The Psychology and Superpowers of Investing
“I run to see who has the most guts, who can punish himself into exhausting pace, and then at the end, punish himself even more.”
Many people believe public market investing is an analytical exercise. Find undervalued equities, buy them, make money. Seems so simple. But public markets are some of the most emotional constructs invented by man, and they test our conviction every day. Psychology and temperament matter as much or possibly more than the analytical qualities needed to succeed in public markets. Generating amazing investment performance requires the kind of guts Steve Prefontaine brought to his races.
It is an emotional journey to work in the world of public equities. Even those who claim to use a “private equity approach to public investing” can’t execute what they claim. They don’t get inside information. They don’t have operational control. And they DO have to suffer through mark-to-market performance reporting. Of course, they mean that they try to understand their companies and they try to be patient, multi-year owners. But how many of them actually refrain from all trading, as if their holdings were completely illiquid for years at a time - especially when volatility is a feature of public markets that creates opportunities?
In the end, all public market participants must “suffer” to extract what we want – our ideal return stream. This post more of a fun discussion about the psychological factors public markets force us to endure and some of the gutsy superpowers the best investors possess.
Ideal Behavior
Is there such a thing as ideal behavior for an investor? What if we think about our ideal behavior in a lab-like environment.
If a stock is up on good fundamentals, what should we do? Buy more? Do nothing? Sell? If a stock is down on bad fundamentals, same question. Buy/sell/do nothing? What if the stock is up but it got cheaper (like NVIDIA in 2023)? What if the stock is down but got more expensive? The market gives us these scenarios and everything in between, all the time – and often without any specific news that is clearly dictating share price movements! What makes public investing so fun, fascinating, and challenging is that the market forces judgments upon us all the time, and we have to do our best to filter signals from noise and to behave rationally based on what we believe to be signals. It is very hard to have a rules-based approach because every situation is unique.
Ultimately, operating in the markets forces us to figure out what source of pain we are willing to tolerate to achieve our investing goals. Some examples:
Some people cannot tolerate mark-to-market losses. They want to see a consistent, upward slope of performance, even if the returns in the end are not market-beating. They are willing to accept lower returns in exchange for a smoother curve.
Some people cannot tolerate low returns. They then seek higher variance investments and strategies. Growth companies, distressed situations, etc. – areas that most investors believe are farther out on the risk curve. They may run highly concentrated portfolios.
Some people cannot tolerate patience and inaction. They are itching to trade. If there’s a new piece of information coming their way, they must respond to it. They aggressively live by the famous Keynes quote: “When the facts change, I change my mind. What do you do, sir?” They see the facts changing all the time, and they must react. Hurricane forming in the Caribbean? Short cruise companies for a -5% move!
Conversely, some people cannot tolerate activity. They might have a “never sell” attitude, and they might let their losers bleed down forever. Maybe they chose their “never sell” portfolio poorly, and underperform forever. Or maybe they held onto Microsoft and Google from their IPOs, or Berkshire Hathaway for the last 40 years, and a few winners have made up for everything else not working out.
Some people cannot handle looking stupid or wrong. They hate to realize losses because it is admitting defeat. They hate to underperform even for a little while because they fear others will think they are stupid or wrong. Or, they may find comfort only in the consensus “highest quality” stocks, following the herd where it’s comfortable and cozy, but where valuations are expensive. They’d rather blame underperformance on market dynamics, macro, and other things - it’s definitely not their fault!
None of these are inherently better or worse than the others - it’s all a matter of investor preference. Whenever I speak to aspiring analysts and investors trying to get into the industry, I tell them the same thing: find a role that makes sense for the intersection of your analytical processes and your psychological constitution. If you are built to be trading-oriented, you should not go to a long-only firm with 10-year holding periods. If you are a long-term investor, you should not go to a trading-oriented firm (I made this mistake earlier in my career).
