We’ve had a very volatile year for markets and in many ways this has just reminded me of how psychology can really wreak havoc with our investment decisions. There is a constant tension in investing between the urge to do something, (which everyone experiences) and the reality that oftentimes the best thing you can do with your investments is nothing at all.
When you select a portfolio which is composed of strong businesses with good balance sheets and promising futures, time becomes our friend. Generally speaking, the longer we own these great businesses, the better we will do. This is the opposite of what happens with a bad business. In a bad business, time is not your friend. The longer you own a bad business, the more you will lose. That’s why we spend so much time and effort making sure the businesses we invest in are good businesses.
Assuming that you’ve been successful in selecting a portfolio of good businesses, then your biggest task that you have is to resist the urge to change it. Changing a good portfolio more than likely will reduce your returns rather than enhance them. That is because every time you make a change there are frictional costs to making that change. The more you change, the more costs you incur. If you own a good portfolio, then the best thing you can do is continue to hold it, and avoid incurring unnecessary costs.
But our primate brains aren’t really wired to sit and wait for returns to roll in. Human beings have been subsistence level hunter gatherers for most of our time as a species, and that DNA is still pretty engrained in our brains. We constantly get impulses to “do something” because that was the only way our ancestors could feed themselves. This is especially true when stock markets are making big moves, both positive and negative. That’s something we’ve seen in spades in 2020 and it’s therefore no surprise that companies like Robin Hood have reported record levels of trading, the likes of which is unprecedented. While this can be exciting, it doesn’t bode well for those individuals’ investment returns.
When should you make a change in your portfolio? Here is the decision process we use to both buy and sell an investment.
Buying an investment is easy. When we identify a good business which is trading at a significant discount to what we think it is worth, then the decision to buy it is easy. In order to determine how much to buy, we have to weigh the probabilities of success and assess the potential upside, and perhaps more importantly, the potential downside if we’re wrong. We then compare it to all the other opportunities we have in the world to see if this new opportunity is better than what we already have. In most cases, it isn’t and therefore we do nothing. When on rare occasions we do find something we think is better, we buy.
The decision to sell an investment is much tougher. There are many psychological pressures about markets which influence people to sell their investments. Most people find it really hard to act rationally when their investments are falling, like they were earlier this year. They often experience the pain of the loss in a very real and visceral way. They therefore sell those investments just to make that pain stop. This is often a disastrous decision.
We will only sell an investment in three situations:
If the funds are simply needed elsewhere, either for a better investment or to be spent personally or in a business;
If the prospects for the future returns of the investment are no longer as good as what we originally thought. This could be because the price of the stock has risen too high, and we no longer can justify owning at that price. Or it could be because our understanding of the business was wrong and the business is worse than we originally thought; or
If the investment has risen to an extent where it is an inappropriately large size position in the portfolio. In this case we wouldn’t sell the entire investment, but we would trim it back to a more appropriate size.
Unless one of these three situations exists, the best thing we can do is absolutely nothing at all.
This lesson was reinforced on me earlier this year with a company we own called Whitecap Resources. At a point earlier this year, the stock had gone from a price above $5 a share to below $1 a share before recovering to around $2 a share in mid summer. At that time I contemplated selling a portion of the Whitecap stake in our portfolio in order to trigger the capital losses that had accrued. The plan was to flip the position to another energy company and then repurchase the stock in 30 days so as to avoid stop-loss rules in tax law. We would trigger the tax benefit of the capital loss, and still benefit if the price of oil was to rise. This makes a lot of sense and is the kind of thing that is done all the time in wealth management.
Luckily for me, I did not do anything. The very next day, Whitecap rallied on no significant news by 23%, and went on to increase in value by over 150% since that $2 trading price. This significantly outpaced other energy companies. It was entirely unforeseeable that such a rally would happen but if I had sold the stock myself and our clients would have lost out on significant gains, even if I had repurchased it 30 days later. This would have been very unfortunate.
Whitecap is a good business, run by great management. Subsequent to our decision to do nothing and retain our Whitecap ownership position, Whitecap made two transformative acquisitions this fall which will greatly enhance returns for shareholders in future years. We didn’t invest in Whitecap because of those acquisitions, but they are the kind of thing that can happen when you invest in a great business and just hold it. Patience and a great business rewarded us with big upside potential that was not immediately present when we bought the shares.
The lesson is clear. If you own a great business, usually the best thing you can do is nothing at all.
- Craig White, BA, LL.B., CIM®
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.