Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Successful investing is hard work because it means disciplining your mind to do the opposite of human nature. Buying during a panic, selling during euphoria, and holding on when you are bored and crave action.
Successful investing is hard work because it means disciplining your mind to do the opposite of human nature. Buying during a panic, selling during euphoria, and holding on when you are bored and crave action. Investing is 5% intellect and 95% temperament. You often have to turn your back to the crowd and stand on your own. It takes strength. It takes courage. If you are a normal passive investor that invests in a bunch of diversified ETFs and mutual funds you only have to worry about market volatility. But if you are a stock picker you have 10x the emotional load. You have to be a rock. You must be unbreakable.
From 1999-2000 I was a Psychology major in college. I was getting more and more into investing and felt a degree in psychology would probably help me more than a finance degree. Then I realized I would have to go to school for another 1,345 years (slight sarcasm) to get a Graduate and PhD so I could eke out a living. I changed my major to Economics. I didn’t realize it then but I was about the get a PhD in Market Psychology. At the time I was also working for a financial advisor so I could pay my way through college. When the technology bubble burst and stocks plummeted I had to answer the phones in the office and talk to clients. They were highly emotional. I also lost 80% of my own money during the crash after making a ton flipping technology stocks on the way up.
By late 2001 most of my mid-cap tech portfolio turned into microcaps. I was already looking at smaller and smaller companies and was trying to make my money back. I stumbled upon an article on XM Satellite Radio. This is when my love affair with microcaps started. You can read about it [HERE]. I ended up putting the $10,000 I had left into XM and it went from $1.78 to $34.00 in 14 months. It was all luck, but I felt smart.
From 2002-2005 I learned microcap investing from losing my money and making it back and by listening to a few mentors I met on public stock message boards. I laugh when I think about some of the experiences. Let me tell you a fun one.
In 2005 Hurricane Katrina hit Florida and Louisiana. It was devastating. New Orleans was under water. $125 billion in damage. The government sent resources, aid, and paid whatever was necessary to get it cleaned up as soon as possible. Disaster remediation companies were sent in and made a lot of money. A microcap company was going to do a rollup of the disaster remediation space. The first acquisition was the 2ndlargest disaster remediation company in the US. The company just did $180 million in revenues and earned $60 million in profits cleaning up after Katrina. I purchased shares. It went up 10x in 9- months. I rode the stock the whole way back down. A seven figure lesson. I was broken.
I have other entertaining stories like this. Some are too crazy to repeat. I wouldn’t trade them for all the money I lost. An investor must experience the highs of success and lows of failure several times before they can exploit these emotions in others.
I’ve been a full-time private investor for over 10 years. When you support yourself on your own capital it adds an additional layer of emotions. You have to produce. Your family’s livelihood depends on it. You can’t let them down. I talk about this [HERE]. Most professional investors don’t know what it’s like to sell stocks to pay bills. When you are supporting yourself on your own capital there is no such thing as savings. It’s just different degrees of spending. To make it work you need to be extremely disciplined. You can’t be broken.
When a group of graduate students visited legendary investor Michael Steinhardt one of the students asked him for his best piece of advice. Steinhardt replied, “I’m your competition.”
I would like to share with you some lessons I’ve learned that anyone can put into action to be a better investor. They are so simple that few people actually do them, but if you do you will have edge on almost everyone. You will be unbreakable.
Unbreakable when the markets are falling
What is the worst case scenario? We hit a market environment like 2008 and your portfolio is down 50% in a year and you don’t have any cash. This was the scenario for 90% of professional investors. What can you control about this situation? You can’t control stock prices. The answer is CASH. If your portfolio was down 50% but you had cash to deploy how bad would it be? Half as bad. A quarter as bad. It wouldn’t be that bad right? Right. A bear market is only bad if you can’t take advantage of it. The difference between having cash and no cash is confidence vs despondence.
December is a great month to bargain hunt in microcap stocks. Why? Tax loss selling. Illiquid microcaps that were losers during the year are sold off even more aggressively in December as investors take the loss for the year and move on. I’ve often thought you could make almost your entire year’s returns being patient and watching beaten down names in December. Many of the stocks might be losers but their businesses are just fine and can rebound quickly. Very few investors have the discipline to have cash to take advantage of the December sell off in beaten down companies.
When you have cash you have confidence. When you don’t have cash you are just like everybody else. Cash is a position.
Unbreakable when your stocks are falling
Over a lifetime you will have as many losers as winners. The key is letting your winners run and cutting your losers as quickly as possible. As Andrew Stanton of Pixar says, “Be wrong as fast as you can.” Losing money has deep psychological effects on our thinking. Losing can lead you to make more bad decisions. A series of bad decisions can set you back a long time.
