September 23, 2011

You Are Not as Dumb as You Think: Psychotherapy for Cyclical Bear Markets (Guest Post)

By Vitaliy N. Katsenelson

I was going to write something smart and pithy about this recent market decline, but then I realized that I’ve written about this in the past (more than once). So here is an excerpt from The Little Book of Sideways Markets.  In addition, here is a copy (Note: embedded below by EconMatters)  of the presentation about sideways markets (below). – Enjoy.

Secular sideways markets are comprised of many cyclical bull and bear markets [take a look again at the chart below]. Though cyclical bull and bear markets can provide great buying and selling opportunities, our emotions will try to get in the way between us and the right decisions. Markets will constantly try to brainwash us into doing the opposite of what we should be doing. I hope [excerpt from] this chapter provides an antidote to this as it contains two missives. Read the first one [You Are Not as Dumb as You Think] during cyclical bear markets and the second [You Are Not as Smart as You Think, which I did not attach] during the cyclical bull markets. Good luck!

You Are Not as Dumb as You Think - Psychotherapy for Cyclical Bear Markets

Lately I’ve been getting this nagging feeling that everything I touch turns to dirt. Every time I buy a stock that is already down a lot, the one that my analysis leads me to believe is cheaper than dirt, it declines more. Did I completely lose my ability to value stocks? Did I start ignoring Will Rogers’ advice to buy stocks that go up, and if they don’t go up, don’t buy them?

No, I didn’t get dumber, and my stock-picking skills haven’t diminished. I was simply a willing participant in the latest cyclical bear market. Bear markets make you feel dumber than you are, the same way bull markets make you feel smarter than you are.

Feeling dumb makes you do the opposite of what you should be doing. Fear and pain—yes, continued losses cause a lot of pain—are dangerous things because they can make you and me panic, lose confidence, and do the opposite of what we should be doing. To alleviate pain we sell, we react, we default to the only asset that made us money so far in the bear market—cash! Cash is only king when other assets are princes. When you cannot find a stock with a long-term superior risk/reward profile, then cash is King with a capital K.

However, during a cyclical bear market, cash is slowly demoted to a prince as great companies are thrown out the window with the junky ones. You have to actively remind yourself of the eight-letter word T-O-M-O-R-R-O-W! Yes, tomorrow. Think of the lyrics from Annie:
When I’m stuck with the day that’s gray and lonely
I just stick out my chin and grin and say, ohhh
The sun will come out, tomorrow
So you gotta hang on’ til tomorrow
Of course, we don’t know if tomorrow is really tomorrow or five years from now. But investing is a marathon, not a sprint, and do not let the bear market turn you into a sprinter. First of all, remind yourself that you are not as dumb as your portfolio makes you feel. You have occasionally bought a stock that made you money. This is what I do: I pull out a chart of a stock on which I made a boatload of money or one I sold for the right reasons before it declined. I do this with pleasure, trying to relive my smart days. We all have these stocks, the ones we nailed.

We tend to forget about them during the bear market phase. But I suggest you remember them now, when you feel lonely and miserable, so you’ll have more of these names to remember in the future, since cash will not bring the pleasure of victory in the long run. The cyclical bull market is still there; it is just hiding under the ugly sentiment of the cyclical bear market. Believe me, it will show its happy face. It is just a matter of time.

In a bear market, it is easy to forget about buying. Selling is a much easier decision to make. Every time you buy a stock you look dumb because it usually goes down afterward. I recently bought a couple of incredibly cheap stocks and, of course, they declined. I don’t feel smart about these buys right now. However, a while back I analyzed these companies, figured out what they were worth, determined an appropriate margin of safety, and got my buy prices. The stocks declined but fundamentals had not changed, so I bought the stocks.
You cannot worry about marking the bottom in every buy.

My objective is not to buy at the bottom and sell at the top. No, my objective is to buy a great company when it is cheap and sell it when it is fairly valued. I suggest you do the same. Will Rogers’ advice is great, but unfortunately I have yet to meet a human being who has figured out how to apply it in real life. No, you are not as dumb as bear markets make you feel.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

About The Author - Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010), and Active Value Investing (Wiley, 2007).  Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. (EconMatters author archive here)

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