Investing is more art than science because psychology affects prices. That’s what makes investing difficult.
Yet, the difficulty is what most investors underestimate at first. Gerald Loeb points out the difficulties of investing throughout his book, The Battle for Investment Survival, before finally summarizing it:
The most important things any reader of these chapters can learn are likewise that investment and speculation are difficult, not easy; uncertain, not clearcut; treacherous, not logical. Here, more than anywhere in the world, is the land of illusion. Things are not what they seem. Two and two don’t always make four. “Stocks were made to sell.” Caveat emptor —”Let the buyer beware.”
And that’s the first of many lessons from the book. Here’s another. Losing is part of the battle:
Accepting losses is the most important single investment device to insure safety of capital. It is also the action that most people know the least about and that they are least liable to execute… The most important single thing I learned is that accepting losses promptly is the first key to success.
Investors hate to take losses. There’s a long list of reasons — sunk cost, a need to break even…at least, unwillingness to change their mind when the information changes, failing the realize that a loss was a possible outcome in the first place…and those are just the self-inflicted reasons.
If preserving capital is the goal, that sometimes means cutting losses early to avoid a worse outcome. It won’t always turn out worse, but it’s an imperfect game.
Of course, investing is as much about avoiding costly mistakes, as it is about seizing opportunities.
The objective is always buy that which the majority thinks is speculative and sell it when the majority believes the quality has reached investment grade. It is in this policy that both safety and profits exist. As price is the all-important consideration, the type of corporation and its characteristics are of relatively minor consequences.
One of the paradoxes of investing is that “poor” stocks outperform “excellent” stocks. The simple reason is that “poor,” speculative, risky stocks are priced that way. All the risk is priced in. The slightest bit of good news, a shift in sentiment, moves prices higher. Conversely, “excellent,” high-quality stocks are priced to perfection. It’s the basis behind value investing.
Only Loeb looks past the value component, focusing more on the psychology driving price:
There is no such thing as a final answer to security values… Market values are fixed only in part by balance sheets and income statements; much more by the hopes and fears of humanity; by greed, ambition, acts of God, invention, financial stress and strain, weather, discovery, fashion and numberless other causes impossible to be listed without omission.
So investors have to not only consider what a stock is really worth but what other investors think its worth.
There’s a fundamental and psychological factor reflected in stock prices. In the long run, price should reflect the fundamentals.
But in the short run, because the market is a popularity contest, the psychological factor can have a bigger influence on price. So the expectations — the hopes, fears, greed, and excitement — get reflected in prices.
But, of course, we can take it a step further because price can influence investor behavior. Every boom/bust period in the past has shown this on a grand scale where price action feeds on itself. The smallest bit of optimism moves prices, rising prices attract investors who don’t want to miss out until euphoria kicks in and a buying frenzy ensues. The key similarity in every boom is that expectations far exceed fundamentals and it shows up in prices.
This can happen at the individual stock level as price rise and fall with the psychology factor. It creates an opportunity to ride out the trend created by new investors and rising optimism.
So while the typical value investor benefits from the early trend, they’re usually selling out close to what fundamentals suggest is “fair value.” Loeb saw the trend as an opportunity for further gains because prices peak when expectations are highest.
Of course, the hard part is recognizing the shifts in psychology around stocks. Experience, knowledge, and dedication are needed. And even then, it’s not guaranteed because every investor is fighting against the same psychology driving prices.
Related Reading:
Notes: The Battle for Investment Survival