Channeling Centuries-Old Japanese Companies

Here we go again – with a twist... The 'big enchilada' of impact bias... It's playing out right now with two popular 'meme stocks'... 'The greatest disease the mind faces'... Trading is an art that you must approach like a science... Just how 'tribal' we humans can be... Channeling centuries-old Japanese companies...

Here we go again...

Once more, I (Dan Ferris) will base an entire Digest on my personal mantra, "Prepare, don't predict." Regular readers know I love to hammer home this advice. But today, there's a twist...

I'll approach it from a totally different angle this time... your emotions.

You see, as humans, we're bad at predicting how we'll feel in the future. So when we make decisions based on how we believe we'll feel, we don't do so well. And of course, out-of-control emotions could be potentially devastating – both to your well-being and your wealth.

Instead, as you'll see in today's essay, it's critical that you prepare for all sorts of scenarios. By doing that, you'll increase your odds of success as an investor over the long term.

We'll start today with a 2019 study from the University of California, Irvine...

The peer-reviewed study is titled, "When and Why People Misestimate Future Feelings." And within the first few pages, the researchers shared their findings that...

People have a persistent tendency to overestimate the strength of their [future emotional] reactions to a variety of events.

The UC Irvine researchers called this effect "impact bias." And they wrote that it...

... includes overestimates of the intensity (how strong a reaction will be) and duration (how long a reaction will last) of future emotion.

Impact bias applies equally to negative and positive outcomes. And it's easy to see at work in your own life...

It's like that good feeling you get when you're anticipating the purchase of a new car. But then, shortly after experiencing the excitement of picking it up and driving it home, you go right back to feeling like you did before (and maybe deal with a little buyer's remorse, too).

Or, on the flip side, perhaps you've had a morbid fear of losing your job... But then, when it actually happened, it wasn't as big of a disaster as you thought it would be.

In both cases, according to the UC Irvine researchers, we overestimate future emotional impacts because we don't anticipate how quickly we'll adapt to the new situation.

We also tend not to anticipate how other events will impact us and occupy our thoughts and feelings. We're clueless about what lies in the future and how we'll feel about it.

That brings me to the 'big enchilada' of impact bias for investors...

I'm talking about the roller coaster of emotions that tends to occur when his or her portfolio falls significantly in value. (As humans, we're not great at handling big portfolio increases, either... But let's save that discussion for another time.)

The classic novice – and frankly, not-so-novice as well – investor foible is to first take too large of a position with very high conviction that it'll perform as anticipated. Then, he or she will watch the investment's value fall 40% or 50%... and commit to exiting "once it breaks even"... only to watch it plunge until it's down 80%, 90%, or more.

At that point, the pain becomes too great. The novice investor just wants it all to end, so he or she sells out with almost no value left.

Consider the many novice investors – using their stimulus checks and new accounts on trading platform Robinhood – who bought previously left-for-dead stocks like movie-theater operator AMC Entertainment (AMC) and video-game retailer GameStop (GME). The two most popular "meme stocks" currently trade 40% to 50% below their early June highs...

Right about now, all those Robinhooders who jumped on the hype train too late are sitting on mounting losses... And they're starting to tell themselves that they'll sell out when they're whole again.

It's perverse – and yet, somehow cosmically just – that their deep aversion to taking a loss will result in a bigger loss than if they simply acknowledged that they were wrong and sold out now. Sometimes, you just need to know when to live to fight another day.

Novice traders and investors often make another huge mistake that compounds impact bias...

They tend to believe a system exists that will predict big winners with great precision and certainty. Author Robert Greene hit the nail on the head in his 2012 book, Mastery...

The need for certainty is the greatest disease the mind faces.

Investors' belief in certainty lures them into taking big bets on super risky situations... And the lack of any type of ability to know how they would feel if those bets didn't play out well creates a crisis.

The way to prevent this awful mistake is through nothing less than the scientific method...

Trades aren't based on certainty. Instead, they're like experiments whose outcome the trader believes is probable enough to warrant taking a position... but which he or she recognizes could produce a loss.

Similarly, the scientific method is based on the provisional nature of truth... There is no final, ultimate truth. There's always more to learn.

We learn more scientifically through a process of conjecture and refutation. We conjecture some new way of describing reality... Then, we conduct experiments designed to refute the new description. You never finally confirm a scientific truth... You either refute it, or you don't.

I'm sure some real, trained scientists will write in over the weekend to explain that it's more complex than that in practice... For example, when experiments continually fail to refute a theory and more and more folks use the theory's conjectures to describe more and more aspects of reality, it leads to a sense of its confirmation.

I would agree with that sentiment... But confirmation is not the basis of a scientific truth. That's not the core upon which it's built... It's built on endless falsifiable conjectures, refuted through experimentation.

Trading is an art that you must approach like a science...

You don't build your wealth through trading and investing by making pinpoint predictions about the future of securities prices and betting your whole wad on one throw of the dice.

