One of the requirements for efficient capital markets involves the rapid dissemination of relevant information necessary to make investment decisions.  Superior information can provide a material edge for investors and has traditionally been viewed as a competitive advantage for those who have the necessary skill and work ethic.  The amount of information available to all investors today is greater than ever before but so is the noise — and the noise tends to become overwhelming and have negative implications for investor psychology.  This phenomenon is glaringly obvious so far this year as sentiment has turned decidedly negative.

Howard Marks recently released his latest memo, On the Couch, in which he provides commentary on recent market developments and current investor psychology.  Toward the end of the memo, Mr. Marks outlines his “prescription” for investors which is replicated below:

• The first essential element in coping with markets’ irrationality is understanding.  The importance of psychology and its influence on markets must be recognized and dealt with.
• The second key lies in controlling one’s emotions.  An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings.  Thus it is absolutely essential to keep optimism and fear in the appropriate balance.
• Emotional self-control isn’t enough.  It’s also important to have control over one’s circumstances.  For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings.  Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance.  At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions.
• And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool.  Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa.

It is likely that the majority of readers of the memo are professional investors who need to be particularly concerned with the third bullet point.  For a professional responsible for managing money on behalf of clients, having the right skill set and emotional temperament is not enough if the emotions of other people can result in fund outflows that force ruinous forced liquidations at just the wrong time.

Fortunately, individual investors have an edge when it comes to dealing with irrational markets.  By not being accountable to others, an individual investor only has to be accountable to himself.  Provided that the individual has made good decisions in the past, market volatility need not be a major concern except when contrarian actions can be taken to benefit from market irrationality.

Individual investors who take a passive approach and purchase low cost index funds are best served by ignoring short term market movements and not even looking at the market value of their portfolio more than once a month.  The perceived level of volatility of a portfolio is much lower if one examines market value once a month or once a quarter rather than daily or hourly.

Of course, many investors view themselves as enterprising investors.  Anyone reading this article is likely to be either a professional investor or an enterprising individual investor.  And who are we kidding?  Such individuals are going to be looking at market quotations on a daily basis at a very minimum.  When even Warren Buffett is known to keep CNBC on during the business day, albeit muted, how realistic is it to think that the rest of us can resist the urge to check quotations relatively often?

It is important to learn to view market gyrations as an opportunity rather than a curse so that we can act as contrarians.  Generally, this means having a certain amount of cash that can be deployed at opportune times.  One approach that can be helpful in down markets is to proactively place good-til-cancelled limit orders at low prices.  This can create a mindset of cheering for market declines rather than advances since those limit orders will get closer to executing as the market plummets.  Obviously, conviction is required to follow through on this approach and one must remain cognizant of intrinsic value changes that are actually warranted and adjust accordingly.

Oaktree has recently started posting videos of Howard Marks introducing the topic of each of his memos.  The introduction to “On the Couch” is available here.  Readers can also subscribe to receive notification of future memos.  Howard Marks is scheduled to be the keynote speaker at the 19th annual CSIMA Conference on January 29.  Mr. Marks previously appeared at the 2011 CSIMA Conference where he made a presentation touching on many similar topics.

Disclosures:  None