One of Warren Buffett’s most famous sayings is: “To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” The challenge for investors is that, as humans, we’ve evolved from hunters and gatherers and are hardwired to feel fear. In fact, fear is our most basic emotion.
One of the best explanations I’ve found to describe why this is the case can be found in the insightful book ‘Sapiens‘, by Yuval Noah Harari. Mr Harari explains ..
“For millions of years, humans hunted smaller creatures and gathered what they could, all the while being hunted by larger predators. It was only 400,000 years ago that several species of man began to hunt large game on a regular basis, and only in the last 100,000 years with the rise of Homo sapiens that man jumped to the top of the food chain.
That spectacular leap from the middle to the top had enormous consequences. Other animals at the top of the pyramid, such as lions and sharks, evolved into that position very gradually, over millions of years. This enabled the ecosystem to develop checks and balances that prevent lions and sharks from wreaking too much havoc. As lions became deadlier, so gazelles evolved to run faster, hyenas to cooperate better, and rhinoceroses to be more bad-tempered. In contrast, humankind ascended to the top so quickly that the ecosystem was not given time to adjust. Moreover, humans themselves failed to adjust. Most top predators of the planet are majestic creatures. Millions of years of domination have filled them with self-confidence. Sapiens by contrast is more like a banana republic dictator. Having so recently been one of the underdogs of the savannah, we are full of fears and anxieties over our position.”
Burdened by fears, it’s little wonder the average investor underperforms the stock market. When we are fearful, our decision making is sub-optimal. We do the wrong things at the wrong time.
“Psychologists have persistently shown that pressures, anxieties, tensions and fears seriously degrade our skills as decision makers.” W Morris 
Most investors sell when they are fearful and wait until conditions improve before they re-enter the market. They sell low and buy high.
And it’s not easy to make the adjustment required for better investment results. But it’s critical if we wish to succeed.
“Fear is overdone concern that prevents investors from taking constructive action when they should.” Howard Marks
“Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.” Walter Schloss
“To remain calm and rational in the face of wild fluctuations in stock prices is, beyond the shadow of a doubt, the most significant quality an investor can have or try to have.” Francois Rochon
“Emotional mitigation – you’re trying to find some way to mitigate the emotional dimension which is constantly driving people to make incorrect decisions. Data that’s accumulating from behavioural finance substantiates the fact we are, by and large, horribly wired to be objective.” William Browne
The good news is that there are strategies an investor can employ to help overcome investment fears and stay the course for better investment returns. These include:
Know What You Own
When you know what you own, you’re far less likely to be influenced by the actions of others and take your cues from the stock price. Imagine yourself standing in your office and seeing a lion on the other side of the glass. If you’re like most people, you’d run. But imagine, the prior day you’d accidentally driven your car into the glass at high speed and bounced off. Later you found out it was toughened glass that not even a truck could drive through. With that knowledge in hand, you wouldn’t run, no matter how large or aggressive the lion was.
And so it is with stocks; when you have confidence in the underlying business through a detailed assessment of the company, you’re far more likely to act rationally when others are fleeing. You won’t take price action as conveying news.
“Fear is overcome by clarity.” Bennett Goodspeed
“Knowledge is the antidote to fear.” Ralph Waldo Emerson
You may remember me writing about walking past someone on the street who is looking up, and without thought, or knowledge as to why, many of us will simply follow suit. Basically, in the absence of information, you’ll look to others for guidance. Similarly in investing, most investors don’t do the work to understand the businesses they own, so it’s easy to see how the crowd can over react. They think someone else knows more and so jump onto that bandwagon, causing a negative feedback loop to emerge. The price becomes the news and stocks trade at levels far from what the fundamentals would suggest appropriate.
“[As humans] we imitate without thinking. Especially when many or similar people do it, when we are uncertain, in an unfamiliar environment, in a crowd, lack knowledge, or we suffer from stress or low self esteem.” Peter Bevelin
“Be undeterred by fears or hopes based on conjectures, or conclusions based on surmises” Phil Fisher
Armed with knowledge you can take advantage of fear.
“We like it when others become fearful of the future. Particularly if they sell shares of companies we own (and would want to increase our ownership) at better prices!” Francois Rochon
“[During scary periods such as major market panics] you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted.” Warren Buffett
Don’t Rely On Tips
When you rely on a tip, you’ve outsourced the thinking to someone else. And there may not be a lot of thinking or analysis behind that tip. Furthermore, you can’t possibly know the right thing to do should the share price start falling.
