Investors’ Mentalities and Investment Decisions
Everyday investors have the opportunity to invest in thousands of publicly-held companies. For most of these companies, the investor can craft a future success story that justifies the purchasing of a stake in a particular company – regardless of the price. The investor’s analysis of a company may include: (1) fundamental factors (operations and competitive environment); (2) technical factors (price and volume patterns); and (3) probable future scenarios. Yet, regardless of the amount of due diligence, there is always a significant probability that the investor’s story will be incorrect due to the fact that: (1) companies are complex entities; (2) future events remain unknown; (3) investing is a game of probabilities – not certainties; and (4) his mentality – or personal biases – may lead to conclusions that do not represent reality. Of these important factors, the investor has the most control over his mentality.
Extreme Mentalities and a Potential Solution
The investor’s mentality is critical because it has the ability to affect every process the investor undertakes before making an investment decision, thus manipulating the eventual investment decision. For brevity sake, there are two extreme mentalities that we have observed amongst market participants: (1) the optimist, which focuses primarily on potential profits, and (2) the pessimist, which focuses primarily on potential losses. Optimists are very hopeful, and tend to exhibit gambling traits. These investors may see a company with the potential return of 400% and have little concern that the company has a 90% chance of going bankrupt. Their minds are very much focused on the 400% return with little regard for protecting their initial funds, or principal. Motivated by potential upside, such investors can be seen eagerly buying the company with the latest revolutionary technology or the company that just disclosed that it may be nearing bankruptcy. As a result, these investors may subject their initial funds to a greater risk of loss than they realize. Incidentally, optimists are more susceptible to stock tips as they will dwell on the few potential profitable scenarios to invest in a company. Also, optimists may rush into an investment fearing that if they wait, they will miss out on potential profits.
Nevertheless, the pessimist is very conservative and tends to hold his money dear. These investors quickly perceive potential downside risk and will overweight it in their analysis, thus failing to consider any upside potential that may more than offset the downside risk. As a result, most of these investors are dismissive of companies facing significant hardship. At times, as soon as the first downside risk presents itself, these investors stop evaluating the subject company. Pessimists miss opportunities where additional research and time would have revealed the hardship to be exaggerated or temporary. Such situations can be immensely profitable to an investor, but the pessimist avoids them almost entirely. While pessimists are likely to avoid large losses, they are also likely to avoid substantial returns. Furthermore, pessimists tend to eschew growth companies, which have more appeal to the optimist, due to the uncertainty that accompanies future growth expectations. There can be significant price risk to a company’s market value if actual growth fails to achieve its expected levels.
Both optimistic and pessimistic investors will look at the same data as everyone else and more than likely draw conclusions that match their mentalities. As discussed above, their mentalities affect their evaluation processes and are likely to result in: (1) facts being taken out of context; (2) key factors being assigned weights that are significantly different from reality; (3) unrealistic assumptions; and (4) the exclusion of critical information.
An investor is best suited adopting a mentality that is between these two extremes. Such an investor equally weighs the analysis of both the downside risk and upside potential of a company. Easier said than done. The key to fighting dominant optimistic/pessimistic urges is to: (1) recognize and understand the potential upside/downside; (2) understand that the company’s possible risks, upsides, and future scenarios most likely have an element of uncertainty and one should try to quantify this uncertainty; and (3) try to remove the element of hope/fear from one’s evaluation of a company.
To help fight one’s dominant optimistic and pessimistic urges an investor may want to create a check list to follow during one’s evaluation process. On this checklist, one may list, “Check for both downside risk and upside potential in operations, financial statements, technical patterns, industry, and future endeavors” as the first item. This exercise ensures that, regardless of optimistic or pessimistic tendencies, the investor considers both upside potential and downside risk.
The second checklist item may be, “Assign probabilities and magnitudes to the listed downside risks and upside potential.” In order to successfully execute this item, the investor is forced to understand both the downside and upside items and their effect on the company. This exercise has two effects: (1) it allows the investor to put the company’s upside potential in context against its downside risks and (2) it forces the investor to understand the level of uncertainty associated with both upside and downside items.
The third checklist item may be “Check over evaluation work and remove the effects of any hopeful and fearful tendencies.” Since a portion of evaluation is subjective, at times an investor can let his hope and fear override the facts and logic. If one catches himself doing this, he should try to remove any effects and implement conservatism.
