I have a friend whom I’ll call Anxious Guy (AG). Kind, caring, hard working, AG is a self-taught investor who muddles his way through managing his family’s $500,000 portfolio. Why does he muddle? Partly because his central nervous system runs too hot. It’s just the way he is. And that’s all fine. Except that when it comes to investing, too much wayward nervous energy is a marked handicap.
For the ten years or so that AG has held the investing reins, his portfolio has returned about 5% annually, net of trading fees. A decent number but nothing to brag about when your portfolio is +90% stocks. I mean, if you’re overweight stocks, you want to see a return higher than 5%, especially when broad equity indexes, such as the S&P 500, are blowing past that number, as it has for the past six out of eight years. This is a matter of looking at investing through the risk/reward lens: because stocks represent higher risk than fixed income investments, you should expect higher reward.
‘Stock’ refers to a share in the ownership of a company.
And while AG knows his performance is subpar, he’s oblivious as to why. He doesn’t get that his fired up central nervous system is not advantageous in the investing world; that his emotional entanglement is busting his investing chops and preventing him from moving the needle past a 5% annual return.
Knowing your self is the highest calling. In learning to know your self, you will understand when to turn left, when to turn right, and when to sit still.
Welcome to Your Brain
Brain exploration. This is the adventure that every determined investor must take. It’s a lifelong voyage and its well worth the trip. And what better place to start than here, with BuddhaMoney as your guide.
Let’s start with the basics. As a human primate, you are a complex character, with your physical body hosting three brains bound into one.
Three brains? What? When did this happen?
Well, our most esteemed scientists seem to agree that the first inklings of the three-brained human appeared somewhere around the time that our ancestors began walking upright.
But I’m getting ahead of myself. You see, the creatures existing before humans were simpler. Being simple creatures, they had simple brains. As evolution progressed, and a wide variety of new creatures emerged, more advanced brains sprouted from the old ones. These new and improved brains superimposed themselves on, and co-existed with, the old model brains.
Alright, generalities aside, let’s talk specifics in the form of a compact, less than 400 word summary of the history of human brain evolution:
Brain no. 1. Reptilian.
Anyone ever call you lizard brain? Well, don’t take offence because it’s true. We’re all part lizard, not just the guy from high school with the creepy long tongue. But hey, we’re better off knowing and accepting who we are, right?
Made up of the brain stem and cerebellum, Reptilian Brain (or Lizard Brain, just for the fun of it) controls movement, breathing, circulation, hunger and reproduction. Lizard Brain is all about ‘me’; it’s about territory, social dominance, and instinctively responding to life circumstances by fleeing or fighting.
When Lizard Brain detects threat or conflict, whether real or imagined, our fear/stress response is triggered to varying degrees. And though Lizard Brain continues to serve a purpose, it is prone to leading us astray. Why? Because its responses are largely unconscious and automatic.
So when it comes to navigating the wide world of stock investing, with all of the markets ups and downs sparking wild oscillations between fear and greed, we would be better off with Lizard Brain disconnected. However, purposefully or not, the manufacturer did not install an on/off switch.
Brain no. 2. Mammalian.
Climbing up the evolutionary ladder, the revamped model belonging to mammals is fittingly known as Mammalian Brain.
Designed to integrate with Lizard Brain, the Mammalian Brain tacked on body temperature and hormone control, connected feelings/emotions to behavior and events, and allowed for memory formation and long-term memory.
And though both Lizard and Mammalian brain primarily operate on a subconscious level, Mammalian comes equipped with a new and improved bonus feature: it’s programmed for self-discipline, allowing us to harness the otherwise automatic responses of Lizard Brain.
Brain no. 3. Thinking.
Ohhh, the cutting edge version! Wrapped around Lizard Brain and Mammalian Brain is the Thinking Brain or Neocortex.
For fans of the original Star Trek series, think Spock personified.