“In a panic it is not easy to avoid being swept along with the mad tide. [I] emphasize one thing – the importance of getting the facts of a situation free from tips, inside dope, or wishful thinking. In the search for facts I learned that one had to be as unimpassioned as an surgeon. And if one had the facts right, one could stand with confidence against the will or whims of those who were supposed to know best.” Bernard Baruch
“A smart man cannot follow another man blindly even though the other man is right, because you cannot have the confidence and act on advice when you do not know what it is based on.” William D Gann
Do The Work
“There is an advantage to gathering your own information and making decisions based on facts that you have gathered yourself. Investing is more of an emotional than intellectual exercise, and it becomes very hard to stay on an even keel and to make rational, unbiased judgements if you’re making them based on someone else’s information.
“So if my buddy at hedge fund XYZ tells me that such and such company is a great investment, or if you go to any of these conferences where someone really smart comes up and makes a bold case on whatever company, it may seem compelling at first. So you think, “Maybe I’ll go out and buy it.” Then the stock goes down 40% and you get nervous. How much time did that really smart guy who made the original pitch spend thinking about this issue that is pressuring the stock? You don’t know, because you didn’t do your own work.
When you’re lost in the fog, you tend to make bad decisions because you’re scared. That’s why to me, you don’t necessarily have to know more than the next guy to have an informational advantage. But you are most certainly at an informational disadvantage if you haven’t made the effort to gather enough information to make an informed decision.” John Harris
“Doing the analysis yourself gives you the confidence buying securities when a lot of the external factors are negative. It gives you something to hang your hat on.” Peter Cundill
Acknowledge Markets will be Volatile
“We are always psychologically ready for recessions or market corrections.” Francois Rochon
Buy Value / Seek a Margin of Safety
When you buy stocks based on value criteria and buy with a margin of safety you’re more likely to have the confidence to hold on should markets turn down. By having an estimate of the value of the underlying businesses you own you have something to anchor to while others sell in despair.
Furthermore, stocks bought with a large margin of safety are more likely to hold up in difficult investment environments.
“You might want to give some thought to how you’ll fare if the future doesn’t oblige. In short, what is it that makes outcomes tolerable even when the future doesn’t live up to your expectations? The answer is margin for error.” Howard Marks
Buy Quality Companies
If you buy quality companies, those with good balance sheets, enduring competitive advantages and strong management, you can be more confident that the business will endure.
“People don’t believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50 year flood, which is what 2008 was, and live to take advantage of it.” Jeffrey Ubben
Take the Time to Think
It’s natural for humans to act on emotion, without thinking. It’s hardwired into our DNA. The world’s best investors however have developed the ability to detach from their emotions and make good decisions. Before investing, try and consider what could go wrong.
When acting on an investment, take the time to consider whether you may be over-reacting to market noise. When a stock price falls in relation to stock specific news, its important to consider the implications of the news on the company’s earnings over the long term. I’ve seen plenty of examples where a small earnings miss wipes hundreds of millions off a stock’s market capitalization, which is many multiples of the implicit value of the miss. Just sitting back and considering whether that makes sense is a worthwhile exercise.
“‘If noise behind the bush, then run’. It is a natural tendency to act on impulse – to use emotions before reason. The behavior that was critical for survival and reproduction in our evolutionary history still applies today.” Peter Bevelin
Focus on the Facts Not the Story
“We must focus on facts – as Dragnet fans will recall, “Just the facts.” Stories usually have an emotional content, hence they appeal to the X-system – the quick and dirty way of thinking. If you want to use the more logical system of thought (the C-system), then you must focus on the facts. Generally, facts are emotionally cold, and thus will pass from the X-system to the C-system.” James Montier
Recognize the Crowd Might Be Wrong
If you maintain a contrarian mindset, and start with the premise that most investors do the wrong thing at the wrong time, you are less likely to be panicked and act on emotion when others do. That’s not to say, you should blindly buy when others are selling or selling when others are buying; the facts must determine that.
“When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.” Warren Buffett
“None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.” Warren Buffett
Test Investment Ideas / Understand the Counter Arguments
Testing your investment thesis and seeking out and considering contrarian views can give you confidence to hold positions you may otherwise look to sell.
