By Kara Lilly, CFA
Special to the Financial Independence Hub
Every year our team devotes a couple of our regular Wednesday morning meetings for reflection on the year that has passed. This is a chance for our team to review the insights, errors and observations that were made in the preceding twelve months and learn from each other.
We thought we’d share three of these lessons with our readers:
1.) Beware the assumption of mean reversion
One of the greatest surprises to investors this year was the continued slide in the price of oil. Like other structural/thematic trends, the decline in the price of oil due to international oversupply and weakening global demand has gone on far longer than some initially anticipated. Many assumed that prices would dip and then return to a more normalized range between $60 and $80. This is a good example of assuming mean reversion, i.e., that prices will naturally revert back to their mean.
Mean reversion is an assumption that is prevalent in investing for a reason; usually, asset prices fluctuate within a band that has been established due to underlying fundamentals. Stock prices, currencies, bond prices…they are all often guided by mean reversion. Their prices move up, or down, but then investment gravity pulls them back within a range. Again, where this gravity occurs is driven by fundamental factors. This means that when underlying fundamentals shift, the appropriate range for prices should also shift—and the original reference points become poor measures of prediction.
In investing it is important to understand the underlying mechanics that contribute to the price of the asset you are examining. Therefore, before we assume that oil will revert back to its “usual” range, it is important to examine the context in which the price moves are happening. When a trend is thematic or structural, it can often go on for far longer than anticipated.
2.) When in a hole, stop digging
This is an oldie but goodie from our CIO, Jim Hall; and it is as applicable in your personal life as in investing. It is a winning strategy but difficult to execute: when in a hole, stop digging.
In every investor’s experience, there is a point when a stock you “like” will start to deteriorate. The learning is: don’t immediately start “chasing.” When a stock is coming down in price, it is doing so because the market, made up of a collective of thousands of individuals, is saying the price should be lower. Now, there are times when the market is wrong and your previous viewpoint could be right; but, often, the market is telling you something. Something you may not yet know.
As fundamental investors, the natural instinct is to presume that you know the story on a stock. After all, you’ve likely spent hours of analysis trying to understand it. But when a stock begins to deteriorate, our lesson over time has been to have patience and not act immediately.
3.) You, as “company”
One of our favourite metaphors this year came from one of our equity analysts, Justin Anderson. View yourself as a company and view your habits as employees. Do you have the habits you currently need for long-term success?
When you picture your habits as employees, it shows that you have less control than you may think over your own behaviour. In a company, employees can be managed—but not wholly controlled. Habits can be viewed similarly.
Like companies who require the right employees to execute on their vision, you require the right habits to get to your desired destination. What these habits should be depends on who you are and where you want to go. For investors, they might include you listening to more audiobooks or taking better notes.
The question to ask: given where I want to go, do I have the right habits on the bus to get myself there?
Kara Lilly is the Investment Strategist at Mawer Investment Management Ltd., which she joined in 2009. Previously, she was an Associate at Q1 Capital Partners in Toronto performing fundamental research on financing and M&A mandates for private Canadian companies. She is a CFA Charterholder. This blog originally appeared on the Mawer web site here and is republished on the Hub with permission.