By all counts, the seven-year period from 2009 to 2015 has been a very favorable time for equity investors. Almost any equity investor, to be sure. A simple pick of many stocks back in 2009 has done quite well over the past seven years, even with the volatility in 2015. After such a feast, a potentially dangerous psychological condition kicks in known as confidence bias. After years of successful investment picks, many people become overconfident in their ability to pick winners.
If this overconfidence replaces a disciplined investment approach, we have entered a period where the market will start separating investment skill from luck. Already, the start to the 2016 market year has begun to create havoc for many market participants. What begins to happen to those who were victim to this confidence bias is that they become very emotional -- and that bias vaporizes into panic.
I don't dare predict what is going to happen to the stock market, or speculate on the many reasons analysts are giving for market volatility. Yet it seems logical to me that, after seven consecutive years of a bull market, perhaps valuations in certain areas are excessive -- and this volatility is a natural response to that.
If I may, however, I will opine on some ways that an investor may attempt to operate in a manner more likely to produce results based on skill, rather than chance.
First, and foremost, a share of stock has to be viewed as an ownership stake in a business. This understanding of equity is perhaps the only way I know how to separate fact from fiction. If one can truly look at investments as businesses and not trading tickers, the chance of trading errors is reduced.
Second, pay attention to stock prices as a proxy on value. A few years ago, I wrote very favorably on Chipotle (CMG) as it was trading at around $200 a share. Despite a price to equity ratio in the high 20s, the value of the business was much greater, in my view. As the stock climbed above $600, my thinking was that I would not buy anymore but instead hold. When news of the contaminated food outbreak began to spread, I sold the position.
In addition to a very rich valuation, history has shown that when restaurants experience food quality issues, it takes time to rebuild trust. I still believe in Chipotle and it's potential, but I am waiting for Mr. Market to completely overreact and provide me with an excellent price once again. We are getting close.
If you can truly apply these two simple disciplines in your investment approach, you are starting your approach with a solid foundation. Indeed, these disciplines are simple to grasp, but not easy to implement. Implementation sits in between skill and luck.
