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Knowing Yourself Part 2

Patient Investing Usually Means Profitable Investing

In an article in the Burlington, Vermont, Free Press of March 5, 1991, Eric Hanson of Fraser Publishing quotes a study done by Jack Vander Vliet of Dean Witter, the brokerage house.  The study assumed that a person put $2,000 into the stock market in each of the preceding 21 years, right at the market’s yearly high.  Each contribution was left to grow and was never sold.  Even though each purchase was made at the worst possible time, the fictitious portfolio, nevertheless, appreciated at a compound average rate of 11.6%.  The seed capital of $42,000 would have grown to $180,000.  This strategy would have worked principally because the market advanced significantly during this 21-year period, according to the study.  Even so, it is important to recognize that this time frame also embraced the devastating 1973-1974 bear market, as well as, the 1987 crash.  Anyone buying bonds between 1960 and 1980 using the same methodology would not have fared so well because bond prices were in a secular, or very long-term, decline.

The argument is not that you should blindly buy, hold for the long-term, and expect to prosper, because this just isn’t the case.  No, the real point of the example is that if you enter an investment with an optimistic and soundly reasoned view, the chances are that it will be profitable.  If you respond to every news item and price setback, you may or may not make money, but you will almost certainly fail to realize the profit potential of your idea.  It is important to sit patiently with the investment-provided the underlying conditions have not changed-because then, your odds of success will be that much greater.

To quote from Mr. Hanson’s article, “The point is long-term planning.  It is far more important to decide how much risk you want to take, how much money your are comfortable investing, and how those assets should be divided among stocks, bonds, real estate, etc., than it is to worry about what is going to scare the market tomorrow.”  In other words, if you do your homework properly, just relax and let the markets do the rest.

I can cite some personal experiences to back this up.  In the early 1980’s, I perceived, correctly as it turned out, that interest rates had reached a historical peak and that over the course of the next 10 years or so, bond prices would rally. I also knew, from studying the markets that this huge rally was unlikely to be a straight-line affair, but would be interrupted by some fairly important counter secular price moves lasting a year or more.  Interest rates on government bonds were in the 11%-14% range at the time.  Having done my homework, the next step was to purchase some bonds, which I did for both a personal account and a corporate pension fund that I was managing.  Since the pension fund did not need the interest, was not subject to capital gains, and had a long-term profit objective, I purchased some zero coupon bonds.  Regular government bonds were purchased for the personal account.   Things began very well for both investments as interest rates did, in fact, decline.

After awhile, I began to study the economy and the technical position of the bond market a little closer and did not like what I saw based on a one-year outlook.  This encouraged me to liquidate the bonds in the personal account.  You can see that I had already broken one of the rules of investing, because I had originally estimate that some major corrections could be expected along the way.  And, as it so often turns out, my shortsighted trading decision was wrong.  Liquidation took place in the very early part of January 1986 at around a price of 87.  By March, the market had reached 105.  In the space of three months, the bond gained as much as it had in the previous 16 months.  You can imagine the exasperation and frustration I felt as a result of this foolish mistake.  The psychology of the situation was that I was expecting yields to fall even further in this “once-in-a-lifetime” bond bull market.  In 1984, I was very happy that I had indeed “locked in” historically high double-digit yields, even though the first part of the decline from 15% to 11.5% had been missed.  But now, I was actually out of a market that seemed destined to rally forever.

Frustration at this point drove me into the Australian bond market, where it was still possible to earn 13% on government-backed paper.  Again, my homework was quite accurate and over the next few years, both the bonds and the currency rallied.  It would have turned out to be an extremely profitable investment if I had the patience to stay with it.  But, of course, I did not.  Within a few weeks, both the bond price and the Australian dollar began to dip.  I had also bought a substantial position and was not psychologically prepared for the twofold risk that was being undertaken.  These were market and currency related.  Australian bond prices declined and so did the Australian dollar-I lost heart and sold.  During the ensuing five years, I made various forays back into the U.S. bond market based on my expectation for the secular or very long-term trend.  While each of these expeditions was profitable, none came anywhere near realizing the potential of the overall price move.

The lesson in patience comes from a comparison of my performance in the personal account, as opposed to the pension account.  You will remember that in 1984, the pension account purchased zero coupon bonds with the identical long-term objective as the personal one.  The difference was that when I cane to liquidate the pension account, I found that the spread between the bid and ask price was considerable because the bonds were illiquid.  This meant that if I was going to repurchase the bonds at a later date and was wrong; the cost of doing so would have been prohibitive.  Consequently, it was the expense of getting in and out that forced me to have the patience to stick with the position.  If I had lost total faith in the secular interest rate decline thesis that would have been another matter, for then, it would have paid to liquidate regardless of the cost.  But my fears were always of a short-term nature and I could always justify getting out of a position in the personal account because of the ease and low cost of getting back in.  What I did not realize was that the desire to reenter the market would fade rapidly once the price had moved above my point of liquidation.

I had read about the danger of losing your position in the middle of a trend in Edward LeFevre’s Reminiscences of a Stock Operator, but it wasn’t until I had gone through the process myself that the lesson began to sink in.  The word “began” has been emphasized because it takes a long time for a learning experience to become a habit.

Excerpted from "Investment Psychology Explained"


Don't forget to check out the glossary - it has over 300 technical terms! 

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