The stock market began 2022 with a volatile ride, as the S&P500 fell 9.2% at its low, before slightly recovering to finish down 5.17% in January.* Many individual stocks showed even greater price volatility as, in our view, the increased uncertainty surrounding macro factors ranging from inflation to the Ukraine ramped up investor anxiety and emotional trading decisions.
Emotional decisions are rarely good decisions. We believe this lesson is especially relevant for investing and individuals must incorporate behavioral analysis into their investment decisions. However, every day we believe investors make poor decisions based on emotions rooted in expectations that are too high for purchases and too low for sales. We all know that every investment carries risk, and in our view investors quite often tend to erroneously ignore these risks for rising stocks and over-react to them when stocks decline.
Loss Aversion Amps Up Emotions
The concept of emotional distress when a stock’s price declines is generally well accepted. There has been substantial economic and behavioral research into loss aversion bias, which describes how individuals feel greater stress for a loss than the pleasure of a gain.** This amplified emotional response to declines, in our view, often leads to poor sale decisions. Time and again, we have seen what we consider to be small investment hiccups that cause an initial moderate decline, set off a cascading series of worries. When one piece of bad news surfaces, it can sometimes seem like investors re-evaluate every investment risk set forth in a 10-K, and continually sell down a stock as if these risks were just discovered. Fear begets fear, which leads to price weakness, which can lead to more fear and more price weakness in a downward spin of emotional sales as investors lose conviction in the position.
Emotional Bias Can Rise on Strength as Well
Conversely, from our experience, when a stock rises, we believe investors generally become more confident in their investment thesis and more comfortable holding on to the position. In our view, this lower level or worry does not lower emotional bias, but quite to the contrary likely increases the level of expectations, raised price targets and missed opportunities to trim back positions of overvalued securities. We believe that the confirmation bias of a rising stock price can also lead many investors to ignore any new or negative information on the stock, simply because the stock has risen and proved them right up to that point.
The Need to Remove Emotion from Purchase and Sale Decisions
We believe the best way to remove emotion from an investment decision is to formulate a long-term investment thesis that not only incorporates all the positive catalysts that exist for a stock, but also a thorough evaluation of the balance sheet and other potential risk factors that could develop into headwinds. We believe it is important to set an upside price target and downside risk level at the time of purchase. By documenting a comprehensive investment thesis at the time of purchase, as well as upside vs. downside risk parameters, we can remove emotion from our decisions at times of price appreciation or price weakness. Purchase decisions and portfolio construction become relatively simple if these levels are set unemotionally.
Not A Contrarian Strategy
The benefit of pre-thinking these price targets is to remove emotion from our purchase and sale decisions, and to take advantage of the emotional investment decisions made by other investors. Regardless of strong moves up or down, we recommend a thorough review of the original investment case to determine if the original thesis still holds, and if there is any new information that justifies altering upside or downside targets. This is not a contrarian strategy, as we are not arguing to rotely take the opposite position of a price move. But, if the investment case is unchanged, and the upside and downside price target levels remain in-tact, we recommend buying aggressively on weakness, and selling into price strength.
Sell When it Feels Good and Buy When it Feels Bad
We strongly believe investor emotion drives dramatic price moves that are seen most every day in the broader market. By following a well-researched, price target disciplined strategy, we believe an investor can increase stock positions into investor fear and price neglect, and harvest gains into price strength and investor celebration. It is emotionally difficult to buy bad statistics and sell good statistics, but when a well-researched, emotionally absent investment thesis exists, buying low and selling high makes all the sense to us.
* The S&P 500 Index performance levels is sourced from Bloomberg. The S&P 500 index is an unmanaged group of securities considered to be representative of the stock market in general. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index.
** One of our favorite books on loss aversion and investor emotion is “Thinking Fast and Slow”, by Daniel Kahneman.