The stock market has been on a real roller coaster ride since the beginning of the year. After falling well into correction territory, it has bounced back recently. At one point, just as the Ukraine war was heating up, our portfolio was down 11%. As of the end of March, it was down less than 5%.
Undoubtedly, investors, anxious over the events unfolding in Eastern Europe, bailed on the market to wait until things cleared up. If they missed the bounce in early March, they suffered permanent losses in their portfolios. Having ridden the roller coaster ride, our clients are sitting on very modest year-to-date losses of 5% (versus the so-called safe-haven bond market, which is down 7%).
The only reason investors sell is that they feel they can’t stomach more losses. Yet, they wouldn’t experience an actual loss if they didn’t sell. It’s a “loss aversion” thing. Investors feel much worse about losing money in a declining market than they feel great about making money in a rising market. They allow their feelings to dictate their decisions, which almost invariably leads to underperformance.
Why Investing is Like Flying a Plane
I have found that investing is like flying a plane, which is a very unnatural, three-dimensional activity. That’s because a pilot’s sense of equilibrium (what they feel) is often not aligned with what is happening. Consider the difference between flying a plane under visual flight rules (sight with feelings as confirming evidence) and instrument flight rules (relying exclusively on data). The difference is dramatic.
That was the difference for John F. Kennedy Jr. when he flew his plane into the ocean off Nantucket. He wasn’t certified to fly instruments alone. He had to rely on his sight and feelings, which told him one thing when he couldn’t see the horizon. As a result of his “special disorientation,” he pitched the plane downward into the water, tragically killing himself, his wife, and sister-in-law.
I had a similar experience during my flight training but was fortunately in a controlled situation at altitude with a flight instructor by my side. So, I have had the experience of having your feelings tell you one thing, and the data (i.e., instruments) tell you the opposite. It is undoubtedly challenging to decrease sensitivity to your feelings and follow the data, just like with investing.
Determine Which Data to Follow
So that raises the question of what the correct data is to look at. Certainly not the news in all its forms—cable, social media, etc. That’s like staring out the window in hopes of finding a horizon. The media only gets attention when it can provoke bad feelings of fear, dread, or hysteria, which never lead to rational decisions.
One way to look at data is to place it in a group of concentric circles, with those circles closest to the middle carrying the most validity (and, therefore, decision-making weight). The data in the outer rings should be discarded or viewed with amusement. Which data belongs in which circle is debatable, depending perhaps on one’s frame of reference and knowledge of which data is available.
For me, as an investor, the data that sits in the innermost circle is a company’s return on tangible equity (ROTE). In my professional opinion, it is the most valid and, therefore, most heavily weighted measurement of a company’s business performance. ROTE is the profit generated on shareholders’ capital, measuring how well a company’s leadership manages its shareholders’ money. It’s a key indicator of management’s efficiency in deploying shareholder capital to create long-term value. The ratio is calculated as follows:
Common Shareholder’s Equity = Total Shareholder’s Equity less preferred stock, goodwill, and intangible assets
The world could be on fire (more than it already is), but companies with a high ROTE (greater than 25%) are what Warren Buffett refers to as “magnificent” businesses—there’s no reason to sell them. We use additional data, sitting in the adjoining circles, such as low debt, high-profit margins, and growing earnings, to reinforce the predictability of the innermost circle.
With our eyes fixed on the critical data, we can ignore the drama going on in the world. It’s crucial to have a component to your investment management process that keeps the bad news in perspective to replace the emotional buy and sell decisions that come with outside market noise. We want to make sure our investment decisions are based on the information we know, not what we think is going to happen.
