Thursday, June 4, 2015

Patience= Investing Edge

About 2 years ago, I dealt briefly on the virtue of patience in investing.

A vast majority of participants in the sharemarket are overly-influenced by short term gains. A clear indicator of this phenomena can  be seen with the obsession with dividends and yield, to the exclusion of other important factors making up a good investment. To satisfy this demand for yield, we have experienced a proliferation of products and services, such as ETFs, financial products, and newsletters catering to yield hungry investors.

This appetite for yield came about via a confluence of various matters, a lollapalooza effect, comprising of:

1. Continual low interest rates;
2. Increasing SMSF growth;
3. The dividend imputation system;
4. Uncertainty generated in the aftermath of the GFC;
5. Low economic growth environment.

Apart from the above, I would humbly submit that the main driver of yield appetite is rooted in deep behavioural psychology, namely the propensity to seek a near-certain short term gain at the expense of larger long term gains perceived to be more uncertain. Various experiments and literature have repeatedly shown that a human subject prefers a gain of $100 today rather than a gain of $200 in 7 days. However, given a choice of $100 in a year or $200 in a year plus 7 days, rational decision making prevails.

So it is that a significant majority of investors also prefer buying shares in companies in expectations of price moving events occuring within a period of 12 months or less. In investing literature, these are loosely termed as catalysts. Developments expected to occur after a period of 12 months or more are severely discounted, or not even assigned any value.

Therefore, from the above, it is logical to deduce that an investor with a longer term outlook gains a significant edge. This  may be simple and obvious, but as good advice goes, simple does not equate easy. The vital ingredient necessary is behavioural in nature, namely temperament and patience. This is where the multitude of investors will fail, giving meaning to the phrase "the flesh is willing, but the spirit is weak."

Value investing is difficult precisely because it requires actions that run counter to ingrained behaviours. I have recently conducted a review of the various portfolios I have operated over the last 7 years, and some of my main findings are:

1. Over 70% of initial purchases are followed by price going lower within a period of 6 months;
2. About 20% of initial purchases experienced price reduction by nearly 50% within a period of 12 months;
3. Over 80% of successful positions experience positive price movements after 1 year, with the gains being experienced in year 2 and year 3 after initial purchase.
4. A significant portion of returns are contributed from positions added at lower prices after initial purchase.
5. Volatility decreases in direct proportion to the length of time of holdings.

What do we see here?  For every share that is purchased, you can expect the price to continue to drop for the next few months. The price drop may be as severe as 50% within 1 year. For the first year, price volatility will be very high, and the volatility starts decreasing only if the shares are held for a longer period. If more shares are purchased on the way down, the returns are increased, provided that the position is held for more than 1 year. A position usually takes 2 to 3 years on average to work out.

In short, my investing methodology virtually assures pain in the short term in the expectations of positive returns in the longer term. The process looks rational only in hindsight over periods of 2 years or more. The human brain is not wired for these sort of experiences. Loss aversion usually prevails, at the expense of long term gains.

Yours sincerely,
One Legged