Now, let’s talk about some behavioral characteristics that act like superpowers in the market. These superpowers show themselves at the extremes and they refer back to the quote above from Steve Prefontaine, which I’ve loved ever since I read about him 25 years ago. Who’s got the guts to outperform? Let’s dig in.
Superpower #1 – Buying on Dips
Maybe this shouldn’t be listed as a superpower, but it is. Most people want to buy on dips, and they do buy when their stocks drop a little. But let’s define a dip. Many investors wouldn’t mind topping up their positions on a -10% pullback. At -10%, we can argue that it’s just volatility. Nothing has changed fundamentally. Nobody’s losing their mind at -10%.
What about -30%? Now we’re getting slightly uncomfortable! Something’s probably not going 100% right fundamentally. Do we know what that is? Can we diagnose the problem, and can we build conviction in the market being wrong? How certain are we?
How many investors are buying more with that fact pattern? How much are they buying? How many have sold and moved on already?
What about -50%? Now, we are in panic territory for most investors. Most have already “bought the dip” to some degree well above this level. Anyone with clients is usually getting some inbound inquiries. An analyst on a team is taking serious heat—or worse—from the portfolio manager. It wouldn’t be unusual for clients to call you an idiot for owning this stock. Maybe they’ll scream something like “Everyone I know is short!” Maybe some furious clients think you are being too stubborn, refusing to change your mind when the facts clearly have changed – and they pull their capital.
To avoid these situations, most managers never let it get here. They’d rather not create any “firm risk.” They take the loss and move on. They’ll do whatever gives them psychological safety and the ability to protect their careers, reputations, and firms from further damage, even if it’s detrimental to returns.
To make matters worse, it’s not just the clients questioning things – you are as well. Stocks can move -30% on transitory bad news, but they don’t often move -50%. -50% means something has gone wrong. Now, we’re in the land of thesis creep and/or bad fundamentals, and maybe some balance sheet concerns as well. The stock is down, but so are future estimates. Maybe it’s technically cheaper, but your confidence in the future is shaken, so you have to assume a higher discount rate.
How many analysts and investors are buying more when they’re already down -50%? What about the investors that double their position when they’re down -50%? When doing so, they are probably entering the area of career risk, and very few professionals are willing to do that.
Adding meaningfully on meaningful dips is hard. It never feels good. It’s almost always accompanied by some personal risk - not just investment risk. But when done correctly, it produces gutsy, Steve Prefontaine-like returns. How many existing META investors loaded up materially on the stock below $100 in late 2022 after the stock fell -75%? And how many of those investors had the next superpower as well, to fully capture the rise up to $500?
Superpower #2 – Letting Winners Run
To me, this is the superpower that is most impactful to long-term returns because it allows natural compounding to occur. We’ve all seen the charts of Berkshire Hathaway or mega cap tech as examples of how powerful it can be to let winners run. How many active holders of Apple in 2007, the year the iPhone was released, still hold it today? The stock is up over 40x since then. If an active manager had a 5% position in 2007 and held through today, that position alone would have produced a 200% return for the fund. How many active holders in 2007 extracted that a full 40x from their Apple positions? How many were willing to endure all the drawdowns and periods of underperformance to achieve those returns?
I am a big admirer of Softbank’s Masayoshi Son. He is a world-bending personality with tremendous vision and incredible strategic vision, and he’s managed Softbank through many different eras in its lifetime. He has this superpower in spades. He invested $20 million in Alibaba in 1999 and let it run until it was worth over $200 billion. Imagine the pressure he must have felt internally and externally! At $200 million, it’s a 10x and an amazing outcome. At $2 billion, a 100x. At $20 billion, a 1,000x. And yet, he didn’t sell. The conviction, the discipline, the GUTS. It’s Steve Prefontaine again.
Another dimension of discomfort when letting winners run is position sizing. Masa allowed Alibaba to be the primary driver of value for Softbank. All the other businesses and investments within the Softbank portfolio, including the large telecom business, were overwhelmed by the value he created by holding onto Alibaba. Almost no professional investors are comfortable with holding what is effectively a one stock portfolio, even if they think they are sitting on the investment of a lifetime early in its life cycle.