“I’m not entitled to have an opinion unless I can state the arguments against my position better than the people who are in opposition. I think that I am qualified to speak only when I’ve reached that state.” Charlie Munger
Diversify / Size you Positions
It’s inevitable as an investor that some investments won’t work out as you expected. That’s an unfortunate fact of life. But by ensuring your portfolio holds a collection of securities across a diverse cross section of industries, and maintaining position sizes that are appropriate, will help you maintain a rational viewpoint should a specific event impact those securities.
It is at the height of fear when we are most likely to act on emotion. Having a plan ahead of time which has been developed when you are in an unemotional state, will improve your investment results.
“[Investors should] prepare and pre-commit. We should do our investment research when we are in a cold, rational state – and when nothing much is happening in the markets – and then-pre-commit to following our own analysis and prepared action steps.” James Montier
“When we go into a stock, one of the things we ask ourselves once we’ve decide to buy is ‘what will make us wrong.’ We try and decide in advance how strong the investment case is and when will we know that we are wrong. One of the things we have learnt over the years is that you don’t let the stock price tell you if you are wrong. The stock price might tell you something is going to go wrong, but the stock price by itself doesn’t contain any information, especially in this environment when everything is algorithmic and where prices are being marked against each other every day.” Bill Miller
“[You must] have the discipline to stay with your strategy when the market tests your confidence, as it inevitably will.” Leon Levy
“At the time of maximum pain, you need to maintain your discipline.” Lee Ainslie
“In my view, the best tools for dealing with volatility are preparation, intellectual humility, and the discipline to stick with ideas that are right in your wheelhouse.” Allan Mecham
Remember you own a piece of a Business
“I think that whenever you go through a period of poor performance or sharp declines, you have to remind yourself that you own a real business, and over time, business results drive returns. You also need to instill a certain level of humility, which allows to re-assessing assumptions to identify mistakes. I fall back on those two ideas to help me make rational decisions in times of distress.” Allan Mecham
Focus on Earnings
It’s important to recognize share prices can be volatile and that from time to time are unlikely to reflect the true underlying value of the business. By recognising shares are the fractional ownership of a business and focusing on the company’s earnings as opposed to the share price, you are more likely to hold onto long-term winners. Provided the earnings are improving, there are no structural issues and the stock is reasonably priced, over time the price will reflect the fundamentals of the business as opposed to the emotions of the market.
“I know that stocks represent fractional ownership in businesses and that, over time, the stock market will reflect their true intrinsic values. And crises bring worries and fears that make many investors forget that simple fact.” Francois Rochon
“What’s the cure for either the fear of stocks or the poor behaviour in regard to market volatility? My answer is quite simple: just don’t look at the market in the short run. If your obstacle to good results is your emotions about the ups and downs of the market, build a system that shields you from those emotions.” Francois Rochon
Maintain A Long Term View
The majority of the Investment Masters recognize successful investing is a long term game. In the short term prices can swing wildly. While the stock market has delivered 10%pa returns on average over the last century, the range of annual returns have been highly random. It pays to focus on the future; will the companies products continue to be demanded? Is there a long runway to growth? Is management capable? Is the company likely to be earning more in 5 years?
“There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.” Warren Buffett
In times of extreme market stress, it pays to remember human ingenuity and the long term resilience of the developed world. Simply changing the environment such as taking a stroll outside and away from your desk, can help you think clearer. You’re likely to find that not a lot has changed. People outside the confines of the financial markets will be doing what they were doing the day before.
“Since 1945, there have been 11 recessions. Four times, the stock market dropped by more than 40%. And crises have one thing in common: they all ended!” Francois Rochion
“An unwavering confidence in human potential in the long term stands as a lighthouse guiding us towards our destination in the investing world—particularly when the storms are raging.” Francois Rochon
None of the above, implies that acting when fearful is the wrong strategy. But the acting must be based on sound, rational and unemotional analysis, and you quite simply can’t do that if you’re afraid, and you certainly can’t do that if the herd is afraid and you’re blindly following them. And despite this, you will also not always be right, regardless of how well you plan and think and prepare – and you will still require humility to accept this on occasion.
Fear and emotions are the great undoers – allow them to control you and the outcomes will be less than ideal.
I think Buffet said it best: “To be Successful in the Stock Market, Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”
Further suggested reading:
Investment Masters Class Tutorial – Weak Market, Pessimism, Uncertainty & Panic
Giverny Capital – [Francois Rochon] 2008 Letter ‘The Opportunity of a Generation’
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