Geoff Gannon November 23, 2017

Risk Habituation and Creeping Speculation

In response to an email a reader sent about some of my recent posts on the difference between investment and speculation, I entered lecture mode…


I am especially worried about the tendency among readers to speculate using the logic that value investors (like me) are sometimes wrong (like in WTW) and these “investments” turn out to be speculations. Therefore, how is buying at 8 times EBITDA in what has historically been a fairly predictable company different from buying at 16 times EBITDA in a company that hasn’t historically been predictable? Aren’t they both speculations since you are always ultimately going to make money or lose money based on how right you are about the future?


Are You Better Off Than You Were 8 Years Ago? – Are You a Better Investor?

I feel this is an issue with the length of the latest bull market. Whether or not stocks are very expensive (and I do find them expensive generally, but this point still stands if I’m wrong about that), most readers of the blog have seen mostly good results from the stocks they’ve chosen to hold over the last 8 years now. Eight years is a long time. Many people have not even been following the same investment strategy for more than 8 years.

Their current approach has never been battle tested.

So, now I hear a lot from people who are more into paying up for higher quality, holding longer, etc. There are ways of implementing a strategy like that which work. But, I think the experience of the “recent” past is what gets them thinking in these directions.

Although I’m “only” 32, I was investing seriously (in terms of how much time I spent thinking about the subject) in 1999-2002 and in 2007-2009. Now, most years are not like 1999-2002 or 2007-2009. But neither are they like the run from the second half of 2009 through to today (the end of 2017). That kind of run is rarely this smooth. And so, when you have not seen a period with P/E multiples of even good stocks contracting 30% or 50% or more – you are less worried about the distinction between investment and speculation.

When you look at something I own like BWX Technologies (BWXT), which has performed well both as a business and as a stock, you see that it is now trading at 31 times earnings. It’s a great business. But, even if it is always recognized as a great business by the market – it may yet be assigned a P/E of 20 instead of 31. Great businesses sometimes trade at a P/E of 20. So, right there, you have the potential for a 35% decline in the price of this stock.

I still own the stock. And I’ll keep owning it till I know for sure that whatever new stock I want to buy is better than holding on to this stock. But, what is always foremost in my mind when I look at BWXT is the potential of this 35% decline in the price – absent any decline in the underlying business – simply because there will come a time when the P/E does contract from 31 to 20.

This is my bigger concern. Not that the Shiller P/E is high (though it is). But, that things have gone so well for so many investors even when their stock picking has been rather sloppy in terms of risk avoidance that they no longer think first about risk avoidance.


Risk Habituation

I’ve always believed that errors in investing which lead to excessive risk taking are the result of habituation. Wikipedia has a fairly good description of habituation which I quote here:

“It is obvious that an animal needs to respond quickly to the sudden appearance of a predator. What may be less obvious is the importance of defensive responses to the sudden appearance of any new, unfamiliar stimulus, whether it is dangerous or not. An initial defensive response to a new stimulus is important because if an animal fails to respond to a potentially dangerous unknown stimulus, the results could be deadly. Despite this initial, innate defensive response to an unfamiliar stimulus, the response becomes habituated if the stimulus repeatedly occurs but causes no harm. An example of this is the prairie dog habituating to humans. Prairie dogs give alarm calls when they detect a potentially dangerous stimulus. This defensive call occurs when any mammal, snake, or large bird approaches them. However, they habituate to noises, such as human footsteps, that occur repeatedly but result in no harm to them.”

In other words: investors should always be scanning their own thinking for risks they’ve taken but haven’t yet harmed them. It’s the risks you’ve gotten used to taking that kill you.

Prairie dogs can’t employ reason. Humans can. Even if the P/E ratios of stocks I’ve owned have done nothing but go up, up, up for the last eight years – I can reason out that multiple expansion is ultimately a self-defeating rather than a self-reinforcing trend.

I think the distinction between investment and speculation is the most important concept in value investing.

When people say they are a value investor, they often stress that first word “value” and forget the second word “investor” is just as important.

An investor looks to the downside first, insists on a margin of safety, and only then thinks about how he might profit from a brighter future than the market now imagines.