Saturday, December 7, 2013

Nothing Should be More Important to Investors

"Ultimately, nothing should be more important to investors than the ability to sleep soundly at night." - Seth Klarman  
In a recent post about becoming a more patient investor, one of the tips I shared was to stay reasonably diversified because having a highly-concentrated portfolio would likely keep you up at night and lead to impatient trading decisions.

Upon further reflection, this advice was a bit off the mark as it was specific to my own investing personality and isn't a universal law. For other investors, a highly-concentrated portfolio of thoroughly-researched investments may provide them more than enough comfort, while others may only feel comfortable in broadly-diversified index funds.

Homer gets it
Each investor's risk-taking personality is different -- it could be in our genes -- but the key is to invest in a manner that lets you sleep at night without worrying what the next trading day, week, or month might bring.

At the core of this discussion is anxiety produced by our investment decisions. Losing sleep may be a consequence of the anxiety -- it can also manifest itself in nail biting, smoking, pacing, or at worst, panic attacks -- but it's the root cause of what we need to avoid as patient investors.

When we're anxious as investors, we're not acting as investors at all -- we're simply speculating and we're much more prone to making destructive short-term decisions.

Thinking about it this week, I see five main causes for undue investment-related anxiety:

  1. Investing outside of your core competency: Remember Peter Lynch's principle #5: "Never invest in any idea that you can't illustrate with a crayon." If you don't understand the business, you're more likely to become overly concerned about temporary issues or not concerned enough about long-term issues. 
  2. Not doing your own research: Whether you're getting investment ideas from a friend, newsletter, or financial website, it's important to look into the company yourself and decide whether or not you agree with the idea. There are pretty good odds you're not going to miss the opportunity if you wait 24 hours after hearing the idea to do your own research. 
  3. Employing unsuitable amounts of leverage: For the individual investor, leverage most often comes in the form of margin borrowing or options strategies. While both of these tools in themselves are not bad, they can serve to magnify both gains and losses and should be used with caution. 
  4. Being a forced buyer or seller: One advantage of being an individual investor is that we typically don't need to be forced buyers or sellers as we don't have clients giving and taking money to and from our funds on a regular basis. Still, we can fall victim to being a forced trader when inappropriately using leverage or investing short-term money in long-term assets.
  5. Reaching for return: In The Most Important Thing, Howard Marks recalls, "It's remarkable how many leading competitors from our early years are no longer leading competitors (or competitors at all). While a number faltered because of flaws in their organization or business model, others disappeared because they insisted on pursuing high returns in low-return environments." This a particularly important point to remember in today's market and dividend investors, for example, who are reaching for ultra high yields (more than 2.5x the market average) are exposing themselves to ultra high risks

Why aren't market movements one of the causes of anxiety? Don't get me wrong, I don't enjoy seeing my portfolio lose money any more than the next person, but if we truly are patient long-term investors and can avoid subjecting ourselves to the five root causes of investment-related anxiety, short-term fluctuations shouldn't result in unmanageable levels of anxiety. In fact, we can even use Mr. Market's anxiety to our advantage by being prepared to buy when he's despondent and sell when he's euphoric.

There are countless investment quotes and sayings worth keeping in mind, but the Klarman quote at the beginning of this post is one of the dozen or so that's worth worth writing down and keeping near your desk. It's a good reminder to always invest in a manner that lets you avoid high levels anxiety as it will allow you to stick to your strategy regardless of what the market is doing in the short-term.

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Good reads this week:

Quote of the week: 
"As a rule," said Holmes, "the more bizarre a thing is the less mysterious it proves to be." - Sir Arthur Conan Doyle