the belief that because a stock went up recently, it will continue to go up. Following the narrative of brand and image and not the math is the same song, second verse. Every time I hear Dr. Anthony Fauci urge us to “follow the science,” I smile because it’s as good a piece of advice in managing a portfolio as it is in crushing the curve of a pandemic.
People are adept at rationalizing their decisions and behavior in both arenas. In investing, there are consequences to perceptions of value built upon fables, rumors, biases and unfounded expectations. In public health, either science will encourage wide-spread mask wearing or rationalized biased misinformation, quite possibly, will lead to further spread.
At the base of all this is how we handle risk. Human nature tends to concentrate our thinking on outcomes. How large a return can we make on any given investment? After fantasizing about success, we spend as little time as possible assessing risk. That’s doing it exactly backward. Risk assessment should always be the first step. Is this the right investment at the right time and in perfect fit inside a larger investment strategy? Do I understand why, and can I quantify my reasoning?
Assessing risk means first acknowledging its possibility. That’s what an Investment Policy Statement initiates by focusing attention on upfront risk, not end-of-the-rainbow returns. Risk is nothing more than probabilities about outcomes. If you’re gambling a dollar and the probabilities are one in 10 that you might lose it, the risk is low. If you’re putting your retirement and quality of life on the line, the risk is far greater.
Here’s a guideline that’s easy to remember, harder to follow. When the markets go down, the tolerance for risk is higher. When the markets go up, tolerance goes down.
That’s why I see my job primarily as bringing order to the chaos we call risk.
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