Overconfidence in ourselves is what has driven the human spirit forward. Belief in ourselves regardless of naysayers is one of the sources of innovation and progress. We are drawn to people with this trait innately. It can win wars and create prosperity. But when abused and wrongfully channeled, it brings misery and destruction. Ponzi schemers, frauds and cheats are in many cases extremely charismatic and overconfident. In investing, be mindful of your nature.
Going Against The Grain
The stock market is one of the places where overconfidence is dangerous. However, by design, intelligent investing (buying low, selling high) requires confidence. The confidence to trust yourself, to ignore the street and to go against the grain. The feeling you get when you find a stock that checks all the right boxes for the right price gets you excited. The danger is when this confidence turns into overconfidence. Since the stock doesn’t know you own it, you should never get attached. If you’re overconfident, you are vulnerable to confirmation bias and start to ignore information that goes against your narrative.
Now, isn’t this itself contradictory with the belief to ignore the street? If the collective minds of the market have established that a company deserves a low price, why would you be any smarter than them and come to different conclusions?
Understanding The Drop
When a stock is down and the lowered price gets your attention, before investing, you must understand the reasons for its downfall. There can be many, and certainly you should stay away from companies accused of fraud, abuse or manipulation. Understanding the institutional imperative is also important.
Perhaps a quarter didn’t live up to expectations, or EPS came in 2 cents shorter than the street’s consensus. A successful company will draw attention and capital to itself like flies to dirt. The longer this success continues, the higher expectations the street puts on the stock (reflected as a rising price). Unfortunately for the street and speculators alike, businesses are not calculators, nor clocks. Business is cyclical by nature. They go through good periods and bad periods. Just as we humans do. And business is run by humans. Why should we believe an entity of people is not subject to the flaws and shortcomings of humans?
The best scenario is when a stock plunges due to reasons that have nothing to do with its core fundamentals. There can be many, but if you can conclude the following, keep researching the company.
- A general market drop, pulling all companies down.
- A missed, high expectations quarter that punishes a stock seemingly unjustly considering its fundamentals.
- A non-fundamental scandal that you can safely conclude will be forgotten within a few years. A few examples: Volkswagen Emissions Scandal, Noro Virus found in one of Chipotle’s restaurants, American Express Salad Oil Scandal.
Remember, institutional holders’ fears are contagious. If one large holder sells, it won’t require much for others to follow. This causes an imbalance in the stocks demand and supply, since there are now more sellers than buyers. And obviously in a buyers market, prices go down.
Invert, Always Invert
Charlie Munger has said that in investing, you should always invert. What this means is that before you invest, you analyze the worst case scenarios and how they could happen. This is why valuation is important. You need to have different conclusions made. Be mindful of overconfidence towards the best outcome. What really matters is how you take into account the downside. This is why you must always look for a margin of safety.
As an intelligent investor, you understand that price and value are not always in equilibrium. Mr. Market’s moods cannot be predicted. He exists to serve you, not to instruct. In the long-run, he will always self-correct his mistakes. Undervalued or overvalued cannot stay as such forever, and price will reflect value. You just don’t know when he comes to his senses.
Conclusion
Some of the greatest investors (e.g. Seth Klarman) have a rule to not talk about their investing ideas. The reason is not that they are big secrets. Instead, they believe that if they talk about an idea, their mind will be steered towards having a bias in defending their position. They understand that they can be wrong, so they are not taking chances with human nature and thus avoid succumbing to overconfidence or confirmation bias. Smart indeed.
Remember that Mr. Market has a short attention span. Most institutional investors do not have a long-term perspective and equate volatility with risk. In many cases they do not think of themselves as business owners, and stocks are just a part of a portfolio diversification strategy that includes different asset classes (e.g. part stocks/bonds/metals/real estate etc.). If one area of the portfolio starts to lag, chances are they will want less weighting of said asset class and start selling.
Your ability to control your emotions, always buying with a margin of safety, understanding the reasons for a price drop and using time-arbitrage can be the best weapons in your investing arsenal.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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