Stay The Course

On Monday, January 6, 2025, Federal Reserve Governor Lisa Cook stated:

Valuations are elevated in a number of asset classes, including equity and corporate debt markets, where estimated risk premia are near the bottom of their historical distributions, suggesting that markets may be priced to perfection and, therefore, susceptible to large declines, which could result from bad economic news or a change in investor sentiment.

Her remarks are reminiscent of former Chair Alan Greenspan's 1996 warning of 'irrational exuberance'.

Nobody can consistently and precisely predict market behavior. There are, however, ‘red flags’ that the US equities market is running on fumes. The conditions are right for a major drawdown.

It would, therefore, be prudent to dial back risk. Limit investments to profitable companies that generate strong free cash flow and which have strong competitive advantages. Doing so increases the odds of not breaking Warren Buffett’s 2 rules of investing:

• Don’t Lose Money
• Don’t Forget Rule #1

Judging from comments on various social media platforms, many retail investors have exposure to speculative companies; many investors are seeking the next 100-baggers. Finding such companies means the need to venture into the universe of micro- or small-cap companies. This is because the likes of Intuitive Surgical, Visa, Mastercard, S&P Global, and Blackstone (all holdings within the FFJ Portfolio) are highly unlikely to become 100-baggers.

Some micro- or small-cap companies may one day become 100-baggers. Most, however, are likely to be decimated over the long-term. This means an investor needs to be extremely lucky to find the ‘needles in the haystack’ to more than offset the losses from the less than stellar investments.

I refuse to play in the micro- or small-cap universe because this would take me well out of my comfort zone. The types of companies in which I invest allow me to stay the course when we experience a major market drawdown.

Investing in companies requires investors to think like business owners. In essence, we need to think from a long-term perspective.

When we do experience a major market drawdown, it becomes increasingly difficult to stay the course with holdings such as:

• Carvana (CVNA) - one of the major shareholders has a criminal record
• Super Micro Computer Inc. (SMCI) - Deloitte and Ernst & Young have parted ways with the company

Successful investing involves thinking in terms of probabilities and not in terms of certainties. Nobody truly knows for certain a company’s share price behavior in the short-term. If we invest in great companies for the long-term and truly understand them, there is a high probability their economic value will increase substantially. Generally, a company’s stock price will follow the company’s performance so as to produce an annualized return that exceeds the rate of inflation.

How long is long-term? According to Warren Buffett:

Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

….so long-term is a minimum of 10 years.

Loss Aversion

Loss aversion is a well-documented phenomenon in the field of behavioral finance; this term was coined by psychologists Daniel Kahneman and Amos Tversky.

It suggests that people experience the pain of a loss more intensely than the joy of an equivalent gain. In essence, an investor is apt to feel much worse from a $100,000 loss than they are to feel good from a $100,000 gain; investors are emotionally affected about twice as much by a loss as they are by a gain.

This can have a significant impact on investor behavior.

Suppose an investor has a portfolio of less than stellar companies and we experience a broad market drawdown. The loss aversion phenomenon suggests this investor is likely to hold losing stocks longer than they should in the hope of avoiding the pain of realizing a loss.

Myopic Aversion Loss

In addition to the loss aversion phenomenon, investors instinctively focus on what is currently happening; the combination of these two cognitive biases has been dubbed myopic loss aversion.

Many investors experience difficulty watching the value of their investments decline for prolonged periods (eg. several weeks in a row). This explains why many investors capitulate and sell when an investment’s value falls with the intention of possibly reinvesting when conditions improve.

The drawbacks with this approach are twofold.

1. Nobody can predict a company’s share price behavior in the short-term.
2. If an investor sells and the value of the investment subsequently falls further, there is no certainty when the share price will resume its rise. It is entirely possible that by the time conditions improve, the stock price could have moved above the selling price.

Missing The Market’s Best Days Is Costly

Avoiding the market’s downs may mean missing out on the ups as well.

Looking at the S&P 500 Index Average Annual Total Returns for the 1994 – 2023 period, 78% of the stock market’s best days occur during a bear market or during the first two months of a bull market. Missing the market’s 10 best days over the past 30 years would have cut an investor’s returns by ~54%. Missing the best 30 days would have reduced returns by ~83%.

Stay The Course - Final Thoughts

If you have a specific goal and have laid out a series of clear objectives, stay the course despite potential setbacks or distractions. This is exceedingly pertinent during times of uncertainty or adversity.

The big money is not in the buying and selling but in the waiting.

- Charlie Munger

Munger often emphasized the importance of long-term investing and simplicity over complex trading strategies. Buying and holding investments for the long term allows plenty of time for the market to reflect their intrinsic worth.

Should you fall in the camp of active traders, consider changing your investment behavior.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.