Instead, you build your wealth through trading and investing by understanding that every position you take is a falsifiable experiment. You could be right... But you could be wrong, too.

Since many great traders lose money more often than they make it, they must engage in a constant exercise of cutting losses... They must always be able to recognize that the market has falsified their latest conjecture.

And because every new position taken is essentially an experiment whose ultimate outcome is unknown... great traders (almost) never bet a large amount on any single position. They control their experiments with proper position sizing and by cutting losses with ironclad discipline.

That's a far cry from betting big on AMC and GameStop because you're 100% certain you and your Robinhood friends will send it to the moon!

Emotions are an inescapable part of being human, but active traders must learn to control them...

At one point in his 2014 book, The Little Book of Market Wizards, author and trader Jack Schwager quoted "free solo" rock climber Alex Honnold. The citation originated in an October 2011 interview on 60 Minutes that began with the following exchange between reporter Lara Logan and Honnold, who climbs high places with no ropes or safety gear...

Logan: Do you feel the adrenaline at all?

Honnold: There is no adrenaline rush... If I get a rush, it means something has gone horribly wrong... The whole thing should be pretty slow and controlled and... it's mellow.

Honnold is one of the greatest climbers who has ever lived. The 36-year-old has completed countless free solo climbs in his lifetime – including his dream of scaling the 3,000-foot wall of El Capitan in California's Yosemite National Park. (By the way, that quest was captured in a powerful National Geographic documentary that was released in December 2018.)

Schwager's Market Wizards traders all say the same thing about emotions in trading that Honnold says about them in climbing... If you're getting a rush, you're doing it wrong. As Market Wizards trader Larry Hite once told a friend...

I don't trade for excitement... I trade to win.

When meme-stock buyers post phrases on social media platforms Twitter and Reddit like "to the moon!!" followed by a bunch of rocket emojis, it's a good bet they're not truly embracing the idea that an adrenaline rush means something has gone horribly wrong.

To make money as an active trader or investor, you must learn to leave your emotions at the door...

I interviewed Schwager on the Stansberry Investor Hour podcast last December.

During our wide-ranging discussion, we talked about the role of emotions... And we noted that all but one of the traders he interviewed over the years for his famed Market Wizards books emphasized how their systems took the emotions out of trading. We agreed that one trader – John Netto – was very sophisticated... and that this approach was difficult to imitate.

If you ever read Schwager's Market Wizards books or anything about other great traders, you'll see that most of them are like the "hedgehogs" we talked about in the July 23 Digest... They all create their own system and never deviate from it.

From an emotional perspective, their systems are not designed to predict how they'll feel under various scenarios. They're more like a plan of what they'll do – whether it's buy, sell, or hold – under a variety of possible future outcomes... no matter how they feel.

It's so simple...

Since humans are so bad at determining the depth and duration of emotion – and since the market itself is unpredictable – a successful trading system must be based on what you can predict... By that, I mean preparing for all the actions you could take, depending on what the market is doing at any given time.

In a way, I'm saying that since you can't predict your emotions and can't really control them... you should give up trying to do so and turn your attention to what's doable. And as the traders in Schwager's Market Wizards series have proven, making money through trading is not merely doable... it's something you can master and grow wealthy from over time.

So now, here we are again, in familiar territory to regular Digest readers...

Self-knowledge is essential to be a successful investor.

Before you can make a penny in the financial markets, you must know whether you're emotionally equipped to even get involved in active trading and investing in the first place.

Schwager once wrote about a trader who was not equipped...

The trader utilized an effective system, but his emotions kept getting in the way. So one day, the trader went to a famous trading coach named Charles Faulkner. The trader used Faulkner's techniques... and soon, he found himself sitting on a gain of $7,000.

Faulkner looked over his previously struggling client's shoulder, proud of what he had accomplished. But then, the trader turned and declared, "This is boring." The undisciplined and emotional trader eventually blew up his entire account. And as Schwager concluded...

The markets are an expensive place to look for excitement.

Perhaps the easiest way to remove your emotions and still compound your capital at acceptable rates of return over the long term is to opt out of active trading and investing altogether...

If your investing is on autopilot – for example, simply contributing to a 401(k) account and not actively trading individual stocks, bonds, options, or other financial instruments – your emotions likely will be much less of a problem than if you're actively trading and investing in the markets daily, weekly, or even monthly.

That's extreme, though.

You can find a happy medium... For example, you could designate a certain percentage of your assets as "passive money" that you just put into an index fund. Then, you could have a smaller percentage earmarked as more active – and perhaps even speculative – money.

(I can't possibly know what's right for each of you... But I know Stansberry Research has all the tools to help you manage almost any combination of stocks, bonds, and options.)

Our lack of ability to predict how we'll feel about our portfolio performance in the future is another reason why I've repeatedly counseled folks to "prepare, don't predict."

And we simply can't ignore the elephant in the room... The constant need for humans to belong and feel accepted by other humans can cause big emotional problems for investors.

