Tag Archives: emotions

Balanced fear and trust in portfolio construction

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1-10-2024 Humans have an emotional basis for thought, including their portfolio investment decisions. Therefore, practically speaking, a successful investment strategy must be able to operate while being associated with these emotions, functioning both in spite of, as well as because of them.

The market correction of 2022 was related to the Federal Reserve’s increase of interest rates, with consequent fears of prospective slowing of economy, and associated adjustments in analysts’ models and earnings estimates.  Market downturns cause fear among holders of stocks. This is not totally avoidable, and it happened to me.

Why was I afraid?  Unfortunately, I had committed a major error in my role as investor, an error which had become a pattern over several preceding years.  New time constraints occurred, related to devotion family demands,  passionate commitments to fulfilling personal pursuits, and duty to professional demands. Therefore, over a few years I had much reduced my formerly practically constant reading about my companies and investing in general.

Bearing in mind the nature of my investments, “eternal companies” with a durable competitive advantage that have the “culture” and capital, human and financial, to adapt to continue dominating their market.  These companies can weather an economic downturn and rise with the recovery and continue on their march to growth.  We know this because they have done so repeatedly over their history, and they continue to develop the qualities which drive this durability. And so these companies do not require constant monitoring to see if their earnings are finally coming into existence, or if paying customers are appearing, as is the case with some novel hot companies.  Indeed, this is one specific advantage of the “eternal company” concept for the individual investor who has done the work to select investments, but does not want to spend an inordinate amount of time on an ongoing basis, worrying about his portfolio.

However, because I was no longer keeping close track of my investments, having reduced my immediate awareness of my portfolio companies’ current achievements and strengths, I was vulnerable to the fear which affects the ignorant in a market downturn.  In the anxious and volatile market of Summer 2022, recession was widely predicted by economists for early 2023. I began to read again. I did not in panic sell my holdings at the low points.  This was because I know they are sound investments and this attachment has an emotional tone.  However, while I refreshed and reestablished my current knowledge of the repertoire of business strengths of my companies, I felt the need to do something to protect my portfolio from a time period of losses of unpredictable duration. I searched for a suitable candidate investment to which I might allocate part of my capital. One which did not correlate with my current holdings and might therefore better withstand a possible upcoming recession.

Thus, at approximately the end of January 2023 I shifted some funds from my current holdings, to a novel portfolio component: United Healthcare Group (UNH).  I reallocated approximately 1/3 of funds from ADBE, 1/4  from MSFT, and less than 1/4 from V. I made these moved because of anxiety regarding recession, rising interest rates and the effects on tech and digital finance stocks. But I made only a partial reallocation, because I trusted my current companies would certainly eventually recover and in fact likely take market share during any recession.

As the broad market recovered in the second half of 2022, it became clear that I had traded a portion of funds out of my current holdings, just in time to miss the major recovery run ups of 12.3% for V, 49.3% for MSFT and 60.6% for ADBE.  In contrast, UNH only appreciated approximately 8% between January30 and the end of 2023. My return on investment for 2002 would have been better had I remained fully invested in my original portfolio of eternal companies.

This episode yielded a couple of investor lessons. By regularly reading, keeping informed about your own investments, you are continually aware of the reason that they are sound investments.  Had I done this, I might have held onto my ADBE, MSFT and V with more confidence, knowing that the companies would certainly survive and thrive.  Even should a recession have occurred, as companies riding a wave of secular market expansion, they would play an early part in the rebound of market sentiment as the prospect of tangible economic growth reappeared ahead.

Second, equally important: regularly search for novel portfolio candidate companies which are in a different business and sector than current holdings.  Do this research in anticipation of a change in economic conditions which makes the novel companies a relatively better value.  In this way, you can be ready to shift allocation into them at this relatively lower valuation compared to your current holdings. Moreover, preferential selection of companies in different sectors promotes construction of a portfolio whose future performance is less vulnerable  to economic changes which harm a specific sector. Finally, keep informed of valuation conditions in the various market sectors so as to know when they are likely to present relatively better values and opportunities for purchase.

Because I did not maintain this regular, anticipatory research, I had yet to identify new portfolio candidates with relatively more attractive valuations, by the time MSFT, ADBE and V hit new highs in the second half of 2021.  Instead, I delayed until they had already reached subsequent 52 week lows in Spring of 2022.  I therefore lost  the initial period of advantaged returns which could have resulted from diversification into non-correlating holdings.

Notwithstanding my apparently poorly timed UNH purchase, portfolio performance (IRR) for calendar year 2023 was quite good at 43.2%  This was a product of both the durability of my long term holdings, and that of the new investment. I continued to trust in my long term holdings and therefore resisted selling them completely even in the face of significant price declines.  This was balanced by anxiety regarding further losses related to a recession, prompting my search for a company meeting my investment criteria, with returns not likely to correlate with my current holdings.

