Negative thinking - part II

In the first part of this month’s Director’s Cut, Think negative, we outlined the many ways in which economies have yet to recover from the impacts of the global financial crisis (GFC), and how the supposed solutions aren’t working out as planned.

Unfortunately, that isn’t the worst of it. Since the GFC, much has been learned and nothing much done. What’s inside America’s banks in The Atlantic magazine, through an in-depth study of JP Morgan, does a neat job of explaining how banks remain black boxes that could still take down the global economy.

This wouldn’t come as a surprise to Nassim Taleb, author of The Black Swan. His new book, Antifragile, explains how many enduring features of life benefit from disorder, chaos and stress; bones get stronger when put under pressure; the destructive force of fire applied to iron ore makes steel; bacteria quickly adapt to antibiotics. The banking system isn’t one of them.

His central premise is that it isn’t enough for something to be resilient or robust, but for it to be made stronger by disaster. So, if politicians won’t make the global financial system anti-fragile, (see Can we avoid another bank crisis?), leaving it susceptible to future crises, what should you do?

Many investors decided long ago. They’ve simply upped sticks. We’d argue that’s the wrong decision. With interest rates near historic lows and stock volatility producing occasional bargains, this isn’t a bad time to invest. But for most investors, that’s not the point. They’re scared and intimidated by what might happen, which stops them from first engaging with the opportunities and then making sensible decisions if they do.

If you’re feeling alarmed by political ineptitude and worried about the risks of inflation or, indeed, deflation, here are three mental techniques to help you rationalise your emotions and make better decisions:

1. Get your head around the worst possible outcome

About nine years ago, a close friend was diagnosed with a chronic but incurable disease. It’s fair to say it changed his life. With young children, he wondered whether he’d ever see them leave primary school, let alone university. It became quite debilitating mentally, causing exactly the sort of stress he wished to avoid.

Over the years, he tried various techniques to reduce the anxiety but only one worked. He imagined himself at the school gates for the very last time, saying goodbye to his children.

It turns out the Stoics were on to this 2,300 years ago. Paradoxically, deep consideration of the very worst possible result removes its power to derail us. In investing, there are no more harmful forces than greed, envy and fear. Talking yourself through the very worst imagined outcomes frees us from paralysing anxiety. Try running through these scenarios in your head:

• You’ve just purchased a stock on which we placed a Strong Buy. In the two days since it has fallen 40%. Now you have to decide what to do;
• You have 50% of your portfolio in the big banks. It looks like GFC Mk II is underway and things may get worse;
• Your neighbour trades speculative mining stocks. In his driveway you see exactly the boat you, a cautious investor, have been longing for. Now he’s walking over to give you his next hot tip;

Having contemplated the very worst possible outcome, you’ll be in a better position to work out how to avoid it.

2. Now take precautions

The beauty of getting your head around the worst possible outcome is that it makes you want to prepare for it. Without this first step, it’s almost too difficult to consider, as if defying the possibility of Armageddon reduces its likelihood.

In practical terms, we recommend members have no more than 10% of their portfolios in the big banks, retain a sizable cash holding to take advantage of opportunities and look overseas to take advantage of a strong local currency and cheaper stocks.

These positions were arrived at after a prolonged consideration of what our portfolios might look like in the aftermath of a disaster scenario. They won’t make your portfolio perfectly anti-fragile (we’ll explain why in a minute) but it will make them more robust. And, in our experience, many members’ portfolios are far more exposed then they believe them to be.

3. Target behaviours, not returns

Not a month goes by without us receiving an email that says something along the lines of, ‘I need to earn 10% a year on my investments.’ Remember that your returns are a function first of your thinking and processes, then of the actions that proceed them. Target good behaviours first and the returns will follow.

