Dramatic price falls can be painful for investors, and there has been no shortage of them in 2016. Whether it’s a market sell-off or a single stock disaster, unexpected events cause stress that can lead to bad decision-making. For that reason, pre-planning for a crisis can be a powerful way of making better choices.
Pre-prepared checklists are nothing new in investing. It’s a subject where you often see the names of finance legends like Mohnish Pabrai, Charlie Munger and Michael Mauboussin mentioned time and again. To varying degrees, all of them suggest using checklists as a way of combatting “known unknowns”. Or as Mauboussin puts it:
“When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone.”
Why precommitment works
Pre-committing to a plan can be used everywhere in investing. It can help in sticking to strategy rules and being properly diversified. But it’s when things get difficult that a plan is most important. That’s because our natural instincts can easily turn a bad situation into a catastrophe. The trick is to make a dispassionate plan before the crisis happens.
Take Sir John Templeton as an example. The late, highly respected value investor once famously wrote that:
“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
It was a profitable contrarian strategy for Sir John. But even he needed pre-planned discipline to make sure he acted on it. His deep-value approach meant leaving open ‘buy orders’ with his brokers for perhaps months at a time. Those orders were set at much lower prices where he knew he’d have a wide margin of safety. But he also knew that when the market tumbled to those levels, he’d be as fearful as everyone else. So he placed those orders in advance. Sir John was clearly well aware of what’s known as the empathy gap…
How the empathy gap can ruin good decisions
There are various studies of how, in stressful situations, strong emotions lead people to behave differently to how they expect – otherwise known as an empathy gap.
In one study, researchers tested the theory people gamble more than they plan to when they’re in a casino. Ahead of the visit, the gamblers in the test were fairly conservative in their expectations. They sensibly thought that they’d bet a lower amount if they were hit with a loss, and bet the same amount if they won.
In practice, faced with a loss, those gamblers actually bet significantly more than they’d planned to (whilst sticking to the original plan when they won). The negative emotions of losing caused them to behave entirely differently to how they themselves expected.
In another study, researchers showed how people tend to have an ‘illusion of courage’ when it comes to predicting how they’ll act in certain situations. Experiments tested the willingness of participants to do something embarrassing in public in return for money. In a ‘cold’, psychologically-distant emotional state, they were much more likely to agree to the challenge. But when the researchers encouraged them to think first about being fearful or angry, they became far less willing. This was a classic case of an empathy gap, where the participants were unable to imagine how they’d behave in future emotional situations.
In investing, the empathy gap looms large and it’s potentially very damaging. As Richard Peterson says in his book, Inside the Investor’s Brain: The Power of Mind Over Money, during calm markets most investors don’t prepare adequately for volatility. He writes:
“They cannot accurately forecast how they will feel and what they might do in such conditions. They project their current sense of security onto their future self.”
Beating the empathy gap
So how do you meet the challenge of making allowances for emotional turmoil? The answer comes back to realising that there’s a strong chance of acting irrationally and making bad decisions in a crisis. In the absence of cast-iron will, a pre-committed contingency plan or checklist that’s constantly updated to account for new eventualities is the way to go.
Unfortunately, there is no one-size-fits-all contingency plan that suits every investing style and risk appetite. But there are some broad tactics that any investor can start to apply. On this subject, Mark Minervini, the US stock trader, is a great source of ideas. In his book, Trade Like a Stock Market Wizard, he insists the best way to ensure stock market success is to have contingency plans and continuously update them as you learn and encounter new scenarios. He says:
“If and when new circumstances present themselves, I add them to my contingency plans; as new unexpected issues present themselves, the contingency playbook is expanded.”
Minervini’s key message is to develop a dependable way to handle virtually every situation that arises.
We’ve covered some of the most painful eventualities in previous articles. They are by no means comprehensive, but there are some useful starting ideas in A checklist for surviving volatility and What should you do when a stock plummets… buy, hold or sell? In addition, our recent research into profit warnings tackles a subject that can leave investors with a visceral fear of financial loss. The finding suggest that on average it makes sense to sell on a profit warning. But without a precommitment to take action, it could be mentally much tougher to make that decision when a profit warning does come