Chapter 11: Master the Art of Behavioral Investing
Chapter 11: Master the Art of Behavioral Investing
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 11 of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real time.
Chapter 11 addresses how to profitably apply cognitive behaviors such as rational thought, discipline, and patience to a quality-driven stock-picking strategy and, thus, counter the blatant lack thereof in the financial markets.
Chapter 11
Master the Art of Behavioral Investing
Rational thought, discipline, and patience equal stock market investing success.
Many investors must increase awareness of the mental pitfalls that sabotage stock-picking and portfolio construction, whether professionally or retail-managed. Mastering the art of behavioral investing bridges the ever-widening gap between psychology and money.
Quality-driven value investors apply rational thought in their continuous improvement of investment wisdom, discipline to conduct the due diligence toward discovering quality, publicly traded companies with stock prices exhibiting wide margins of safety, and patience in waiting for the compounding of capital gains and dividends to build personal wealth over time.
The Art of Rational Investing
As much as the institutional way of stock-picking attempts to convince its devoted followers otherwise, it is far from rocket science.
On the contrary, by keeping investing super simple, the beneficiaries of quality-driven stock portfolios will be grateful. And when the Wall Street fee machine insists that its complex and predictive investing paradigms are best, rational investors on Main Street remember that common sense prevails.
For better or worse, rational thinking becomes the leading indicator for predicting the general direction of future company performance and stock prices. Unfortunately, the Wall Street Way often gets in the way as it cannot monetize common sense and instinct into a deep-dive sell-side research report or buy-side quarterly note to clients.
In contrast, sticking to the facts by reading 10-Ks and researching a company’s value proposition, returns on management, shareholder yields, valuation multiples, and downside risks, quality-driven investors gauge the worthiness of being part owners of the business, assuming the current wealth of fundamentals are favorable, the present value of the share price is reasonable, and the downside risks are below average to low.
Why Predictive Analysis is the Fool’s Game
Unfortunately, too many investors consistently believe they can predict trends, catalysts, and macro events with abandon.
Their crystal balls, disguised in sophisticated methodologies, encapsulate forward revenues, earnings projections, and specific future stock prices. History dictates that such practices are the fool’s game.
On the contrary, rational investors refrain from attempting to predict specific future movements in the company shares, whether by price targets or percentage gains and losses, leaving nonsensical games of chance to market speculators.
Rational investing ignores equity analyses that make calls, such as “XYZ shares undervalued by 42 percent.” Common sense investors disavow any self-illusion of the ability to predict exact percentages of presumed pricing discrepancies, instead surmising from research and thought that stocks appear mispriced in general.
When market timers are wrong—the probable outcome—in predicting surprise market, industry, or company events, substantial assets are lost because traders are too long or short.
On the other side of the trade, rational-thinking investors are prepared to take advantage of the surprise event or black swan by allocating planned cash reserves for new or increased positions in the value-priced shares of quality companies.
Placing Bets is the Antithesis of Quality Investing
The market consensus estimates the combined unanimity on publicly traded stocks from analysts, bloggers, portfolio managers, retail investors, and senior executives.
The contrarian assumes the crowd is wrong regarding a company’s longer-term prospects. Although additional research is necessary to confirm or contradict the accord, the consensus is often a counterintuitive indicator for rational-thinking investors. However, making bets and crossing fingers is the antithesis of quality-driven investing.
Rational thought increases their chances of being right more often than wrong by applying common sense based on tangible current wealth and present value instead of speculative future growth. Moreover, knowing that the Wall Street consensus is often senseless, rational investors avoid the temptation to interpret group think as a definitive buy or sell signal.
Buying and selling stocks based on attempts to predict future events is no different from investing practices launched on hope. Rationally thoughtful investors stick to objective facts and ignore subjective forecasts.
In Business, Rational Thought Outperforms Emotion
Fickle retail and aggressive professional investors are lost in the crowd and ruled by raw emotions in buying and selling investment securities to quench their thirst for fast money. Such emotional investing produces losses more often than gains.
Too many investors—rarely for better, more often for worse—trade on geopolitical news and other macroeconomic events, inspired by misguided passionate feelings more than rational intellect.
The good news is that irrational behaviors create profitable buying opportunities, if only temporarily, providing quality-driven value investors the potential to outperform the market over time.
Rational investors are leery of the talking heads for the sake and safety of their portfolios. This chapter is neither about current macroeconomic conditions nor what one should buy, sell, hold, short, or exploit to outwit the market in the short term, leaving that chatterbox to the financial entertainers. Instead, it is about muting the noise emanating from the markets and investing with rational thought and common sense by taking advantage of the time-tested winning strategy of buying value-priced slices of high-quality, enduring companies and then holding each for the long-term as proud shareholders.
Investors applying rational thought and a pinch of common sense know that quarterly earnings, the daily news cycle, and other short-term events create buying opportunities for the shares of already determined quality enterprises. In contrast, countless other investors sell at a loss on the report or event by placing raw emotion ahead of common sense. As in politics and business, rational thought prevails over irrational feelings for quality-driven value investors.
