The evidence in favour of value investing is overwhelming. For example, value stocks (those with a low price-to-earnings ratio or price-to-book-value ratio) outperform, on average, growth stocks (those with a high P/E or P/BV), and the more a fund behaves like a value investor – the more concentrated a fund is – the better it does, just to mention some of the evidence.
If this is so, why isn’t everyone a value investor? Why don’t we all do the right thing? Our human nature prevents us from doing the right thing. We are all subject to irrational behaviour. We are not patient and nor are we disciplined. We tend to extrapolate past performance, we are overly optimistic about our abilities, we overreact and, most important, we succumb to herd thinking – that the crowd is right.
A case in point: In a study carried out by investment manager Blackrock entitled “Investing and Emotions,” researchers showed that, from 1992 to 2011, the average mutual fund investor made, on average, 2.3 per cent, whereas the equity mutual funds in which these investors had invested made, on average, 8.2 per cent. How is this possible? Simple, investors tend to buy high and sell low. They are euphoric at market peaks and panic-stricken at market bottoms. Market timing leads to underperformance.
Another case in point: The Business Insider blog recently reported Fidelity analysts found that people who had forgotten they had an account at Fidelity outperformed other accounts. The fact that these accounts were forgotten prevented their holders from making buying or selling decisions driven by their emotions, and so they outperformed.
With this backdrop, here is my advice. To be a successful investor you need the following:
1. Reasonably good intelligence
As Warren Buffett says “investing is not a complicated game, it simple, but it is not easy. It is not an issue of high IQ, but rather an emotional stability and inner peace about the decisions you have made. If you are in the investment business and have an IQ of 150, sell 30 points to someone else.” He has also said that the wealthy people he knows, while they are very intelligent, their competitive advantage is not their intelligence. It is more their ability to approach their investments with “a cool head and a steady hand.” An MBA or CFA is not sufficient to become a successful investor. In fact, one of the most successful value investors in Canada - Francis Chou - has only a Grade 12 education.
2. Sound principles of operation
Understanding the business in which a company operates and its business model is one of the most important steps in successful investing. Determining a company’s intrinsic value starts with a deep understanding of the company’s business and its markets.
Making investment decisions using the concept of the margin of safety is also paramount in protecting an investment’s downside. Investors should not feel the urge to invest; they should invest only when the margin of safety is met. They must take advantage of market movements as opposed to following them. As Mr. Buffett says, “Be greedy when others are fearful and fearful when others are greedy.” This implies a lot of patience and discipline.
If time and expertise are an issue, investors should gravitate toward fund managers who follow a value investing approach and have concentrated portfolios, as these managers tend to outperform. Avoid managers who are closet indexers, as they seldom outperform. And remember, you should invest in the best ideas with conviction or with the managers who have conviction. This implies finding good investments and putting a lot of money into them. Unless you are willing to put a lot of money into an investment, you should not expect to get much out of it.
3. Firmness of character
An investor should understand the weaknesses of human nature, identify them in himself and try to correct them or develop strategies to deal with them. How? Investors must avoid making impulsive decisions. They should step back and think things over – the market is not going to run away. One should always think of the opposite. The crowd is never right, as value investor and Baupost Group founder Seth Klarman says.
Investing based on the consensus leads to paying a high price which, in turn, leads to underperformance. Being independent and doing your own homework protects you against the conflicts that everyone in the money management business has. “Much of this business is a marketing business that happens to sell investments” as a Wall Street Journal article recently put it.
Moreover, investors should be analytical. Being analytical and having a well-structured process helps you avoid making decisions that are driven by emotions. Finally, have a checklist – when to buy, why to buy, what to buy and when to sell. Having a checklist helps investors make investment decisions when there is high risk. Airline pilots know this well.
The weaknesses of human nature are not going to go away, but following the advice outlined above will help you make better investment decisions.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western OntarioReport Typo/Error
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