How to Act in a Bear Market Part2

 

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Last time, I wrote an article discussing a valuable piece of advice from Seth Klarman (Trades, Portfolio) on how to act in falling markets.

The key message of the article was that in a bear market, the best strategy to follow is to continue as you always have. As Klarman notes, “Controlling your process is absolutely crucial to long-term investment success in any market environment.” The last thing you should do is try to time the market:

“While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed…the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

 

Considering the above, I summarized:

“A focus on process, not outcome, will help you make the right decisions in a falling market and not become a slave to your emotions, which may lead you to make mistakes.”

Klarman gives us more insight into his investment style in an interview with the Financial Analysts Journal in 2010, titled “Opportunities for Patient Investors.” One of the interview questions asked the renowned value investor if it was easy to invest in 2008-09 when markets all over the world were falling, and it looked as if the whole financial system was under threat.

Klarman answered:

“You may be skeptical of my answer, but, yes, it was easy. It is critical for an investor to understand that securities aren’t what most people think they are”

“Investing is buying a fractional interest in a business and buying debt claims on a business. If you are afraid that a bond you bought at 60 might go to 50 or even 40, you may find it difficult to buy more; but if you know that the bond is covered, with extremely high likelihood, between 80 and par or even above par, the bond becomes more and more compelling as its price falls.”

To build this kind of knowledge about a security, you need to do your research; there are no shortcuts. Klarman is known for his in-depth research capabilities. He goes one step further than just assessing an asset’s underlying value; it appears Klarman and his team at Baupost also stress test a business through market environments:

“Our approach has always been to find compelling bargains. We are never fully invested if there is nothing great to do. We test all our assumptions with sensitivity analysis. Through stress testing, we gain a high degree of conviction that we are right. We are prepared for things to go slightly wrong because we adhere to a margin-of-safety principle that gives us the necessary courage to go against the tide. Yet, we don’t actually think of it as courage, but more as arrogance.”

According to Klarman, arrogance is required to be able to have the conviction to buy when everyone else is selling:

“In investing, whenever you act, you are effectively saying, ‘I know more than the market. I am going to buy when everybody else is selling. I am going to sell when everybody else is buying.’”

However, it is critical that you are not too arrogant and can change your view if new facts come to light:

“That is arrogant, and we always need to temper it with the humility of knowing we could be wrong—that things can change—and acknowledging that we have a lot of smart competitors. Thus, in worrying about all the things that can go wrong, you can prepare, you can hedge—and you must remember to sell fully priced securities so that you are underexposed when things go badly.”

Research and process is only part of the battle. A more significant factor is confidence. You must have the courage to believe in your abilities, analysis and management. The best way to build this confidence, according to Klarman, is to stick to your process and work through thick and thin:

“So, by being conservative all the time—by being both a highly disciplined buyer to ensure that you hold bargains and a highly disciplined seller to ensure that you don’t continue to own things at full price—you will be in the right frame of mind. Avoiding round trips and short-term devastation enables you to be around for the long-term.”

The original post is penned by Rupert Hargreaves and appears on gurufocus.com. It is a two-part post and the first part appeared last time. The original post can be accessed here.

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