How to generate extreme returns (Part 2) – The market exists to serve, not to guide.

In ground rules, I stated that “Your manager seeks to avoid permanent losses, but not quotational losses. A security can trade at any price, hence price volatility can never be avoided.”

That a security can trade at any price should be both seductive and intimidating. The stock bought at $10 yesterday can trade at multiples higher today or $1 the day after. Any price is possible. Many investors have this principle seared into their psyches during the Covid-19 downturn.

If volatility is threatening, one is looking to the market for guidance. A large decline from purchase triggers fear, which activates the human instinct to abandon self-thinking and follow a higher order, in this case the crowd and the market, for guidance. Succumbing to these instincts is a grave mistake. Investors should look to the market for opportunities, not for guidance, and embrace volatility as a provider of opportunities.

But doesn’t the market know more than any individual? Isn’t the wisdom of crowds worth following? In truth, the market may not know more than the individual. The market price is the product of many buyers and sellers who are not always motivated by fundamentals. They may transact based on emotions such as fear and greed or on technical factors such as portfolio rebalancing.

Therefore, the investor who keeps a cool head and has conviction in the right fundamental perspective may actually know more than the market. He looks to the market for opportunities, not for guidance.

To have conviction in the underlying fundamentals of a stock is to follow the rules outlined in part 1. Practice investing based on cash flows and avoid speculation; avoid excessive leverage; know the boundaries of your knowledge; have processes that guard against destructive human instincts.

Following the aforementioned rules effectively leads to a focus on the asset and business, not price, resulting in an evaluation of the stock’s fundamentals relative to price, not an evaluation of price alone. A stock does not exist in a vacuum. It is an ownership stake in a business. Even experienced investors forget this during extreme bouts of volatility.

Volatility that feels intimidating functions as a feedback mechanism. It is the market’s way of informing investors that they lack conviction and understanding of fundamentals. Investors who heed the warning would exit and reflect. Those who don’t will eventually succumb to destructive instincts and look to the market, instead of independent thought, for guidance, suffering losses as a result. Yet this is the brutal fate for the majority of investors, providing the minority that keeps a cool head with opportunities.