Expecting or needing a particular return actually reduces the chances of you achieving it because it means you’re concentrating on the wrong thing. For example; you should have a considered, proven process for evaluating a business and establishing its value; at the very least you need advisors you can trust to do it for you; you should set aside time each week or fortnight to review your stocks and consider new opportunities; and every few months you should review your portfolio composition and weightings.

But above all, you need to make your portfolio anti-fragile. That means developing a system where you learn from your mistakes and actively incorporate them into future decision-making. This is how we become better investors, through painful experience. We need to develop an effective way to learn. The problem is that often the experience is so painful we block it out altogether.

Over the break I realised that’s what I’d been doing with my worst-ever investment (a story for another day). So I took a few hours and wrote down why I had invested in this stock in the first place and hung on when it turned bad. Then I took myself back to the pain of the loss itself—it really did make me feel stupid—and then wrote down what I could learn from it. It’s taken six years for me to reach this point because I was afraid to confront it. With a disciplined process for uncovering what I might learn, I might not have waited that long.

Of course, such esoteric concepts are all very well. We can agree and commit to them in principle but in practice, undertakings slip into the vortex of (over)commitments and undertakings. Life is busy; humans are full of good intentions; most are unfulfilled.

So we make mistakes instead. Avoiding them means making good behaviours habitual. But how do we do that?

Good habits

Willpower, by Roy F. Baumeister and John Tierney, offers a few fascinating pointers. Based on many years of psychological research, it argues that self-control is a key ingredient to any successful human endeavour (see the famous Stanford 1972 marshmallow experiment) and that ‘the best way to reduce stress in your life is to stop screwing up.’

The authors offer some very specific pointers on getting it right, based on the idea that willpower, or self-control, is a store of energy subject to depletion. That’s why we’re better off making important decisions straight after eating, and taking our big decisions first.

One of the experiments revealed how Israeli judges were far less likely to grant parole to prisoners serving the same sentence for the same crime if they came before them just before lunch or late afternoon, when they were depleted and more prone to stick with the risk-averse status quo.

So, if you need to make an important investment decision, do so early in the day or after lunch on a full stomach. And clear your diary of other obligations so it has your full attention.

You also need to pick your battles. At this time of year, we all make commitments to drink less, exercise and read more. The research indicates we fail at all of them because we ask too much of ourselves. So, don’t go on a diet at the same time as committing to read all of Buffett’s shareholder letters and giving up smoking. Choose one objective at a time, keep track of it and reward yourself for reaching it.

There are hundreds of irritating but necessary tasks that call on our attention each day. Having them stuck in our heads, undone, is a great source of anxiety that depletes our energy. So, write them down. Research suggests that once we’ve committed to doing them at a later stage, we stop worrying about them now. Get them out of your head and onto a piece of paper.

Lastly, and perhaps most importantly, we need to overcome procrastination. Nike’s solution is to ‘just do it’ but novelist Raymond Chandler didn’t force himself to write; he just forbade himself to do anything else. He could gaze out of the window or simply sit in his chair, but he didn’t read a magazine or go for a walk. ‘Two simple rules’, he said, ‘a. you don’t have to write. b. you can’t do anything else.’

If you’ve been delaying your next portfolio review, thinking of changing your broker, or have been putting off reading an important investing book, this is a simple and effective technique.

Which brings us to Share Advisor’s own output. Our service has expanded considerably since the days of a 16-page printed newsletter. With podcasts, more special reports, Ask the Experts and more stock research, full engagement takes a couple of hours each week.

We don’t believe you need to read or listen to everything we produce to get full value from it. Use My StockWatch to keep abreast of the research published on the stocks you own; monitor recent changes in recommendations for all new stock upgrades and downgrades; and cherry pick the rest. That will deliver you real value for money over the coming year, without a massive commitment in time.

In a similar vein, from now on Director’s Cut will be published quarterly instead of monthly. Taking its place will be more regular features on specific investing topics, with the first one kicking off next week on the art of selling. And please, if you have any tips on improving personal productivity, please leave them in the comments section below so other members can benefit from them.