Neocortex allows for logic and rational thinking, decision making, planning, information processing and purposeful behavior. Present in all primates, but most highly developed in us folks, the humans, Neocortex operates mostly on a conscious level (unlike Mammalian Brain). Meaning, when properly nurtured and skillfully operated, Neocortex may dominate, and effectively shut down the other two models.
Make Friends With Your Brain … Pick Winning Stocks
Now that we’ve had our entirely thorough and informative lesson on brain functioning, you may be asking … so what? Why should you care? How does this help you build a portfolio of mostly winning stocks?
Well, it’s about getting to know your self at the most fundamental level. If you know that there are three different primary parts to the human brain, each part serving a different function, each part integrating with the other though often operating at competing ends, then you may be able to better recognize, understand, and direct your own behaviour.
And clear understanding of your behaviour feeds into wise decision-making. Put in a way that makes sense to your portfolio, excellent investors have learned to tap into rational, non-emotional Neocortex.
As far as Anxious Guy is concerned, he’s been at the investing game a long time. But he still isn’t tuned into him self. So what should he do? Get to a couch. One where he may lay down and open up to study and analysis by a competent professional (oh, I don’t know, say someone like BuddhaMoney). Someone who would work with AG to strengthen his Rational brain for the purpose of subduing Lizard brain, and its prone to flee (investor translation: fear) or fight (investor translation: greed) instinctual responses.
With findings in hand, AG may then decide whether he is up for the challenge. And if he is, it would be really helpful if he considered the following Need To Knows before resuming his picking stocks ways:
1. Buy Value
Never buy a stock when it’s trading at or close to its 52-week high. Sure, the price may continue to rise. And if it does, oh well, let it go and look for the next opportunity. Because odds are the price will drop before it resumes an upward climb. So wait for the price to pullback, to go on sale, then go shopping. This is how you maximize profit: by maximizing value.
Unfortunately for AG, he does not honour this Chewy Bit. And as if buying high weren’t bad enough, he sells low, when stock market hordes are delusional and panicked with fear. Oy! What are we going to do with you, AG?
You’ve probably heard this before: the basic rule with stocks is buy low and sell high. How many investors actually do this? Way too few.
Because Lizard Brain takes over and manipulates investor lemmings into running for cover when it appears the doomsday comet is moments from implosion (fear spreads, selling intensifies) or piling in when word spreads that stock prices are on a one way ticket skyward (greed surges, indiscriminate buying results).
The thing is, comets rarely strike and stocks are not immune to the law of gravity. By not paying attention to these realities, AG’s profits are minimized when he buys at a high price, and his holdings get burned each time he sells at a bargain basement price to some other primate with a more finely tuned Neocortex.
Buy low, sell high. A simple formula rarely executed. You’ve got to master this if you’re going to invest in stocks. You’ve got to tamp down fear when the market has fallen 30%, sit tight and wait for the rebound. Better yet, when turmoil strikes (not if, but when) and the share price of your favourite, fundamentally sound company has fallen near its 52-week low, gather the courage to buy more because its share price is likely to bounce back once market wide fear subsides. And when it does, and the shares approach their 52-week high, you then have to crack the whip at greed (it will go higher and higher, forever and ever – NOT), and take profit off the table; then put those funds to work again in a company that offers better value.
2. No Sure Thing
There are no guarantees, no certainty, in the stock investing game. If someone tells you about a ‘sure thing’, run the other way. Fast. Because they are wrong.
3. Tune Out
The stock market should come with a warning label: Watching daily stock market gyrations may cause you mild to extreme discomfort. Knowing this, do yourself a favour … stop watching.
Unless you’re a day trader (I’ll write about this another day; for now, know that you should never day trade unless you suffer from the ‘I-want-to-lose-my-money-real-fast-and-kick-myself-real-hard-afterward’ disease) there is no reason to check stock prices or your portfolio daily other than to give yourself an ulcer. Sure, you should monitor your portfolio on a regular basis, say once every few weeks, but if you’re locked in every day, you’ll drive yourself nuts.
4. Ignore Headline News
If your ulcer wants company, say hello to migraines by reading the financial pages every day.
