Saturday, May 22, 2010

Emotion isn’t something to fear, but to exploit

Below is one of the better articles by Derek Decloet of the Globe and Mail on Investing. Highly recommended reading indeed.
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Published on Friday, May. 21, 2010 7:53PM EDT Last updated on Friday, May. 21, 2010 7:55PM EDT

In Bangkok this week, anti-government protesters set the stock exchange on fire. In financial centres around the world, investors wished they had done the same.

There is something odd about the way in which a market slide – and that’s what this month has brought, a slide, not a panic – sets off a frenetic search for causes. Many times, these explanations make no sense, or are half-baked guesses, or are (at best) incomplete. Take Thursday’s drop, which sent the U.S. markets tumbling nearly 4 per cent and the TSX down more than 2. It was purportedly set off by “nagging worries that Europe’s debt crisis could spread,” said The New York Times , or by “fears of a disorderly crackdown on banks and financial markets,” according to the Financial Times.

So the problem was either politicians foolishly running huge deficits or politicians passing ill-conceived rules for banks – unless, of course, the real culprit was politicians acting arbitrarily against traders, as Germany’s leaders were accused of doing with a sudden ban on naked short-selling of certain investments, such as credit default swaps tied to government bonds.

Now it’s true that some people would decide to sell stocks for these reasons. It’s also true that a great many investors, particularly individuals, can’t tell you what Portugal’s debt-to-GDP ratio is, haven’t got a clue what a credit default swap is, and believe that “naked” is something you get with your spouse, not with your portfolio. When these people sell their stocks at a moment like this, they often do so for one reason: because stocks are going down.

It’s emotion that’s driving them, not reason. But that’s not something to fear. It’s something to exploit. Doing so is simple, which is not to say it’s easy.

“The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.” So wrote Ben Graham, the intellectual father of value investing, in The Intelligent Investor, the most important book ever written about investing (an endorsement by none other than Warren Buffett, Graham’s former student).

What makes Graham’s volume so valuable is a single insight: The best way to make money in the stock market over the long run is to (mostly) ignore the stock market. He didn’t quite put it those words. But the book’s underlying message is to block out most of what you hear about the S&P 500 doing this and the 200-day moving average doing that and “official corrections” (a 10-per-cent drop in an index, which some major benchmarks, such as the Dow Jones industrial average , hit this week).

You don’t need them. The vast majority of investors don’t even need to know much of anything about the complicated financial instruments at the centre of the credit crisis. Collateralized debt obligations backed by residential mortgage-backed securities, asset-backed commercial paper, credit default swaps – these things may be fascinating, but they’re distractions from an investor’s real job.

Which is what, exactly? To identify a good business, figure out what it’s worth, then wait until someone hits the panic button and will sell it for less than that – at which point you take them up on the offer. Repeat until rich. In volatile times, the market allows you to do this, because – and this is by far the most important thing one can take away from Messrs. Graham and Buffett – stock prices fluctuate far more than real business values do.

If Johnson & Johnson, one of the world’s great businesses, were a private company, would it be worth $15-billion less than it was a month ago? Clearly not. But as a public company, it has shed about that much in market capitalization as Europe’s crisis gained steam. UPS and MasterCard are worth $6-billion less than they were a few weeks ago – have their businesses deteriorated that much, that fast? Is Air Transat, the Montreal airline and tour company, really half as valuable as it was on New Year’s Day? (It’s an airline, admittedly, the toughest industry there is. But this is not some nearly-bankrupt U.S. carrier; it’s a company that has been consistently profitable in the past that is enduring a temporary panic about its future.)

I’m not saying you should buy these stocks. But the formula for good investing in trying times is clear enough: Decide which ones you do want to own, and when the stock exchanges are battered and smouldering, make your move. Credit default swaps and “naked short-selling” don’t have much to do with it.

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