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Do you know who your worst enemy in investing is?

It is you. Your human nature, that is. Humans are not rational. They panic, they get greedy, they herd, and the list goes on.

A few years ago Blackstone produced a report in which they showed that even though the average equity mutual fund in the US averaged 8.2% over the last 30 years, investors who invested in these funds averaged only 2%. The reason was investors tried to time the market. They were panic stricken at the bottom of the market and exuberant at the top. So they sold at the bottom and bought at the top. Individual investors are the worst market timers. They invest as a herd at the top of the market. This seems to have happened the last few months before COVID-19 hit the world. And they are getting out at the bottom, and this is what has been happening at this time.

It is true that companies with a lot of debt may go bankrupt. Investors who have invested in these companies will have permanent loss of capital. This is how we define risk in value investing. Risk is not volatility. Volatility is good as it allows us to buy cheap. As Howard Marks says you can ride out volatility, but you cannot undo a permanent loss of capital.

That is why value investors avoid companies with a lot of debt as they will go bankrupt and in this case we have permanent loss of capital. Same is also true when you invest on margin, you may have permanent loss of capital as you may be forced to sell at a point in time that such an action is not desirable. But modern portfolio theory emphasizes volatility as a measure of risk, as it is something that can be measure, irrespective of whether it is a correct definition of risk or not. It also emphasizes diversification as a substitute for due diligence. Both of which value investors reject. We reject this coin tossing view of risk.

The coin tossing view of risk refers only to the risk we know we do not know, like playing roulette – we know the odds but we do not know which number will come up. However, in real life we are also faced with the risk we do not know we do not know, the fat tails risk, the black swans. This is what we are experiencing right now and no diversification would have saved investors from losses. Due diligence and the margin of safety requirement that value investors observe prior to investing always help minimize losses.

In this COVID 19 environment, companies that are well managed with the right business model and little debt have nothing to fear. But this is not how the markets price them. The value of a stock is the present value of future cash flows to infinity, for companies without financial distress. It may be true that next year cash flows could be negative, but the model goes to infinity and this should be small potato in the long run, unless one feels that there will be a permanent impairment of a company's business and its balance sheet due to the crisis. I believe one can find great companies at great prices these days.

But again human nature comes to impede our actions.

A quote from Seth Klarman is in order here: “When prices are high the perceived risk is low but the actual risk is high and when prices are low the perceived risk is high, but the actual risk is low.” And as Sir John Templeton used to say the best time to invest is when there is blood in the streets, which Warren Buffett echoes when he advises people to be fearful when others are greedy and greedy when others are fearful

Of course all this goes against human nature. It is in our DNA to run away when we are faced with risk. This helped our ancestors survive, but in investing it does not work this way. And modern portfolio theory taught at universities around the world makes things worse. That is why Seth Klarman wants his company to hire people young before they are exposed to the harmful influence of this theory.

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 Ontario.

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