No one wants to go through another crash fully invested. That's why when the Dow fell 1,300 points in two days Wayne Himelsein, one of my managers, has more than doubled the S&P 500's return over the past 18 years, in large part by keeping a level head through two market crashes and numerous corrections. I asked Wayne about the most common mistakes investors make in turbulent times and how to avoid them.
Ken Kam: Wayne, when markets start falling like this and panic sets in, I hear from lots of investors who either want to sell everything, or hold on for dear life. Are either of those reactions rational?
Wayne Himelsein: Above all, emotions must be quelled in exchange for rational decision-making.
Fear, and/or the fear of missing out, drive us to either under or over react to these events, and quite simply, to make the wrong decisions.
I think of these as “blind spots”, as the emotions come in and cloud our otherwise reasoning minds.
Kam: Which of our “blind spots” should we be most concerned about during heavy market sell-offs like we had last week?
Himelsein: The first blind spot of this sort is “Availability bias”, which causes us to frame a new event in terms of a similar one in our recent memory, the one that is most “available”.
This, in turn, can divide in two different directions; one, Representativeness, and two, Saliency.
Kam: Lets start with Representativeness. What is it?
Himelsein: With Representativeness, we feel like this event “looks just like” the correction in February. It ended at a certain percentage drop, so this one will likely do the same.
But proximity in time has absolutely nothing to do with what may happen this time. Its “availability” in our memory means nothing, statistically. The market does not know us.
Kam: Tell me about Saliency? How is that different?
Himelsein: Saliency sees the outlier in relation to a prior extreme. Here comes the next global financial crisis -- it happened in 2008, it can happen again. No, it can’t. Those extreme moves happen a few times in a century.
Kam: What mistakes do these two flavors of Availability bias lead to?
Himelsein: The take-away of both these distortions of perspective is to recognize that we cannot connect this event to any prior, especially anything recent.
One could study all market corrections of the last 200 years and perhaps gain a small edge. But for most people the easy answer is don’t frame this event. Just recognize that it is not like anything you recall, or expect.
The market does not have a memory. It will move how it's going to move. The best thing for you to do is not worry about how big the move will be, or when it will end, but just focus on the stocks you want to own.
Kam:Are there more biases or blind spots that cause investors to make mistakes in turbulent times?
Himelsein: The two that come most to mind are Anchoring and Overconfidence.
Kam: What is Anchoring?
Himelsein: Anchoring is when the stock’s current price in relation to a past price; most usually, what we paid for it, determines whether we think the stock is a buy or sell.
But the stock doesn’t know us or what we paid, and quite certainly, doesn’t care. When one thinks, I paid ‘x’, its gone up too much, or I paid ‘y’, and its down so I have to wait until I make that back, one is attributing the future potential of a company, its product line, and executive management to the cost basis on their tax return! It verges on narcissism.
In reality, and most especially in falling markets, you have to forget about what you paid for each position in your portfolio, and instead, focus all your brain power on what stocks are the best ones to own going forward.
Kam: What kind of mistake does Anchoring lead to?
Himelsein: Waiting to sell stock 'A' until it recovers to your cost basis is a mistake if it prevents you from buying stock ‘B’, that then goes up 10%.
When investing, you are in the business of making money, and much like a business owner cuts a bad product line in favor of increasing production for the ones that are flying off the shelves, so should you transition your capital to the best opportunities.
Kam: That’s great advice. Tell me about Overconfidence bias.
Himelsein: Overconfidence bias speaks to how much we think we know.
Studies have shown that 75% of us feel we are “above average” -- clearly, impossible. With stock picking, we have to be even more careful in believing we have found the “one”. Or believing that a stock will double. Or move x% “next week”. Or that something we read is something we know for certain. These are all hopeful illusions driven by overconfidence.
To manage overconfidence, we must be humble, and aware of what we don’t know. In terms of stock picking, this means, be skeptical, look for the holes, the voids, the issues, etc… Ask more questions, and always have doubt.
When you do find a stock you like, don’t love it, just like it. Don’t invest too much of your capital in any one position. Find a few good ones, and spread the love.
My Take: One of the keys to getting through turbulent markets is understand how our blind spots/biases can lead to mistakes.
Availability, Anchoring and Overconfidence are three blind spots that last week caused many people to make what in hindsight will turn out to be mistakes once the fear abates.
I certainly have made enough mistakes to be able to speak from experience! These mistakes can be expensive so it behooves us all to learn from them so we don't repeat them.
One of the best reasons to use a manager like Wayne is to avoid mistakes that everyone makes when they are learning to invest.