Guts, in this case refers to risk appetite.
Risk appetite refers to the level of risk you are willing to take on while investing in order to grow your money.
The central problem around all investing approaches is that few people truly know their risk appetites.
Compounding the problem is our innate urge to protect hard earned capital, hence leading to investors yanking cash out when they should be putting cash in.
Peter Lynch, a well-regarded fund manager and author of the book One Up On Wall Street recorded this phenomenon well in the Magellan Fund. As quoted;
During his tenure Lynch trounced the market overall and beat it in most years, racking up a 29 percent annualized return. But Lynch himself pointed out a fly in the ointment. He calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.
He is not alone in this.
Joel Greenblatt, another fund manager with a record performance and author of the book “The Little Book That Beats the Markets” noted;
“”Joel Greenblatt has found that investors struggle to implement his Magic Formula in practice. In a great piece published in 2012, “Adding Your Two Cents May Cost You A Lot Over The Long Term,” Greenblatt examined the first two years of returns to his firm’s US separately managed accounts. Greenblatt conducted a great real-time behavioral investing experiment. He gave his clients two choices to invest in US stocks.
One account was like the business owner. They picked what top-ranked stocks to buy or sell and when to make these trades. The other was like the quant investor. This account followed a systematic process that bought and sold top-ranked stocks automatically.
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Essentially, business-owner accounts had discretion over buy and sell decisions, while quant-investor accounts were automated. Both choose from the same list of stocks.
So, what happened?
The business-owner accounts didn’t do badly. Those accounts averaged 59.4% after all expenses over the two years, a good return. But the S&P 500 rose 62.7% over the same two years.
The quant investors account averaged 84.1% after all expenses over the same two years, beating the business owner by almost 24% (and the S&P 500 by well over 20%). That’s a huge difference, particularly since both accounts chose stocks from the same list and were supposed to follow the same plan.””
The main issue?
Lack of knowledge regarding their own ability to stomach risk.
In the stock market, the most important organ is the stomach. It’s not the brain.Peter Lynch
I think we can come to a consensus that at least, investing means suffering some amount of drawdown (meaning the stocks you bought went DOWN) and that investors must be prepared for market volatility (the degree to which stocks can swing up or downwards) in their investments.
But let’s come back to the central question – we know we want to be able to stomach risks, and develop guts of iron, but how do we go about finding our own yardstick?
Here’s an unpopular answer.
You can only truly know your risk appetite after investing and trying it yourself for some time
Take $2,000. Learn a style of investing. Apply it. See if you are comfortable doing it.
Like skating, riding a bike or learning to jump out of an airplane, some experiences just have to be tried before one truly knows whether or not it suits them.
There is nothing that beats experience in matters such as this.
Further, here’s a secondary opinion.
Your risk appetite is directly affected by how much you know about what bought – it is all about your DISCIPLINE
When I’m talking about discipline, I’m talking about whether you did your homework.
- Did you understand all the nuances and intricacies of what you are invested in?
- Do you understand its volatility, history, sector, and prevalent/common practises?
- Did you check valuations to see if this is the price you’re supposed to coming in at?
- Did you ensure you have a margin of safety in case you’re wrong?
- Did you see if management has a history of shareholder destructive actions?
- Did you see if management owns significant insider holdings and are thus not likely to destroy their own wealth?
- Did you check for fraud?
- Did you check for recent insider buyings indicating a turn around?
- Do you understand the tail winds?
All of these are questions you have to ask yourself. We certainly do when we ask our students to check sum a company in fifteen minutes.
If you are uninformed, how do you understand the risk you are taking through a dirty lens?
You should be getting as much information as you can on the company and then painting a picture with the facts – not opinion, facts! – and then making a decision to invest.
Here’s an example of my own investments with shipping stocks.
My shipping stocks and options, which were up between 20-50% are now down from where I bought them by about 20%.
- Scorpio Tankers swung from $40 to $24
- Teekay Tankers from $25 to $14.94
- and Euronav from $12 to $9
Corona virus or not, I felt some slight amount of joy watching prices come down.
Prices had run up a little bit more than I wanted it to be (who doesn’t ever want it cheaper?) but I had entered because I felt the risk/reward was still significantly in my favour.
Then the year turned and the corona virus happened.
Despite strong earnings reports, most tanker/energy sector stocks got hit with a 40% decline in share prices.
I was rejoicing.
The shipping companies had enjoyed a very strong 4th quarter, had journeys booked our to 1Q 2020 for some, and were still enjoying above breakeven cash flow rates. This is after deleveraging their balance sheets, increased scrapping of ships due to lower rates, and increased demand for tankers to store oil offshore not being accepted by China.
Who the hell sells a taxi fleet when taxi rates are going to be more profitable and taxis are going to be more in demand?
The answer in this case is nobody.
But who sells a taxi feelt when share prices go down?
As it turns out, most of the people who didn’t do their own homework.
They didn’t understand the risks they took, couldn’t measure good from bad, and sold when share prices scaled down because they didn’t understand a thing about the shares they bought.
They didn’t do a rough valuation of whether it was cheap to enter, didn’t know if prices had seasonal volatility (shipping does btw), and didn’t understand whether current share prices were an attractive buy.
In short, they lacked discipline to do their own homework
In summary, the you can only really gut check yourself by trying out investing and seeing if its for you or if its just too painful, and you can really only additionally inform that risk knowledge by knowing what you are vested in.
I know for example, that my stocks just got cheaper and just got more attractive. Previously, they had dangerous debt levels, low asset prices (ships go up and down in asset values when demand goes up and down, a taxi that is in more demand will command a higher price).
Now, after Q4 earnings, based on approximates of rates and tracking systems (which btw, offers real time earnings, which sector other than REITs offer real time transparency into earnings? think about these invisible advantages when you invest!), the companies have less debt, better advantages, and are in fact cheaper than before, with less risk.
What am I going to do then?
Hope share prices go lower, buy more, thank the market for swinging down for me.
As for the people who jumped in without knowing their guts, and without the discipline?
As the title implies, no guts, no discipline, no glory.
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Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.