Most people won't prepare for their future investing actions with a strategy that they can execute no matter how they feel. They won't control their emotions under difficult market circumstances. Most folks will react based in part on their own fears... and in part on how others are behaving in the heat of the moment.

I recently read an anecdote that underscored just how 'tribal' we humans can be...

In the 2016 book Tribe: On Homecoming and Belonging, author Sebastian Junger related a story told by Founding Father Benjamin Franklin in a 1753 letter to a friend. As Franklin wrote...

When an Indian child has been brought up among us, taught our language and habituated to our customs, [yet] if he goes to see his relations... there is no persuading him ever to return...

And that this is not natural [to them] merely as Indians, but as men...

When white persons of either sex have been taken prisoners young by the Indians, and lived a while among them, [though] ransomed by their friends, and treated with all imaginable tenderness to prevail with them to stay among the English, yet in a short time they become disgusted with our manner of life... and take the first good opportunity of escaping again into the woods.

Various aspects of tribal life remain innately appealing to us as humans – and perhaps even more so now that modern life has thoroughly isolated us from one another.

When money is on the line, emotions will run high... And that potentially prompts us to crave the comfort and sense of belonging that comes with doing what everyone else appears to be doing. The "herd" mentality is dangerous, but folks don't often realize it.

Following in the footsteps of everyone else is usually a giant mistake... It could be devastating... And it's yet another reason to adopt the "prepare, don't predict" mantra.

A truly diversified portfolio of stocks and bonds, plenty of cash, gold and silver, and maybe some bitcoin will prepare you for many different economic and financial outcomes. These outcomes could include deflation, inflation, a genuine currency crisis, the list goes on...

Beyond that, true diversification should probably go even further than just your portfolio... It should include preparations for such outcomes as continued violence in the streets, (an even greater) loss of civil liberties, a large natural disaster, the outbreak of war, a never-ending global pandemic, a massive personal health crisis... or just about anything really.

Think about adopting some of the long-term, survival-oriented focuses of Japanese companies...

I talked about this idea with asset manager, author, and old friend Chris Mayer on the most recent episode of the Stansberry Investor Hour podcast.

We agreed that certain aspects of Japanese culture have led to low returns on capital for many of the country's businesses through the years. Part of that is an emphasis on survival over the very long term...

Five of the 10 oldest companies in the world are Japanese – including the two oldest, which are roughly 1,250 and 1,440 years old, respectively. They might not earn high returns on capital, but they're built to last... and that's something worth thinking about.

When longevity is a company's primary goal, return on capital becomes less important than retaining enough excess capital to weather any storm. And while the amount of excess capital will lower overall returns, you shouldn't underestimate the protection it offers...

While I wouldn't want to own an entire portfolio of such companies, that approach to business feels similar to my approach to investing with a truly diversified portfolio... The cash, gold, silver, and bitcoin components all function to protect and preserve wealth over the very long term.

It's all about preparing and keeping a comfortable margin of safety...

Instead, if I wanted to try to maximize my returns, I would stay 100% invested in businesses with high returns on capital – maybe with a manageable amount of leverage... I would stay fully invested at the bottom, the top, and everywhere in between... And I would need to ride out all the bear markets and market crashes without selling out.

For many investors, that's difficult to do with an actively managed portfolio. But I'm a little bit like those centuries-old Japanese companies... I'm giving up some return on capital to be prepared for a wide range of potential outcomes over the long term.

I do that not only because I can't predict the future of asset prices... but because I also can't predict the future of Dan Ferris' emotions.

And unless you can predict the future with complete certainty... perhaps you should consider doing the same before it's too late.

New 52-week highs (as of 8/19/21): American Tower (AMT), Brown & Brown (BRO), CBOE Global Markets (CBOE), CoreSite Realty (COR), Costco Wholesale (COST), Intuit (INTU), James Hardie Industries (JHX), Microsoft (MSFT), Motorola Solutions (MSI), Novo Nordisk (NVO), Procter & Gamble (PG), ResMed (RMD), and Sea Limited (SE).

In today's mailbag, more feedback on the two-part interview between Stansberry NewsWire editor C. Scott Garliss and former Federal Reserve official and presidential adviser Lawrence Lindsey. (If you missed it, read it here and here.) As a reminder, you can also learn more about Lindsey's new novel, Currency War, right here... And last but not least this week, what's on your mind? Tell us at feedback@stansberryresearch.com.

"I like Lawrence Lindsey and what he writes. I also read Jude Wanniski's blow-by-blow of the Reagan administration in his Polyconomics website and investing service.

"As great as the Reagan economy was, it lost enormous amounts of political capital fighting for free trade. Now, it was free trade in the service of the Paris and Louvre Accords, but, unfortunately, it was free trade nonetheless. This is what drove the Democrats to fight every cut in taxes and regulations, when the real policy should've been protectionism at home combined with lower taxes and regulations." – Paid-up subscriber O.P.

Good investing,

Dan Ferris
Eagle Point, Oregon
August 20, 2021