Don’t give media the power to influence how you feel. Remember that media is in the business of attracting eyeballs and clicks and advertisers. Boring does not make for a good story. Sensationalism sells. Objective facts get in the way of selling news. Go ahead and stay informed about domestic and global events, but don’t let headlines influence your investment strategy. Sound research and objective information should be your sole sources of investment decisions.
5. Can You Afford To Lose?
If you cannot afford to lose your investment dollars, then don’t buy stocks. Go enjoy life and be content with the knowledge that your principal is protected with low interest, low risk and/or guaranteed return investments.
6. Know The Risk
Stocks are volatile. You know this. But does this mean they are inherently risky? (‘Risk’ defined as the chance of losing money).
Risk and volatility are not the same. Stock volatility, now that is constant, it isn’t going away, let’s say ever. And stock risk? Well, the risk attributed to a well designed all stock portfolio is largely a function of time.
What this means is that, given a short-term investing period, say 1-2 years, stocks are a riskier asset class than bonds or cash-equivalent instruments. But here’s the thing: when you look at a 5, 10, 20 year or longer investing period, non-stock portfolios are actually riskier than well designed stock portfolios. How so?
First off, take a look at history. According to Morningstar (MORN:NASDAQ – investment research company) since 1926, large cap stocks have an annual average return of 10% and long term government bonds have an average annual return of between 5-6%.
‘Large cap’ means a company with a market value of more than $5 Billion.
The risk with fixed income does not necessarily come from excessive risk of losing money. Rather, it’s the lost opportunity from not investing in a better paying investment.
Think about this: if you’re earning 5% on a bond, and inflation is running at 2%, and taxes take 1% of the investment return, your net return is a mere 2%. Now, today, we could only wish that there was a safe 5% bond yield on offer. If you can get 1-2% on a blue chip corporate bond, you’re doing well.
But guess what? With a current inflation rate of 1.5%, that 2% return becomes 0.5% (inflation erodes your purchasing power, reducing what you get for your money; at a minimum, you want your money to grow at a higher rate than inflation to maintain your purchasing power). After taxes and after inflation, that 2% bond return likely reaches zero or negative. Sad but true.
Granted, history does not predict the future but it may offer a general guide. And with a long-term investing horizon, investing in stocks appears to be a worthwhile risk.
7. Seek Dividends
Dividend paying stocks offer compensation not offered by non-dividend paying stocks.
‘Dividend’ is a payment made by a company to its shareholders. Depending on the company, a dividend is paid monthly, quarterly, semi-annually or annually.
Let’s use Ford (F:NYSE) as an example. If you owned Ford in 2015, you would have seen a share price loss of more than 5%. But with the company paying a dividend of more than 4% during 2015, your loss would be in the neighborhood of 1%.
Generally speaking, unusually high dividends (above 7% and we’re getting into the ‘high’ category) should be closely watched owing to increased risk. If a company’s earnings are weak or there are insufficient funds available to pay dividends, then the dividend payout will be reduced or cut altogether. When this happens, share price often tanks.
8. The $64 Question: Is Your Brain Wired For Stock Investing?
Many, many books have been written about stock investing. If you want to dig deeper, please inform and educate yourself by reading and studying some of the classics. Here’s three of my favorites:
- The Intelligent Investor, by Benjamin Graham
- How To Make Money In Stocks, by William J. O’Neil
- Stocks For The Long Run, by Jeremy Siegel.
And remember, even if you read these books, and other books, and an array of financial publications, and glue your self to the business section of the Wall Street Journal, Financial Times, Barrons and other notable major media outlets, and you listen to the so-called experts, and talk to as many people as you can who work in the financial industry, and make the annual pilgrimage to Berkshire Hathaway’s shareholders meeting to listen to Warren Buffett and Charlie Monger share their wisdom, and you amass all the knowledge about finance and business and investing that this universe has to offer, you still have to ask the question that only you may answer … is that sexy and wonderful brain of yours made for stock picking?