The Antidote to Market Fears and How It Can Save Your Portfolio

Everyone who invests has heard the most common investing clichés:

“buy low and sell high”

“invest for the long term”

“buy what you know”

“be fearful when others are greedy and greedy when others are fearful”

“the market never moves in a straight line”

These sayings have all become clichés because they are all broadly true. Unfortunately, that doesn’t help the majority of investors who often behave in the complete opposite way.

As most investors know, we experienced a sharp correction in the market in the final three months of 2018. According to the clichés, this should have been the time when opportunistic investors should have been buying into new investments they understood, while at the same time holding the investments they already owned with the trust that their market prices would come back. Instead we get headlines like this “Investors Flee Stock and Bond Funds in Record Numbers in December”. This most recent trend has been exacerbated by the increasing numbers of investors who invest through a passive index ETF or by those investors who invest as a do-it-yourself investor.  Both of these types of investors are more prone to this kind of behavior.  At the point where the prices were at their lowest, that was the exact point where the selling was at its highest amount.

This is of course, no co-incidence, as the large amounts of selling is what causes the lower prices. It’s simple supply and demand. But why are so many investors incapable of resisting the urge to sell? 

I think that the number one reason is fear. Fear can be a very powerful emotion and it often serves to override our logical, rational brain to our own detriment. Everyone who has experienced a true market crash can appreciate this. The fear that losses that have already occurred are only a precursor to even greater losses fuels investors worst nightmares about their investments. These fears quickly override any realistic appraisals of the situation as investors imagine increasingly worse and worse scenarios. This type of behavior is common for amateur investors but can also happen with seasoned investors. 

This type of scenario was described by Howard Marks in his book “Mastering the Market Cycle – How to get the Odds on Your Side”. In the book Marks describes how investors pessimism and fear during a downturn can be extremely excessive. In Chapter 8, Marks describes a meeting with a pension fund where Mark’s company was pitching the pension fund on a potential investment in the depths of the 2008 crisis. Here is an excerpt of the conversation from the book:

Marks – The worst 5 year period we’ve ever had showed defaults averaging 3% per year, obviously not a problem relative to the yields we’re talking about.

Pension Fund – But what if it’s worse than that?

Marks – The average default rates in the high yield bond universe, without assuming any ability to avoid defaults through skillful credit selection, has been 4.2% per year. Resulting credit losses of 2-3% clearly wouldn’t do much to jeapordize the results on this investment.

Pension Fund – But what if it’s worse than that?

Marks – The worst 5 years in history for the universe averaged 7.3%. Still not a problem.

Pension Fund – But what if it’s worse than that?

Marks – The worst 1 year default rates in the High Yield Bond History was 12.8%. That still leaves plenty of return here.

Pension Fund – But what if it’s worse than that?

Marks – 1.5 times the worst year in history would be 19% and we would still make a little money given the portfolio yield in the 20s, and for such a minimal return to result, defaults of that magnitude would have to happen every year, not just once.

Pension Fund – But what if it’s worse than that?

I think these types of conversations illustrate how fearful investors can become, even if they are professional investors like a pension fund. No level of safety is able to comfort the investor and they are not willing to invest at virtually any price. At the same time, they are also unwilling to stay invested at any price. Over the past few months I have had many discussions with clients which are similar to the one above, and that is with a relatively run of the mill market correction.

This behaviour is EXTREMELY destructive to an investor’s returns and when it happens, it is often impossible to recover from. So how can we try and avoid it?

Well to my knowledge the only remedy to this kind of emotional behavior is truly understanding your investments. You need to understand the businesses that you own, and why you should feel comfortable being invested for the long term. If you draw the comparison to a family business or even a rental property you might own, very few investors would sell their investment just because the market price of that investment dropped. That’s because the owner has a great deal of personal knowledge about the investment. Their fear is pre-empted by their knowledge. When you buy a publicly traded business, your approach shouldn’t be any different.

When we invest in a business we look for a few key ingredients.

1.      A stable or growing business with consistently high profitability of the business

2.      A competitive advantage or moat which protects the business from competitors

3.      Low debt relative to the cash the business generates which is usually a by-product of good and effective management

4.      A market price which is trading at a significant discount to its intrinsic value

When you truly understand the business, you are really putting the odds in your favour. If you don’t fully understand the business or have knowledge of the profitability or debt numbers, you are no longer investing.  You are gambling, and in my view the fear of losing all your money is justified.

Of course many of our clients don’t have the time, education, or experience to assess a publicly traded company. It takes a lot of time and effort to analyze a business, and even the very best can still make mistakes. As such, our clients often rely on our expertise and knowledge to select the investments for them. Part of my job is to educate our clients on what they own so that they will have the knowledge they need to truly understand the business they have invested in. By doing this, it’s my hope that we can alleviate a lot of the fear which comes from these periodic market corrections, and by extension avoid the most destructive investor behavior that can happen at those times. If you have any questions about your portfolio, or even just about a particular investment, I’d love to talk to you about it.