I admit these emotionally related errors not just because I value transparency and truthfulness.  It is important to know that an investing strategy can be reasonably successful in spite of your fears. A strategy which depends on perfect logic is pure fantasy. 

Interestingly, the selection of UNH actually represents an evolution of my eternal company criteria. This innovation was stimulated by necessity, the mother of invention.  I will describe my process for selecting UNH in a separate article.

Bought more ADBE in 2016; reflection upon the emotional aspect of the trade

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January 19, 2017.  On January 11, 2016 I sold 6.5% of my MSFT stake to buy ADBE.  I thus somewhat more than tripled my stake in ADBE, which nevertheless made up only 5% of my portfolio as of 12-31-2016.

The timing and pricing of this trade was as follows.  In August-September 2015 the market sold off by 10%, then recovered, only to sell of by approximately 12% in January 2016.  ADBE had bottomed on 8-24-2015 at 75, down 13% from its previous peak at 86 on 8-17-2015.  It then rose again to peak  at 95 on 12-29-2015 before falling 22% to nadir at 74 on 2-9-2016.

 I bought ADBE at 88 on 1-11-2016,  down less than 8% from the 12-29-2015 peak of 95.

In fact, since 1-11-2016 MSFT is up 20-83%, ADBE up 19.56% as of 1-18-2017.

But MSFT pays a dividend of 2.35% currently,  That trade isn’t looking too impressive. Bear in mind of course that the prices of both fluctuate, so on a different date, the assessment would be different.

Had I bought at the nadir of both stocks with MSFT at 75 and ADBE at 74 on 2-9-2016, since than ADBE up 46.24, MSFT up 26.89 not counting dividend, as of 1-18-2017.

adbe-msft-2016-chart

The rationale for the trade was that ADBE is a high PE stock with expectations of high future growth which have become well recognized by the market. This type of stock rarely trades at an attractive, relatively lower purchase price. I wanted to increase my holding of ADBE and wanted to take advantage of a lower price. I still agree with the decision to increase my holding of ADBE, but obviously I totally missed the true opportunity for a better price. 

This episodes proves again two timeless investing truths.  First, it is true that valuable and expensive stocks will be available at a better price, if you can only be patient.  Second, if you feel impelled to do something less you run out of time, just again, be patient. In fact using more time to decide will result in a better outcome.  This is not the only time that it would have been more profitable for me to wait for a better price.  In fact it is a recurring theme. 

But upon reflection, I find that this conventional lesson only probes one layer of this experience.  A distinct lesson is provided by considering the emotional aspects of the trade.

First, I felt I was missing out by not owning more of ADBE, a wonderful company with an insurmountable competitive advantage in its business (digital media) which it is strengthening, while building a second business (digital marketing) which looks likely also to have a sustainable competitive advantage.  This created a sense of urgency to trade.

Second, since I held no cash, I needed to sell another holding to buy more ADBE.  All of my 5 stocks are treasured holdings.  Part of holding such a concentrated portfolio is the nagging thought that perhaps I should be more diversified, at least within my 5 holdings.  This added to the anxiety surrounding the trade; on one hand, I should trade into ADBE, on the other hand, I was reluctant to sell my other holding.

the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

In perspective, the sum of money used for this trade was a very small proportion of my portfolio , less than 3%, as to make only a small difference at best.  This suggests that instinctive fear led me to avoid putting a healthy proportion of my portfolio on an investment.

Regarding strategies to reduce the roil of emotions interfering with sound trading next time.  One suggestion is to create a relatively fixed, preplanned trading strategy.

For instance,  wait until it is reduced 10% from the peak and use half of the money available for the sale.  Then use the rest when or if the 20% discount is reached.

This assumes that you really want to own the company.  If it is a new investment that may not have the same conviction as a better understood, long term holding, then waiting for the full 20% discount is probably best.

Second, in order to isolate the decision to purchase from the reluctance to sell a current holding, it would be helpful to have a source of cash for new purchases.  This is the topic of a subsequent post. 

The lesson to be learned from this episode is not just that patience is a virtue in investing.  For the barrier to patience is often posed by the emotions impelling a trade.  One cannot simply make one’s emotions disappear.  I for one, have been successful in making them disappear so far, and I am surely not alone. 

A better approach may be to 1. analyze the source of the emotions.  In my case, my rush to trade and poor decision making was not simply from a greedy rush to chase a hot stock.  By understanding the source of the feelings, you can know how to neutralize them.  2. have a strategy to avoid a repetition. For example, I will trade at specific target reductions in price, and not worry about trading until then, merely watching the market prices regularly.  I know my portfolio is sound as is, there is no urgency to trade unless it is actually at an attractive price.  3.  have a source of cash  for purchases.  Again, this point will be the subject of a different post.

In sum, the emotional aspects of investing must be explicitly embraced and addressed, rather than just suppressed.  Same as in the rest of life.  Remembering that good investing is a model for a fruitful life, lived to its fullest potential.

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