The Intersection Of Value Investing, Behavioral Finance And Other Market Musings

From my experience and studying of value investing thus far, I have gathered that two elements must be present in order for a company to be regarded as a worthy investment:

1) High probability of success (could be in the near future or further out)

2) High conviction in the investment, which is correlated to high probability of success.

In order to achieve a satisfactory degree of confidence that a company will have a high probability of success, the company must satisfy both qualitative and quantitative factors. They are both extremely important, and one should not disregard one in favor of the other. You may attribute different percentage of importance to either one, but it would be a grave mistake to completely ignore either of them.

Speaking more practically, I attempt to judge the high probability of success of a company based on an unemotional, detached view of the past and the future. In the process, I am not impressed by a stellar past or a supposedly gloomy future, depending on the particular investment. By not being impressed by an excellent past performance, I am not suggesting that the past doesn’t matter- it does, but the past sometimes can be looked at favorably and unfavorably by external events that are not directly related to the particular company I’m looking at.

For instance, a company can experience an increase in share prices due to an excessive pervasive euphoria, such as in the case of a bull market, or excessive gloom in the case of bear markets. Other factors that don’t directly relate to a company’s intrinsic performance are short-term performance problems, or on the other hand short-term slight positive improvements. Look beyond the short-term problems or current performance of the company- they are temporary noise to the road of success or failure. Try to reasonably predict the future of the company 2 to 3 three years from now- if the company is experiencing problems that you believe won’t be there in 2,3 or even 5 years ahead, don’t hesitate to be confident enough to invest in it- those are some of the best high return generating opportunities.

Shareholders of all classes and income levels fall prey to random volatility and short-term day to day and month to month, when in fact they shouldn’t. As Nassim Taleb says, randomness and variability are good for us ( if you haven’t read Taleb’s books, do right away- you won’t regret it).

Think about it this way: would it be healthy for your body temperature to be constant at 67F all the time? Of course it wouldn’t. Then, why would you be nervous when the market or a company that you have invested in, suffers a short-term loss, or be overly excited when it makes quite some money?

I believe that most investors, as behavioral finance and countless studies tell us, yearn for a false consistency when selecting their investments. By false consistency, I mean that they are dead set in seeing their company increase in share price- if it fails to achieve that goal, immediate anxiety and fear kicks in. False consistency is a major killer of performance, because it’s simply unrealistic- to be frank, it belongs in a Disney movie fantasy tale. The key to becoming better at investing, and any other game for that matter, is to tolerate, or better yet embrace uncertainty. There’s a reason for the expression:” change is the only constant”- it’s because it’s true.

In summary, conduct a thorough due diligence of the company that you intend to invest in, and try to reasonably foresee the prospects for the near to intermediate future (2-5 years) – anything beyond that, is best left to Warren Buffett. Buy at a discount and hold as long as the fundamentals are still intact, the intrinsic value has not been reached yet, or a better investment has not been found yet. Even more importantly, buy in times of distress such as a financial crisis or an unjustified decline in the price of the company that has nothing to do with the long-term prospects of the company. Don’t pay much attention to the pundits on TV and newspapers- they are paid to embellish lies, your job is to uncover the truth.

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