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Tuesday 16 June 2009

It’s OK To Lose Money

Markets Go Down, Often

It’s hard to believe that markets spend nearly as much of their time going down as up. Obsessing over market or portfolio highs seems to be an international investor pastime, as though some permanently high valuation plateau is the ideal state. It’s not, of course, if you’re intending to buy in the near future.

Losing money investing in shares is a perfectly fine state of affairs as long as you’re not alone. However, if you're losing regularly when everyone else is gaining then you may need to take a long, hard look at what you’re doing and then go and do something different. Probably for the best if it doesn’t involve investing money, though.


There seem to be a rare breed of investors – chameleons, let’s call them – who have the happy knack of second-guessing the market’s every move. No matter what happens they manage to be one step ahead of the game, shorting before shares collapse, piling into precious metals just before the price soars and generally never seeing the value of their portfolio fall.

Of course, they’re liars, but what’s more interesting is why they're so attached to their high-water points. While it’s a pleasurable experience for most of us to see our wealth hit a new high surely most people don’t regard this as a permanent state of affairs? Share prices are writ in water, not stone. Yet a lot of people quite clearly believe that the cumulative capital value of their share portfolio is the be all and end all of investing. Long after the last high was hit they stay anchored to the idea of reaching that mythical peak again.

Anchoring: Heaven Knows, We’re Miserable Now

Anchoring is, of course, the psychological tick that drives this process. This was first discerned by the founding fathers of behavioural finance, Tversky and Kahneman in their seminal paper Judgment under Uncertainty: Heuristics and Biases. In simple terms you can induce someone to change their answer to a question by giving them a completely spurious number to anchor onto.

If anchoring on spurious numbers has this effect imagine what a number with real meaning may cause. Attaching oneself to a peak valuation or a buying price are the most common anchors - hugely prevalent among investors of all kinds, amateur and professional. Even discussions about market performance are commonly anchored on the all time high of some index or another.

Yet we know that markets fall on average one year in three so worrying about peak performance simply means we’ll be miserable for at least a third of our lives. All over some arbitrary number which, when all is said and done, doesn’t actually matter very much. Much of the problem stems from the peculiar prism of capital value through which most investors peer. If you change your viewpoint you can get a very different perspective on the valuation of stocks.

Earnings Streams Not Capital Pools

Rather than viewing a company as a pool of capital we can look at it as a long-term earnings stream. Most companies doing useful things will generate a rising flow of profits over time. This will undoubtedly be punctuated by falls from time to time through worsening economic conditions, poor management decisions or sheer bad luck, but the general trend will be upwards. Applied over a decently diversified portfolio or a balanced set of index trackers the overall capital value of the investments will also trend upwards, eventually.

The point about viewing stocks as earnings machines is that the cumulative effect of earnings being compounded has hugely beneficial impacts on investors’ long term wealth. Retained earnings should, all things being equal, lead to future company earnings increasing, while distributed earnings – primarily dividends – can be profitably reinvested in other earnings machines. Taken together the overall outcome is nicely satisfactory for investors who can afford financially and psychologically to take a long term view.

DCF – Don’t Consider Following

In fact there’s a model that allows investors to analyse the impact of long-term earnings on investment returns. It’s known as Discounted Cashflow (DCF) analysis and it provides a way of valuing companies by discounting their current earnings into the future. I could now spend some time explaining this but frankly it’s done elsewhere and I can’t be bothered because as a valuation tool it ranks somewhere alongside crystal balls, chicken entrails and penny share tipsters.

The problem is that to come up with a valuation the model has to make assumptions about future earnings. Frankly trying to foresee what a company will be earning in five days is hard enough, but five years away is simply ridiculous. DCF has its heart in the right place but it’s a pointless tool for most investors: they’re a bit like those new business model projections that always have earnings projections that look like a hockey stick – jam in future but never right now.

Smooth Earnings

Most companies will not have smoothly rising earnings and expecting that they will is to ensure a constant stream of disappointment. Admittedly there are a few rare corporations that have business models that are immune to most economic downturns but even these can be visited by misfortune or, at least, incompetent management. Ideally we want companies that can be run by idiots because eventually they will be.

It should be noted that companies generally go to a lot of trouble to smooth earnings to show a nice rising trend to make analysts’ lives easier. Mostly this is OK but it does rather open up the possibility of companies going to extreme lengths to do this by making imaginary transactions, counting future revenue as current earnings or any of the other endless tricks that the evil legion of accountants can get up to when they’re not out destroying crops, molesting virgins and spreading pestilence. Or is that the Four Horsemen of the Apocalypse? I’m always getting those muddled up.

Don’t Debate With The Deluded

Often it’s possible to vaguely foresee that a company will have future earnings problems and most capital obsessed investors react by selling and will be completely unable to understand why earnings focussed investors won’t join them. However, if you’re taking a long-term view of these things you generally come to recognise that you can’t accurately judge the future. We remember all too clearly the times we didn’t sell when we should have and completely forget the times we didn’t sell and it turned out all right. Trying to be a chameleon and time the market is a pastime fraught with danger. Most market timing investors lose money because of transaction costs and mistiming.

Obsessing about overall portfolio valuations and worrying about stock prices going down is the investor’s pathway to Hell. Getting anchored on absolute valuations and ignoring earnings and dividends is just about the most basic mistake a long-term stockmarket investor can make. The only more basic mistake is getting involved in arguments with chameleoid investors about the whys and wherefores of the process.

Chameleons are, at best, mildly delusional and, at worst, outright liars: you might as well try and debate politics with a politician. Why bother?

Related Posts: Capitalism Evolving, Be A Cockroach, Not a Dinosaur, The Death of Homo economicus

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