In golf they have a statistic called the Bounce Back percentage. Bounce Back is a statistic that shows the percent of holes that scored over par immediately followed by a hole that scored less than par. This stat shows a players ability to “Bounce Back” to good performance after a bad hole. In 2018, Dustin Johnson had the highest bounce back percentage at 29.3%. When Dustin had a bad hole (a bogey), 29.3% of the time he followed that bad hole with a good hole (a birdie). As an investor you also want a high bounce back percentage.
When you lose money you want to make it back twice as quick because you anchor yourself to your original cost basis and your original expectations for returns. Let me give you an example. You buy a stock at $5 that you think can be $10 in a two years. Instead the stock drops to $2.50. At $2.50 you are still thinking about $10. Perhaps the story changed in that stock and you sold, but you are still anchored to that $10 and the desire to now make a 4x return. You start looking for stocks you can make a 4x return instead of a 2x return which are inherently more risky. When you are down in an investment or sell a loser you need to purposefully slow yourself down.
Unbreakable with your largest positions
My largest positions aren’t the ones I think I’m going to make the most money from. My largest positions are the ones where I don’t think I’m going to lose money. — Joel Greenblatt
Instead of making your largest position the one you think can go up 500% in the next 6 months, your largest position should be the one where you can’t lose over the next few years. Ironically, the latter is where you will often find the next big winner.
Unbreakable while waiting
The stock market is similar to life. Wrong decisions are often punished quicker than right decisions are reinforced. Successful investing is delayed gratification. . It is called “delayed” because we always expect the reward sooner than we get it.
How many of your successful investments occurred in the timeframe you originally predicted? How many times do you ever remember saying, “Well that happened a lot sooner than I thought?” Exactly. Not often enough. A majority of my successful investments took longer, in many cases a lot longer than I originally expected. It just proves that even when we are right our timing and expectations are wrong.
Unless you buy a stock at the exact bottom (which is next to impossible), you will be down at some point after you make every investment. Your success entirely depends on how dispassionate you are towards short term stock price fluctuations. Behavior matters.
– Joel Greenblatt
When you finally realize it’s impossible to be right in the short-term it frees you up to be right in the long-term. Your time horizon can be your biggest competitive advantage. Let others fight over pennies while you hold for dollars. The key to holding is focusing on the business, not the stock. If you own businesses that are growing, earning more money, and not diluting the market will eventually come back to them and push their stocks higher. Also read Conviction to Hold and The Art of Holding.
I’m going to be honest with you. A weakness of mine is optimism bias. When I find a company I like I generally think it can get a lot better. I’m self-aware enough to acknowledge this. There are other people that believe that any good situation can get worse. These people love to look through the filings and can find a misplaced comma in a 100-page document. They love finding discrepancies. It gives them joy. They also happen to be really good at financial analysis and picking up on red flags. I have a few friends that fit this mold and I have them help me from time to time. I’m not ashamed to admit it. I can utilize them for their strengths and it frees me up to focus on my strengths.
Know your strengths but also know your blind spots. Acknowledge your weaknesses. Fill the holes.
I learned investing by losing money, making it, losing money, making it. Investing’s best teacher is loss. These lessons will stay with you a lifetime and help you develop an investment strategy that is unique to you. Many of the best investors ever have almost opposing investment strategies. Don’t be afraid to be different.
Stop trying to prove that your investment strategy is the best one for everyone else. It just needs to be the best one for you. I explain my thoughts on portfolio construction [HERE]. The way I think about things will be different than you. It doesn’t mean my way is better than yours. The best strategy for you is the one that keeps you in your winners the longest.
Sometimes what you do doesn’t make sense to others. I like to invest in management teams that have skin in the game. What is interesting is you can find empirical research that shows that high insider ownership, founder ownership, CEO ownership doesn’t yield greater returns. If the evidence shows it doesn’t matter, then why is it still important to me? When I know management has to live with the consequences of their decisions it helps me stay invested longer and hold through the volatility.
I’ve studied many great investors. Great investors aren’t super human. They are super self-aware. They are disciplined and do the simple things that other people don’t do. They embrace being different because it doesn’t matter what other people think. What matters is returns.
I recently launched Intelligent Fanatics Capital Management, a firm dedicated to the smaller half of the microcap ecosystem. I now manage a few outside accounts and help others gain some intelligent exposure to this unique investment class. I received some great advice from some phenomenal managers when I was setting up the firm. Since I launched I’ve spent the better part of two months scaring away the wrong investors. The right investors are as important as the right investments because the wrong investors won’t let you stay in the right investments. Be very picky with your investors. Don’t be afraid to say no. You need operate a strategy like it’s a single unit. You must be unbreakable.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.