By Jack Forehand, CFA, CFP (@praticalquant) —
I wrote an article last week that challenged some commonly held beliefs about dividend investing. When you take on dividends, you can expect to receive some pushback and I certainly did. But the process of questioning an idea that so many investors strongly believe in got me thinking about the whole concept of conviction in investing.
Dividends are something that many investors have a very strong belief in. That level of conviction is usually a very good thing. It helps them stay the course when the market gets choppy. It allows them to continue to believe in their core principles when others question them during rough times. It leads to better long-term returns.
But conviction isn’t always a good thing. Sometimes it leads us to miss major flaws in our investment strategy. Sometimes it leads us to stay the course when the facts have clearly changed. Sometimes it hurts our long-term returns rather than helping them. Although conviction is probably the most important thing we all need to achieve our long-term goals, sometimes it also fails us.
And I am not pointing the finger at other investors here. I am pointing it at myself. I tend to pride myself on having conviction. I want to be the guy who is still staying the course when everyone else around me is panicking. But there have been times in my investing career where I have taken that too far.
The Guy Who Defended the Price/Book
My defense of the Price/Book is a good example of one of those times. I learned about factor investing by looking at academic research. If you look at the academic research about value investing, you will see that Price/Book is the most widely used metric to define value by far. Earlier in my career, I thought that fact was an indication that the Price/Book was one of the best ways to define value. After all, if it is good enough for Fama and French, how it could it not be good enough for me?
But what I missed is that academics didn’t use the Price/Book because it was better. They used it because long-term data for the Price/Book is more available than for other metrics. They also used it because it was a more consistent measure and led to lower turnover. But they didn’t necessarily use it because it was the best way to define value.
Over the course of my career, I learned that there were clearly better ways to define value than Price/Book, especially in a world dominated by intangible assets. But I kept defending it longer than I should have. I even wrote an article to make my case. But I was wrong. My conviction got in the way of the facts.
I wish I could say it won’t happen again, but it will. Conviction will surely get the best of me again at some point in the future. That is the nature of conviction. We need it to succeed in investing and stay the course during the tough times, but it can also blind us to obvious truths.
And this isn’t just an issue for value investors like me. You see it with Bitcoin and Tesla supporters all the time. Any time anyone dares to challenge either of those on Twitter they get brutally attacked from all different directions. Bitcoin and Tesla supporters have both clearly benefitted from their conviction, as holding both assets through the volatility has been the right thing to do so far. But that conviction could also make them miss some potential versions of the future where their bull cases don’t play out.
For example, if you are a Bitcoin supporter, can you see a future version of the world where it doesn’t succeed in the way you think it will? Is it possible government crackdowns could derail it? Or is it possible some sort of cyber-attack could occur? Or is it possible that the gold of the future could be the same as the gold of the present?
Or for Tesla supporters, could adoption of electric cars go slower than many think? Or could new entrants into the market like Ford’s Mustang Mach E lead to a significant reduction in Tesla’s market share as traditional automakers catch up? Is it possible that the current price reflects a level of optimism that exceeds the company’s future potential?
I don’t know the answer to any of these questions, but I would guess that the odds that some of those answers are yes are not zero. That doesn’t mean that bulls for both Bitcoin and Tesla might not end up being right. But it does mean that their conviction could be blinding them to the fact that there is a potential future version of the world where they aren’t.
The Double-Edged Sword of Conviction
Investing in general requires conviction. Over the past 100 years, U.S. stocks have been one of the best ways to grow long-term wealth. However, over that period of time we’ve seen recessions, bear markets, wars, pandemics and other events that have shaken the conviction of most investors. There have even been long-term periods (i.e. 2000 – 2009) where benchmarks like the S&P 500 lost value. But generally, those investors who maintained conviction and a belief that stocks were good long-term investments were the ones who won out over time.
Conviction is clearly a good thing in most cases. But it can also lead to bad decision making. It can also bring ego into the investing decision making progress. So maintaining conviction will continue to be crucial to achieving long-term investing success. But unless what we believe is a one hundred percent certainty, it also makes sense to take a step back every once in a while and think about what the world might look like if we are wrong. It could help avoid some major mistakes.