Superpower #3 – Buying Higher
Sometimes, a company we know well smacks us over the head so hard that we know we should buy (Carvana in May 2024, anyone?). But it’s hard, because the market sees it too, and the stock is up big on the day. So we tell ourselves that we’ll buy it when it comes in -5%. And then it keeps going, and rises another 20%. And then we think we’ve missed it and it’s run away from us, even if we think it could double still over the next 1-2 years.
It is a superpower to buy on big upward moves. It is a superpower again to continue buying as the stock keeps rising. It goes against the nature of most value investors. Many investors are wired to want to buy on a down day, even if the down day occurs at a higher price.
Knowing when it’s appropriate to “chase” a stock higher and actually doing so is a superpower. Not many do it well. This is not to be confused with FOMO or momentum investing – it’s recognizing when fundamentals have “gapped up” and the higher price is justified and still attractive - perhaps even more than before given the new information.
Superpower #4 – Knowing When to Sell
Of course, not all superpowers involve buying. We’ve got to know when to sell optimally. Selling often is the hardest decision an investor makes. We first have to understand the reasons for selling. Here’s a couple options:
Our thesis is disproven. This is the easiest scenario once it’s been recognized. Exit and be done. Do it that day if possible. However, how many investors are brutally objective enough to know on the first signal that their entire body of research, used to build enough conviction to buy a stock, has been invalidated? Usually this is a process that takes some time and a longer time series of evidence, which means they are exiting lower and later.
It’s “too expensive” or some other variation of “cash or X other stock is a better risk-adjusted return.” This unleashes a smorgasbord of scenarios that induce significant second-guessing and potential self-loathing (see Superpower #2 above).
The best investors are able to identify when their thesis is disproven clearly and immediately. They act swiftly. Many investors don’t want to sell because a stock is down, so they wait until they get a bounce. Like clockwork, the stock surely continues to fall, trapping them even further.
When an investor sells to buy something else (even cash), either another opportunity is vastly superior (great!), or maybe he is worried about a pullback in shares. Amazing traders can avoid those pullbacks with Superpower-like tactical prowess. Amazing investors can consistently identify when one investment is clearly superior to another, thereby justifying the swap in the portfolio. Trading is best measured by batting averages, while investing is best measured by slugging percentages. In the end, both approaches must generate superior long-term performance, and every trader or investor should evaluate their actual results vs. the “no trading” results to see if they’ve added any value from their sales.
Nailing the “exit” decision right is the non-trivial and quite difficult – and it makes a big difference.
Superpower #5 - Position Sizing
Position sizing is a superpower closely related to all the powers discussed above, but it deserves its own section. To generate truly superior long-term outcomes, great investors have to be willing to bet big when a situation calls for it. Imagine nailing NVIDIA, but you owned only a 0.5% position in your portfolio before it rose 100x. Sure, you would have made 50% of performance from it, but your performance relative to the market probably would have had much more to do with the other 99.5% than your amazing call on NVIDIA. Now, imagine you started with a 10% position. That would have generated a 1,000% return for the portfolio. It’s a completely different outcome. It would be almost impossible not to outperform.
Many investors are uncomfortable with large positions because they elevate the portfolio’s volatility and deviation from indices. It’s not safe and comfortable anymore - it’s a big, gutsy bet. Getting those big bets wrong can really hurt returns and can be embarrassing to peers and to clients.
Closing
The stock market is incredibly emotional on its own and also deeply emotion-inducing. To excel as operatives within this fascinating marketplace, we have to show Prefontaine-like guts in some (but not all) dimensions. We have to withstand the psychological pressure to reduce pain and stress in areas that matter to other participants in order to achieve our goals.
Every investor should do an honest assessment of what he or she can tolerate at superpower levels. Individually, where is your most powerful intersection of process and psychology? The answer is different for everyone, and that’s the beauty of the market. Everyone can use different approaches to exploit their greatest superpowers.
