SweetSpot Investing: Why It Works
Legendary investor Warren Buffett has said that the most costly
mistake investors make is to be greedy when they should be fearful and fearful when they should be greedy. This
concept can be reduced to a formula:
Greed minus Fear = Risk Tolerance (?)
When greed exceeds fear, risk tolerance is high (but should
be low); when fear exceeds greed, risk tolerance is low or nonexistent (but should be high). If your financial
adviser asks you what your risk tolerance is, you should reply in your best zen-master voice, "How's the market doing?"
Then apologize for answering a question with a question...
Investors sell in droves when everyone is fearful. By buying
the sectors that have seen the most prolonged selling, SweetSpot investors assume an attitude of greed. Mr.
Buffett would approve...
The typical scenario: You hear about a promising investment and the story
is appealing enough that you buy in. Of course the investment was doing well for some time before you ever heard about
it -- you just "bought high."
After you hold the investment long enough to fall completely in love with it, its
upward momentum starts to peter out. Like a failed space launch, it had been rocketing skyward but now the only thing propelling
it is the force of gravity as it heads back to earth. If you're like most investors, you sell when the price falls
to a level that exceeds your pain threshold. You just "sold low."
SweetSpot, on the other hand, identifies
investments that have been bid down, not up. And we sell them only after they have had ample time to recover their value.
In effect, we sidestep the "buy high, sell low" cycle that plagues most investors while capitalizing on others' failure
to do so. So far, our sell price has been higher than our buy price every time, even during the 2000-'03
bear market. Our buy and sell decisions are automatic, leaving us to use our judgment for something it's qualified to
do: decide that this is a course of action worth following...
Will
SweetSpot Lose Its Edge?
SweetSpot seems like a great approach to investing, but why should we
expect it to be any different from all of the other "great" investment strategies that performed poorly once they came to
light? Whatever advantage they enjoyed disappeared quickly and mysteriously.
The answer is that SweetSpot investing is rooted in human nature. Studies
of human behavior have shown that people react predictably (and irrationally) to the same stimuli. Scientists can now map the human brain and monitor its functioning in real time. They can actually show
us how tasks involving money and investing cause our "caveman" (and cavewoman) brain to fire on all cylinders, allowing our
rational brain to function just enough to carry out directives and think it's in charge. Yet the stock market as we know it
has only been around for a couple of centuries. If it's the caveman brain we're bringing to bear, the human species is maladapted
to the stock market!
Investors who buy high and sell low think they're acting rationally but in reality they're at
the mercy of subconscious primal forces. When the news is bad and everyone is selling, those forces are working
overtime. Caveman brains are frantically making bad trades...
Our advantage as SweetSpot investors comes from knowing
that our rational brain can overrule our caveman brain if it only knows why it should. We can end-run the madness by using
objective criteria to identify the mispriced assets the cavepeople leave behind after the selling is done. We just do what
the numbers tell us, something the rational brain can handle. In the meantime, we'll be on the lookout for a pickup in the
pace of human evolution, which is what it would take for SweetSpot to lose its edge...*
