Value Investing? Watch Out For Psychological Denial!

Sometimes an investor is his own worst enemy.

Back before I discovered net net stocks, I had already gotten into value investing but I wasn't set on a certain strategy. I was still finding my way.

Not knowing quite what to do after becoming thoroughly disillusioned with the value investing low P/E approach, I thought I would just put money into cheap investments run by legendary value investors. One of those stocks was Sears Holdings, the firm that owns Sears department stores, K-Mart, and other smaller assets. New to value investing, I thought it looked somewhat cheap. The housing boom was in full roar and a few value investing reports had come out claiming that Sears had a sum-of-the-parts value of about $200-250 per share. Since the stock was trading around $130 per share I decided to make a purchase.

Value Investing Does Not Require a Harvard Degree

There are a lot of smart, well educated people in the value investing industry that just don't make money. It's not that they can't figure out the values or prices that things should be trading at -- they have gone to some of the world's top schools and represent some of the the brightest people on Earth -- it's just that, when it comes to value investing, smarts isn't everything. Buffett himself said that a guy doesn't have to be supernaturally intelligent when it comes to value investing.

A high level of intelligence and a Ivy league education may actually work against investors. To be good at value investing, a person needs a whole host of positive traits -- not just smarts. One of the most important is humility. Charlie Munger often talks about hubris being the downfall of a lot of smart men. Hubris is sort of like narcissism, it involves an overly high assessment of ones self, sometimes to the point where mistakes aren't recognized or cautions aren't heeded when they should be. To a person with hubris -- extreme pride or arrogance -- a value investing career can be very short lived.

Avoid Denial When Value Investing

Dfn Denial

An unconscious defense mechanism characterized by refusal to acknowledge painful realities, thoughts, or feelings.

One of the dangers these people face is psychological denial. For whatever reason, people can often take a mistake as a direct attack on who they are, causing their closely held self-image to crumble. If a man thinks he's smart, then making a mistake (or a series of mistakes) can destroy the image he has of himself. This can be tough to swallow since for whatever reason people in general keep their inner selves, the core of who they think they are, well protected. To protect their sense of self, people will keep well away from conflicting evidence when value investing, fail to recognize it when they stumble upon it, or even explain it away if they feel it becomes a threat. This is the essence of denial.

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Psychological denial can be even stronger once a person has stated his position publicly. Not only does he have to protect his perception of who he is deep down from new threatening information but he also runs the risk of looking like a fool in front of others -- something most sane people dread. State your position publicly and you will subconsciously do everything in your power to keep from facing the fact that you were wrong -- ignoring contrary evidence and explaining away any that does emerge to disrupt your value investing stardom. You'll just end up viscously arguing against detractors and deny the relevancy of any possible conflicting evidence.

When it comes to value investing, a net net stock investor can do this by ignoring companies that haven't worked out. A value stock sits in your portfolio for a couple years, each month dropping a little further in price. Instead of revisiting the financial statements to see if a mistake was made you ignore it, turning your attention to the other securities you're holding. Instead of possibly finding out that your original thesis was wrong or that things have drastically changed since you purchased the company's stock you let the net net stock sit there, unloved, eroding in value.

My Personal Value Investing Faults

I'm not different. While I don't consider myself suffering from hubris (no one I know seems to think I am, either) I still find myself drawn away from stocks that have failed to perform since I bought them. Every value investing portfolio has a small percentage of losers but investors should really make sure that the stocks that aren't performing in their portfolio haven't had their assets impaired or some other event hasn't upset the original value investing thesis.

The stock that sparked this realization for me is Total Telcom. When I picked it up, Total Telecom was just a tiny net net stock whose main asset was a bank account worth about 9 cents per share. Currently the stock is trading around 3 cents per share, roughly a 60% drop in value since I bought it.

Total Telcom sparked this realization because of another dead stock that was sitting in my portfolio, Sears Holdings. Unlike Total Telcom, Sears Holdings is not a net net company and its value is a lot less certain because of the assumptions that have to go into performing a full valuation of the firm. Despite dropping roughly 2/3rds in value since my purchase some years ago, I haven't brought myself to revisit the original value investing thesis or perform a new valuation of the company. This isn't laziness, it's a psychological trap that you have to be aware of or fall victim to.

How to Protect Yourself When Value Investing

It doesn't have to be this way. An investor can recognize his own human psychological pitfalls and take corrective action.

For me, that comes down to four different courses of actions when value investing:

1. The first is nailing down a solid holding period. A solid holding period is a date by which you will sell the stock if the stock price has not moved up to full valuation. Doing this will prevent you from holding on to stocks for far longer than is financially healthy.

2. The second is forcing yourself to perform an value investing autopsy before a stock is sold at the end of your holding period. Force yourself to ask the tough questions by making a list. What was your investment thesis? Did it work out? Did something happen that you didn't predict? What failed? What can you learn from what failed?

3. The third is arguably the most important when value investing -- recognize the importance of failure in learning and become the person who openly embraces failure to grow and learn. This involves seeing the core of who you are as someone focused on learning through failure. Set your sights on succeeding but, if you fail after giving it your all, ask what went wrong and learn from it. Don't shy away from it like those other investors who are too engaged with protecting self-delusions. Your value investing record will thank you.

4. Fourth, keep your investments to yourself but, if you can't, be humble and fallible in your assessment of your own value investing prowess and the investment merits of the company.

5. Fifth, keep objective. Assume the position of someone who is skeptical of the stock even at the time of purchase and wants to see what actually unfolds in order to see whether the stock is worth continuing to hold or not.

Develop Psychologically to Get Better at Value Investing

There are a whole host of psychological mechanisms that work when you start value investing. If not realized, these trap will drag down your returns. As a net net stock investor, you have to rise above it, discovering them and finding ways to circumvent them.

You started value investing because you're smart enough to recognize just how much evidence there is out there for how well this stuff works. Now, take the next step and cultivate your own character so you can get the most out of your financial decisions.

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