Friday, 12 June 2009 Lessons from the recent severe bear market
Reviewing my investing of the last 1 year.
Here is a concise summary of your investment review and lessons learned.
Summary
This review outlines a disciplined, value-oriented investment strategy that was successfully stress-tested during a severe bear market. The core philosophy is based on buying high-quality businesses within one's circle of competence, but only when they are available at a bargain or fair price.
The Strategy That Worked:
The investor's success stemmed from a strict adherence to value principles: focusing on business fundamentals rather than stock price movements, having the courage to buy when prices were low, and the patience to hold quality stocks through a downturn. Key to this was maintaining a cash reserve to capitalize on opportunities and avoiding the emotional temptation to sell good assets at depressed prices.
Key Lessons and Behavioral Hurdles:
The main challenges were psychological. The review acknowledges the difficulty of executing the strategy perfectly, citing specific errors like reacting emotionally to falling prices, selling some quality stocks after they had already fallen, and failing to buy more at the market bottom due to fear.
Path Forward:
The plan for the future is to "double down on the proven process." This means continuing the same disciplined strategy of focused, high-conviction investing, reinvesting dividends, and maintaining cash for opportunities. The primary goal is to reinforce the successful behaviors while building better defenses against the identified emotional weaknesses.
In essence, the bear market confirmed the validity of the investor's long-term, fundamentals-driven approach and highlighted the critical need for emotional discipline to fully benefit from it.
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The above is an insightful piece of self-analysis in June, 2009 after the severe 2008 severe bear market. It demonstrates a mature, reflective, and fundamentally sound investment philosophy. Let's expand, discuss, and critically review these points to see what we can learn from this.
Critical Discussion and Expansion
Your review effectively separates the philosophical (what you believe) from the behavioral (what you did). The "right" list is a strong foundation; the "wrong" list shows the human difficulty in executing it perfectly.
What You Did Right: A Strong Value Investing Framework
Your "right" list is a near-textbook application of value investing principles, heavily influenced by Benjamin Graham and Warren Buffett.
Points 1, 3, 6, 7, 14 (Quality & Price): This is the core of your strategy. "Good quality" + "bargain price" is an unbeatable long-term combination. You correctly note that high-quality stocks can weather a storm and rebound, while "lousy companies" may never recover. Your rule to "never, never, never" buy at a high price is a powerful behavioral guardrail.
Points 2, 4, 5, 13 (Buying at Low Prices): You've identified the key catalysts for buying: general market pessimism and specific, non-fundamental sell-offs in quality companies. This is where fortunes are made. Using PE bands as a guide is a solid, quantitative method to remove emotion.
Points 10, 11, 16 (Holding & Ignoring Noise): This is the most difficult part. Not selling quality at fire-sale prices and not timing the market is what allows you to capture the full rebound, which you correctly identified as the source of your biggest returns. This requires immense emotional fortitude.
Points 8 & 9 (Selling): You show nuance here. Selling is not always wrong. Prudently reducing exposure to overvalued or cyclically challenged stocks as a downturn establishes itself is a form of risk management, not necessarily market timing. It's about balancing the risk of loss of capital vs. the opportunity cost of lost gains.
Point 12 (Averaging): Your method of "averaging down" (buying more as price falls) is a hallmark of conviction investing. However, it's critical to constantly re-check the thesis—is it still a good company? Averaging down on a failing business is a recipe for disaster, but you mitigate this with your focus on quality.
Point 17 (Cash): Always having "dry powder" is what separates the prepared investor from the reactive one. It turns market panics from threats into opportunities.
Critical Consideration: Your strategy is highly concentrated (Point 5 in your "hope" list) and requires you to be right about your stock picks. If your valuation is wrong on one of your eight core holdings, the impact on your portfolio is significant. This is a high-conviction, high-risk/high-potential-reward approach.
What You Did Wrong: The Behavioral Hurdles
Your "wrong" list is a candid admission of the psychological challenges every investor faces.
Point 1 & 2 (Price vs. Business, Emotional Reacting): These are two sides of the same coin. When you look at the price instead of the business, you are allowing Mr. Market's mood swings to dictate your emotions. This is the fundamental battle in investing.
Point 3 vs. Point 4 (The Selling Dilemma): This is the most profound part of your analysis. You have identified a core tension:
Point 3: "I should have sold earlier." (Tactical error)
Point 4: "But selling good quality stocks was a mistake." (Philosophical error)
Your own resolution is correct: For a long-term investor following your philosophy, holding or adding was the correct move. Selling after a major fall locks in permanent loss of capital and misses the rebound. This conflict shows the danger of deviating from your core strategy during stress.
Point 5 (Not Buying More in March): This is the classic "bottom-trap." Even when everything in your rational mind says "buy," the emotional, fearful part screams "what if it goes lower?!" This is why having a disciplined, pre-defined process (e.g., "if PE hits X, I buy Y amount") is so important.
What I Hope to Do: Reinforcing the Process
Your plan for the next 12 months is essentially: "Stick to the plan." This is the correct conclusion. However, we can expand on point 8.
8. Please expand... What to do next:
Formalize Your Checklist: Create a written checklist for both buying and selling. For buying, it should include: Quality Score, PE vs. Historical, Reason for Sell-off, Circle of Competence check. For selling, it should be strict: Fundamentals deteriorated? Permanently impaired? Price reached extreme overvaluation? This reduces emotional decision-making.
Define "Reasonable Intervals" for Rebalancing: Don't rebalance too frequently. Let your winners run. Perhaps rebalance only when a position becomes dangerously large (>20% of portfolio) or when the thesis breaks.
Journal Your Decisions: When you feel fear (like in March) or greed, write down your reasoning at that moment. Refer back to it later. This accelerates the learning process and builds emotional discipline.
Stress-Test Your Portfolio: Ask "what if" questions. What if a recession hits? What if interest rates stay high? How would my top 8 holdings be affected? This isn't about predicting, but about understanding your risks.
Plan for the Next Downturn Now: Decide in advance, during a calm period, what you will do when the next bear market hits. "If the market falls 20%, I will deploy X% of my cash. If my top holding falls 30% without a fundamental change, I will add Y%." This turns panic into a predefined process.
Summary
Your review demonstrates a successful transition from a theoretical understanding of value investing to a hard-won, practical application of it. You have built a robust, high-conviction strategy centered on buying high-quality businesses at bargain prices and holding them for the long term.
Your key strengths are your discipline on price, your focus on quality, and your ability to hold through extreme volatility. Your primary challenges, like all investors, are behavioral: overcoming the fear to buy at the bottom and the fear of seeing paper losses, which occasionally led you to act against your own best principles by selling quality stocks low.
The path forward is clear: Double down on your proven process while systematically building defenses against your identified behavioral weaknesses. By formalizing your criteria and pre-committing to actions for future scenarios, you can further reduce the gap between your excellent investment philosophy and your human execution of it. You are not just investing in stocks; you are diligently investing in refining your own process, which is the ultimate edge an investor can have.
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