These items are mentioned as potential ways one can help combat his dominant tendencies and ensure that he evaluates both downside risks and upside potential. Chain Bridge Investing, while employing other techniques and models, will not invest in a company until we have gone through these three items in one way or another. We recommend using a checklist, but the investor can be flexible in employing these various exercises throughout one’s evaluation process. Such practices, if executed properly and depending on the investor’s investment return goals, will usually result in the investor being more selective of investments, but also allow one the opportunity to finding investments with lower downside risk and significant upside potential.
Portfolio Construction
Regarding portfolio construction, the optimistic investor is likely to follow one of two paths: (1) an over-diversified portfolio or (2) a highly-concentrated portfolio. Since the investor is likely to consider more companies as acceptable investments, he risks investing in too many companies (assuming fairly equal portions of the portfolio) and thus diluting much of his potential return through over-diversification. Basically, a company that posts a 50% return will have less of an effect on the portfolio’s return when the company represents 1% of the portfolio instead of 5%. Furthermore, there is the possibility that since little attention is being paid to potential losses, the optimistic investor faces an increased risk of picking companies that underperformed, which could also dampen performance. In the case of the over-diversified portfolio, the investor is likely to have fewer stocks outperforming the market (assumed to be the S&P 500), whose gains will be increasingly mitigated as the level of diversification increases. Yet, the increased diversification will partly offset individual stock losses. Such a portfolio created by an optimistic investor can achieve returns greater than the market (usually in situations where the portfolio is concentrated in certain industries that are outperforming the market), but the optimistic investor faces more headwinds than he should in seeking excess market returns.
While we at Chain Bridge Investing favor a concentrated portfolio, such a portfolio designed by an optimistic investor is likely to be dangerous. The investor’s optimism for certain names may lead him to take large positions in some of these companies. As described above, the optimistic investor has a higher chance of missing potential downside risks on the company specific level, which can lead to a much lower percentage of correct stock picks. In a situation where the portfolio ranges from 10 to 20 companies, a few large misses can easily offset some impressive gains. Furthermore, if the investor does not have any risk controls in place, then as some of his favored companies take losses he may be more willing to hold on to them and may even increase his investment. Such actions create new psychological and mathematical forces that will weigh against the investor’s decision making ability. First, as many know, if a company’s price drops 50%, then in order to recover the loss the company’s price has to appreciate 100% (assuming no additional investment at the lower price). Second, from the psychological aspect, the more an investor loses on an investment the harder it becomes for him to cut his losses and close the losing position – generally speaking. Consequently, a concentrated portfolio for an optimistic investor appears to be very risky.
Nevertheless, the dismissive nature of the pessimistic investor is likely to lead to a concentrated portfolio. Such a portfolio is unlikely to generate excess returns as the pessimist tends to avoid potentially high return companies that require a large shift in sentiment. The pessimist is also likely to avoid fast growth stocks. These are generalizations, but they are headwinds the pessimist faces. The pessimist’s portfolio will likely perform in line with the market returns or below market returns. Without many large return stocks, the portfolio lacks the safety and power necessary to drive it into excess return territory. If any of the pessimist’s relatively safe companies should unexpectedly begin taking losses, the portfolio would need a few potential large return stocks to offset these losses and to have a chance to post a good return. The pessimist demonstrates that it is not enough for one to solely focus on avoiding downside risk. There is never any certainty that a stock, no matter how safe it may appear, will not go down in price. In an extreme effort to avoid downside risk, the pessimist actually takes on additional portfolio risk due to the lack of investments that offer large potential returns and can offset losses.
As discussed above, an investor walking between these extreme mentalities is likely to be more selective of investments, while also finding finding investments with lower downside risk and significant upside potential. Such a mentality tends to lead to a concentrated portfolio, but unlike the pessimist’s portfolio, with some significant upside potential. As always, there are no guarantees with this approach and there are many variables to consider that are out of the scope of this piece; however, it is important to understand the risks of these extreme mentalities and the effects they have on one’s investment selection process. Understanding these effects on one’s results can only make one a better investor in time.
Chain Bridge Investing (“we” or “CBI”) states at the outset that the opinions, judgments and derivation of thinking in this writing are solely Chain Bridge Investing’s. It is imperative that any judgment or valuation you take from information dispersed by CBI be examined within the context of your portfolio investment and overall objectives. To that end we urge you to contact your investment advisor or portfolio manager to insure that the information or suggestions proposed by CBI conforms to your needs and financial strategy.
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Tagged with Investing Strategy, Investors, Mentalities, Portfolio Construction
