I realized that long-term investing is much like flying a plane. Turbulence is inevitable! But good pilots remain calm because they remember what they've learned about the mechanics of flying. We, too, can fall back on our knowledge during times of market turbulence. In fact, that's the only way to remain committed to your long-term approach — and not let volatility dictate your actions.
So ... what have you learned about the mechanics of investing? A lot, actually. These processes are probably so ingrained in you that everything seems to run on auto-pilot. Here's what you're actually doing when you invest.
Step 1: Answer the Things You Can Know
The first step in making a good investment is finding a good business. Some investors like to do that by diving deep; others find gems just by looking around. Some can see patterns, some replicate successful investors' portfolios, and others opt for screening. But the process ends with having an understanding of the business:
- How does it makes money?
- Where are the margins compared with the market?
- How did the company build a competitive moat?
- Did margins and returns improve over the years?
- How did the company perform compared with its peers and the market in a downturn?
- What is management's track record?
- Could the company expand in new geographies or launch new products?
- How strong is the balance sheet?
- If the stock has under performed, is there a good reason?
Step 2: Estimate the Things You Can't Know
Step 2 in the mechanics of investing requires us to peer into the future of the business. We read, think, discuss, and deduce to try to answer these questions:
- Will the business grow?
- From where the growth will come?
- What kind of growth rate can we expect?
- Can the company maintain its competitive advantage?
- Can margins expand?
- What is the barrier to entering the company's market?
- What is the switching cost for customers?
- Will the landscape of the business change?
- How much will a company spend to fuel growth?
- And finally, what can go wrong?
Step 3: Brace for the Things You Have No Control Over
However successfully you've navigated the first two steps, you'll eventually face something you can't control or predict, such as the market bottoming out, the company missing earnings estimates, the price of oil changing, the stock getting an upgrade, the revelation of fraud, a short attack, interest rate fluctuations, or an executive announcing a serious illness. I didn't imagine these things; they're real events that triggered market overreactions. Some of them might have affected the returns of your portfolio, for better or worse.
Because you can't control these surprises, the way to stay calm in their wake is to focus on what you can control: Answering the questions in steps 1 and 2. If your answers don't change after the surprise and you have some cash (dry powder is always advisable), you can take advantage of irrational market sell-offs. If you don't have money to deploy, you're better off completely ignoring the noise.
Be a Good Pilot
Investing isn't easy, but the inevitable turbulence creates tons of opportunities. It's one of the rare instances where inefficiencies can be incredibly useful: Because of the exchange nature of the business, one right equals one wrong. So be good pilots, Fools, and remember what you've learned. If you fall back on that knowledge, volatility won't be driving (or piloting!) your decisions.