Emotion-free rational thought and a pinch of common sense often equate to success when investing in stocks for capital gains in the long term and dividend income in the near term.
The Art of Disciplined Investing
Alpha-achieving portfolios are possible for disciplined, quality-driven investors.
Their research or due diligence focuses on fantastic companies with ethical management generating consistent, organic revenue growth, sustained profitability, abundant free cash flow, and high returns on equity and invested capital.
Investing in stocks is simple, although never easy. It is doable, albeit intimidating. However, uncomplicated research conducted with a disciplined approach to portfolio construction, capital allocation, and dividend reinvestment has more significant potential to outperform the market over an extended holding period.
A profitable concentrated stock portfolio resembles a collection of owned slices of companies that produce high-quality products or services with enduring competitive advantages.
Quality-driven investors enjoy picking stocks and managing investments through rigorous education and self-discipline. By keeping their investment research focused on a few crucial metrics combined with rational thought, disciplined investors can outperform Wall Street’s fee-driven, sophisticated, deep-dive predictive analyses and outperform the market with lower costs and less risk despite capital limitations.
Get to Know the Business
Disciplined investors perform bottom-up analyses focused on finding quality companies regardless of the specific industry or any macro conditions of the general economy, which are forever guaranteed to be fickle.
They stick to the tried-and-true approach of researching the fundamentals of the targeted business to determine the potential level of ownership worthiness.
Disciplined investors own companies with efficient and transparent management who leverage returns for customers, employees, and shareholders. They think of themselves as investors who own slices of excellent businesses instead of accumulating electronic shares of common stock purchased instantly from their online discount broker. The actions are identical, although the affirmation as an owner of actual companies is more substantial than being the trader of faceless stocks.
Measuring actual returns on management or current wealth compels disciplined investors to limit precious capital to the stocks of quality operators held for the long term to profit from the compounding returns courtesy of the enterprise’s superior capital allocators.
Disciplined stock market investors increase the likelihood of market-beating total returns by focusing on the fundamentals without regard to the institutional pressures of fast-money-seeking clients and quarterly out-of-the-park performance.
Instead, they buy slices of high-quality, enduring companies when trading at reasonable prices.
Commit to Reasonable Valuations
A sensible assertion is that disciplined investing involves a commitment to suitable valuations.
Arguably, every investor buying securities on the long side believes prices are going up by the end of the day, week, year, or decade. So, why do many fail at the valuation part?
When buying stocks based on present value, disciplined stock investors benefit from growth later. On the other hand, investors or traders needing discipline are apt to pay more for securities. Why pay more?
Special situations or surprise events often spell buying opportunities for the common shares of quality companies destined to prevail despite the temporary economic or industry downturn. Disciplined value investors are inclined to wait for the economy’s macro or a company’s micro events to deflate the targeted stock to a reasonable if not bargain, price.
As day traders and momentum investors cast votes daily, disciplined investors carefully weigh the fundamental analysis of a company, tempered by the patience to act only when the stock price is attractive.
Frustratingly, owned equities held in a portfolio or targeted common shares on a watchlist often appear at fair value or overvalued to disciplined investors focused on owning the mispriced stocks of quality companies over long-term holding periods. Nevertheless, they keep sifting for value regularly, as the occasional surprise bargain often appears when least expected.
Disciplined, quality-driven value investors never attempt to predict a market, industry, or company event and, instead, prepare to take advantage of sudden discounted stock prices after the fact.
Understand and Accept the Downside Risks
Assessing downside risk is paramount to the ultimate success of quality-driven investors.
Disciplined investors own risk-averse slices of wonderful companies, thereby leaving the trading of stocks to risk-defying speculators. Nonetheless, although the mispriced shares of magnificent capital-deploying companies deliver rare opportunities in every market, each is never devoid of risks.
Regardless of the cause or ultimate duration, any market downturn delivers a stark reminder that managing risk is paramount to disciplined investing. Likewise, any sudden downturn in the market reminds us of the cornerstone of thoughtful investing — understanding the downside risk profile for each holding.
Second-level investors become sellers as stocks trend upward and buyers as the markets head south. The pattern followed by disciplined, value-driven investors generates profits from the unintended generosity of the inept who act against glaring lessons from market history.
On the contrary, the discourse of disciplined investors includes that a risk assessed, understood, and well-managed is worth taking. They know that although returns are unpredictable, the risks are controllable.
Measuring, understanding, and accepting the downside risks of a company and its common shares from an unforgiving market offer the best opportunities for investing with a tolerable, asymmetric risk/reward profile. Often, successful investors are rewarded more for limited portfolio downside in bear markets from a disciplined approach to risk management than from the upside in bull markets driven by exuberant participants.
Disciplined behavioral investors generate profitable returns over their lifetimes by managing the downside risk while letting the upside take care of itself.
The Art of Patient Investing
Patience is perhaps the scarcest—and, thereby, most valuable—commodity in the stock market. Quality-driven value investors profit from this market incongruity.
Slow and steady investors know that stable companies appreciate in the long run, as active traders move in and out of positions in reaction to good and bad news, often getting punished in the short run. So, instead of following populist stock trends to their potential peril, the winners invest in great companies over long-term horizons to benefit from the magic of compounding with wide safety margins. They chase high quality at a reasonable valuation.
