We’re only human after all…
It is now well established that people tend to make bad investment decisions. Study after study has confirmed it: As a group, investors buy high and sell low. Whole new fields of academic research have sprouted up to find out why this is so. Recent advances have shed light on what goes on when the human animal struggles with questions involving risk.
Scientists can now map the human brain and monitor its functioning in real time. They can actually show us how tasks involving money and investing cause our “caveman” (and cavewoman) brain to fire on all cylinders. Meanwhile, our rational brain is allowed to function just enough to think it’s in charge as it carries out directives. Yet the stock market as we know it has only been around for a couple of centuries. If it’s the caveman brain we’re bringing to bear, the human species is maladapted to the stock market.
This explains investors’ sometimes crazy behavior. We think we’re acting rationally but in reality we’re at the mercy of subconscious primal forces. When the news is bad and everyone around us is selling, those forces are working overtime. Caveman brains are frantically making bad trades….
What to Do?
If we ask a financial professional how to respond to these new findings, maybe she’ll say, “Don’t do that!” Not much help if our problem is both subconscious and primal. It’s as if we’re being told that we need to evolve, so what are we waiting for?
Okay, let’s evolve. But how? Ironically, we begin by presuming that most investors won’t evolve anytime soon. Investing is a zero-sum game — and even less than that if we factor in everyone’s “friction” costs — with each trade producing both a winner and a loser. If we know people are making bad trades, we would be right to take the other side. Maybe our rational brain can overrule our caveman brain if it only knows why it should. If so, we may be leading the way in human evolution!
SweetSpot Investing: Why It Works
SweetSpot directs us to the other side of the bad trades that less-evolved humans feel compelled to make. SweetSpot investors rely on cold numbers to identify the mispriced assets left behind after the frenetic selling has played out. We avoid the pitfalls that imperil most investors, while at the same time positioning ourselves for superior investment returns.
Warren Buffett has said that most investors are greedy when they should be fearful, and fearful when they should be greedy. This concept can be reduced to a simple relationship:
Greed minus Fear = Risk Tolerance
When greed exceeds fear, which is common near market tops, risk tolerance is high (but should be low, according to Mr. Buffett). When fear exceeds greed — typically near market lows — risk tolerance is low or nonexistent (but should be high). If your financial adviser asks you what your risk tolerance is, your natural answer might be, “How’s the market doing?”
Investors sell in droves when everyone is fearful. SweetSpot investors buy the sectors that have seen the most prolonged selling. In effect, we assume an attitude of greed in the face of fear. It seems likely that Mr. Buffett would approve.
The typical scenario: You hear an exciting story about XYZ Corp. and decide to buy stock in the company. Of course, by the time you hear about it, XYZ’s stock price has already been bid up. You just “bought high.”
Maybe the stock continues to climb for a while after you buy it. You’re showing a nice profit, and feeling like a smart investor. At some point, however, the stock’s upward momentum starts to peter out. Like a failed space launch, it had been rocketing skyward but now the only thing propelling it is the force of gravity as it heads back to earth. If you’re like most investors, you sell when the price falls to a level that is simply too painful to tolerate. You just “sold low.”
SweetSpot identifies investments that have been bid down, not up, and we sell them only after they have had ample time to recover their value. We sidestep the “buy high, sell low” cycle that plagues most investors, and we capitalize on others’ failure to do so. Our sell price has been higher than our buy price almost every time. Our buy and sell decisions are automatic, leaving us to apply our judgment to something it’s qualified to decide — that this is a course of action worth pursuing.
Will SweetSpot Lose Its Edge?
All of this sounds great, but why should we expect SweetSpot to be any different from all of the other “great” investment strategies that performed poorly once they came to light? Whatever advantage they enjoyed could only be relied upon to disappear.
One part of the answer is that SweetSpot is rooted in human nature, which tends to move at a glacial pace. Investors who buy high and sell low think they’re acting rationally at both ends of the trade. They are mistaken, but do we expect them to change their behavior anytime soon?
Another part of the answer is that the laws of physics are even less likely than the laws of human nature to change anytime soon. Simply put, you can’t fall through the floor. (Of course, sometimes the floor isn’t where we thought it was.) SweetSpot’s margin of safety comes from the simple fact that the masses who have sold out of the sectors we’re about to buy cannot then become sellers after we buy.
Our advantage as SweetSpot investors comes from knowing that our rational brain can overrule our caveman brain. We end-run the madness by using objective criteria — read: numbers — to identify the mispriced assets the cavepeople leave behind after the selling is done. We just do what the numbers tell us, which is something the rational brain can handle….
See also: Annotated SweetSpot Bibliography.