Value investors tend to be philosophical during market meltdowns. “Be greedy when others are fearful and fearful when others are greedy” is well understood as the intellectually sound attitude when markets go haywire. Nevertheless, most of us do not have perfect mastery of our emotions and can quickly get swept up in particularly nasty market routs if we do not decide in advance how we will behave during such events.
“Checklists? That’s for Amateurs …”
The benefits of using checklists in a variety of fields is the subject of Dr. Atul Gawande’s recent book The Checklist Manifesto: How to Get Things Right. One major obstacle to the wider use of checklists is the perception that doing so is a form of intellectual weakness. In other words, checklists are great for those starting out at a task, but why on earth should an experienced practitioner stoop to such levels? The book does an excellent job of shattering this point of view in a number of fields. There is a reason airline pilots use checklists prior to every flight. The consequences of not doing so can be catastrophic.
The Best Investors Use Checklists
Charlie Munger has been recommending the use of checklists in investing for several years as we can see from reading about his ideas in Poor Charlie’s Almanack and Seeking Wisdom: From Darwin to Munger. To borrow a “Mungerism”, those who fail to use checklists are like a one legged man in an ass kicking contest. In The Checklist Manifesto, Dr. Gawande interviews value investor Mohnish Pabrai regarding his use of checklists when selecting investments. Many investors have taken the advice to use checklists when selecting investments, but the same can be done for dealing with market panics.
Brief Checklist for Market Panics
The following is a brief set of checklist items that an investor can ask himself when faced with a market panic. In some cases, the checklist items assume that the investor used a good decision making process when selecting investments to begin with. It may seem obvious, but investors who do not have a good investment rationale for what they currently hold are at greatest risk of acting foolishly in a panic. However, even investors who do everything correctly in terms of forming investment rationales can fall victim to panic when they see their portfolio drop 15, 20, 40, or even 50 percent in short periods of time.
- Disconnect from Business Media. It is impossible to make reasonable decisions when assaulted by the constant noise of the mainstream business media. CNBC, Bloomberg, Fox Business News, and other television programs are particularly hazardous to your wealth during a market panic. If you must watch business news, consider a calmer format such as Nightly Business Report on PBS or better yet refrain from all television. Reading newspapers online or in print is important to understand the broad scope of what is happening, but do not pay undue attention to self proclaimed experts and do not allow macro considerations to justify indiscriminate selling of investments without looking at the fundamentals of each business.
- Examine each of your investments starting with those that have suffered the largest recent market price declines. For each investment, revisit the document that you wrote when entering into the position along with any notes you have from reviewing financial reports since the original purchase was made. What was your estimate of intrinsic value at the time of purchase? Is there any reason to believe that business prospects of the company have changed enough to alter your intrinsic value estimate? Revise your estimate only if company specific issues have come to light that are material to long term business results. Compare the current price to the intrinsic value estimate (revised if needed). Is there still a large margin of safety provided by the gap between today’s quote and intrinsic value?
- Disregard Cost Basis. Tax issues aside, do not consider your historical cost basis when evaluating your portfolio during a market decline. Human emotion makes us less likely to be distraught when we still have paper gains on an investment compared to having paper losses even if the recent price decline was the same in both cases. The reality is that your cost basis has no bearing on whether the investment is a sound one today. Examine the business prospects of the company relative to today’s quotation. If the intrinsic value of the company is far in excess of today’s quote, the margin of safety is there regardless of original cost basis. As an aside, the investors who took losses in the recent “flash crash” due to stop loss orders were engaged in a practice that is illogical in general because it calls for an automated sale of an investment at better prices than the investor originally paid without intelligently taking into account fundamentals.
- Examine your instinctive desire for liquidity. If you feel compelled to sell during a market meltdown, examine the instinctive desire for liquidity. Do you seek liquidity because there are more compelling opportunities available but you have little cash on hand to make purchases? If you are an individual investor, are you raising cash for near term expenses? If you are managing money, are you getting large redemption orders from clients? Understanding the desire for liquidity is critical because it drives our motivations for seeking shelter in cash. A defense against the instinctive desire to want more cash during a panic is to ensure that your ongoing cash balances are adequate for expenses, redemptions, new opportunities, etc as the case may be.
- Consider putting cash to work. Obviously, the ability to put cash to work during a market decline requires having cash to begin with. Although it is not always easy to retain cash balances at zero percent interest, having some cash to deploy helps emotionally because it allows us to “take action” during market meltdowns. Even if the incremental purchases are small, it still provides some psychological benefits. Go through the list of your existing investments and rank them by the degree of undervaluation and then pick some of the best opportunities to put new cash to work. Alternatively, some new opportunities that previously did not provide a sufficient margin of safety may now qualify as good investments.
This list is just a starting point and may not work for everyone, but in concept, having a list that works for you can be very helpful in times of stress. It is important to note that this list will not be useful if an investor does not have a good rationale for each of the investments that he already owns. A market meltdown can be a terrifying experience if you have no idea what the true intrinsic value of your investments are because then you are simply looking at random quotations that keep declining and watching your net worth melt away.
Focus on Long Term Net Worth
Those who know what their investments are actually worth can view such moves with more detachment. One of the best ways to do so is to maintain a spreadsheet with columns listing each investment, the current market value, and an estimate of intrinsic value. Focus on the intrinsic value column when assessing your long term net worth. Unless you are tricked into selling by failing to control your emotions, there is no reason to allow the short term emotional distress of Mr. Market harm your long term net worth.