It’s because patient investors know that the common stocks of companies providing valuable, in-demand products and services endure across market cycles despite a few erratic price movements in between rendered by the nearsightedness of the crowd.
Quality-Driven Value Investing Requires Patience
Investors or traders needing more patience risk paying more for the equities purchased or sold before realizing intended capital gains.
On the contrary, patient stock market investors know that if they wait long enough, their targeted quality companies—including some already in their portfolio and now trading at higher valuations since initial purchase—become available at bargain prices, if only temporarily.
Surprise macro occurrences, controllable company events, market downturns, adverse news reports, or quarterly earnings misses often trigger buying opportunities of excellent companies for patient quality-driven value investors instead of panic selling in lockstep with the herd.
Being a scarce and thereby valuable commodity, embracing patience is often the difference between the success and failure of stock market investors. Despite the imposing challenge, practicing patience in waiting for investment theses to play out is paramount to long-term success. Contrary to conventional wisdom, creating wealth in financial markets from short-term trading is rare. However, the market often rewards perseverance.
Patient investors pursue alpha by selecting companies demonstrating the propensity for upside and exhibiting downside protection or the safety margin that protects invested capital. Then, if choosing to purchase, they wade with patience through market and company gyrations for the investment theses on the stocks to play out over long-term holding periods.
Investor patience changes the conversation from the proverbial Wall Street way of quarter-to-quarter reactions to revenue or earnings hits and misses to the intelligent investor model of multiyear compounding returns on capital and dividends purchased at reasonably-valued prices.
The lesson is that although hindsight is forever 20/20, patience is always forward.
Patience Uncovers the Needles in the Haystack
Quality-driven value investing is the equivalent of finding the proverbial needle in a haystack and, therefore, requires large doses of patience for long-term success.
Patient investors wait for the valuation multiples of the shares of enduring enterprises to drop to levels signaling temporary bargains. So, they keep their eyes open to avoid blinking and missing those fleeting buying opportunities.
Despite conveying confidence, do market forecasters know what will happen to a market, company, or stock price at any specific time?
The historical capital gains in the common shares of enduring enterprises spawn from the occasional, sometimes generous, upticks in the stock price of high-quality businesses adding up over time. Patient investors more often experience this alpha or the excess returns of an investment relative to the benchmark index’s performance.
Patient investors focused on current wealth and present value, uncover the elusive needle, and then stick with it, no pun intended.
Be Willing to Buy and Hold Forever
Patient investors equate buy-and-hold-forever as an enduring commitment to quality enterprises and the common stocks representing each.
Patient, quality-driven value investors buy low, hold high, and sell when they die.
They are willing to hold the common shares of great companies for a generation, enjoying the compounding growth of capital gains and dividends. On the other hand, selling when they die translates to passing the asset on to their heirs and designated charities.
The challenge for many investors is to think ten to twenty years out instead of the customary ten to twenty months or even ten to twenty days. However, from the vantage point of years, the gains seem to creep up over time for the patient investors who own slices of companies with quality business models.
The buy-and-hold forever method pays off for these investors. Again, in terms of buying value now, they benefit from growth later.
Despite the perpetual and unrelenting market noise, patient investors quietly monitor an enterprise’s business prospects while collecting dividends as the short-term reward for their perseverance in awaiting capital appreciation.
Patient, quality-driven value investors remain stoic, wondering when or how those opportunities will emerge. Yet they often do, eventually.
Mastering the Art of Behavioral Investing
A behavioral approach to investing in the stock market is purely cognitive.
This chapter addressed how to profitably apply cognitive behaviors such as rational thought, discipline, and patience to a quality-driven stock-picking strategy that counters the blatant lack thereof in the financial markets.
It is important to remember that long-term results are the best barometer of equity performance for rational-thinking, disciplined, and patient quality-driven value investors.
They don’t need to chase quarterly performance, as do many of the players on Wall Street and their hordes of followers on Main Street. On the contrary, the art of behavioral investing is the quality-driven value investor’s best friend.
Investors who master the art of behavioral investing look forward and beyond, knowing that a legacy portfolio comprising the slices of exceptional, enduring enterprises continues to compound in the appreciative hands of loved ones.
Behavioral investors buy and sell to profit, not quell emotions. Nevertheless, when purchasing enduring quality companies at reasonable prices, there are fewer incentives to sell other than to finance an essential life milestone such as a home purchase, college tuition, a wedding, a hobby, a business start-up, or a comfortable retirement.
They pursue alpha with large doses of rationale, saving any emotion to celebrate successes or assess failures after the trade — never before. The lesson for investors is to stop market timing or stock trading and start investing or divesting as macro and microeconomic conditions dictate.
Alpha-achieving stock picking requires the behavioral arts of rational thought, self-discipline, and unrelenting patience in every aspect of the investment paradigm.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Writer
David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, MSN Money, TalkMarkets, ValueWalk, Yahoo Finance, QAV—Australia’s #1 Value Investing Podcast, Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University.
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