The Psychology of Successful Micro-Cap
Investing
by Richard Geist, Editor
Richard Geist's Strategic Investing
There
are four primary factors that contribute to success in the micro-cap market:
financial understandingknowing how to evaluate a company's performance and
its management; experiencea good intuitive feel for products and services
that will impact society; luckunpredictable good fortune blessing a few
of your holdings; and psychologyunderstanding enough about yourself to avoid
emotional mistakes.
During
the past decade, in my role as consultant to money managers, psychotherapist,
newsletter publisher, and financial analyst for small companies, I've had
the opportunity to interview hundreds of investors. From helping to hire
financial analysts, to discussing investment errors with newsletter subscribers,
to treating in psychotherapy a number of very talented investment professionals
and individual investors, the stories being told around the investing campfires
began to have a familiar ring. This diverse group of investors continually
conveyed that success in the micro-cap market no longer depends solely on
how smart we are, what information we possess, what academic degrees we've
earned, how much experience we've gained, or what systems we use; but increasingly
on how well we handle our emotionson what some would call our emotional
intelligence. Listening carefully to this group of investors, a pattern
began to emerge suggesting several essential psychological qualities associated
with successful micro-cap investing (defined arbitrarily as companies with
a market cap under $200 million).
The Successful Investor:
The Right Thinking Style
Successful
micro-cap investors appear to have personality characteristics which are
in harmony with the nature of small company development. For example, most
small companies worthy of consideration tend to have a visionary product
or service that has the potential to change forever the way large groups
of people carry on their lives. At the same time, however, they often provide
very little long-term financial information that allows for an accurate
assessment of intrinsic value. As we have seen with many young Internet
stocks, analytic skills alone are not enough to determine the merits of
the investment.
In
order to understand and embrace such forward-looking ideas, one must have
a particular cognitive capacitythe ability to engage the right side of the
brain. We know that the left and right sides of the brain function somewhat
differently. The left side of the brain helps us with analytical, rational,
intellectual, deductive, and disciplined reasoning. The right side of the
brain seems to direct more imaginative, intuitive, symbolic, emotional and
contemplative thinking.
Most
investors in, and founders of, small visionary companies have the capacity
to utilize right brain thinking. Thus, management frequently appears to
act irrationally and uncommunicatively, making snap judgments that they
do not explain clearly. These are examples of right brain signals that are
directly translated into decisions without being verbalized along the way.
This is one reason that traditionally trained financial analystswho depend
much more on their rational, intellectual left brain for analysisdo not
attempt to analyze small companies. To be a successful micro-cap investor
requires that one be able to think intuitively and inductively. Without
these cognitive capacities, one is better off sticking to well-analyzed
large caps.
Successful Investors:
Feeling Like an Outsider
Successful
micro-cap investors report a long history of experiencing themselves as
not quite belonging to or fitting in with their world. They remember themselves
as being different from others in their peer group. These investors were
not lonersthey had friends, often intimate friendsbut they carried with
them a vague sense of not being adapted to their world.
Rather
than stepping outside of society, however, these successful investors remained
within the system and developed the capacity to belong while concurrently
valuing and believing in their own idiosyncratic ideas. Thoreau's notion
of walking to a different drummer is applicable here, but with the addition
of coming to terms with having taken the road less traveled so that remaining
an outsider became part of a valued identity used in the service of picking
stocks that are off the beaten track. This characteristic is in direct contrast
to those who invest in large cap stocks; the latter tend to be much more
comfortable investing in companies where there is plenty of companionship
from individual investors, institutions, and analysts who painstakingly
examine the financial histories of the companies.
The Successful Investor:
Tolerance for Loss and Separation
Because
there is a much higher failure rate among micro-cap companies, successful
micro-cap investors have developed the capacity to tolerate loss. They have
come to terms with the fact that many of their stock picks will crash, but
they also know and are comfortable with the idea that all it takes is a
few really large winners to come out significantly ahead of their peers.
Belief in this principle helps these investors tolerate mistakes without
undue self-criticism or threats to their self-confidence. While most unsuccessful
investors become preoccupied with their mistakes, blaming brokers, analysts,
company management or themselves, successful investors expect to make mistakes
as part of the investing process. They reverse themselves quickly, attempt
to understand where they went wrong, and tend not to repeat the same mistake
again. Most of these investors seem to enjoy the process of investing more
than they enjoy making money.
The Successful Investor:
Decentered Awareness
Within
the micro-cap market there is usually a wide disparity between the quasi-logical
world of the market and the more emotionally laden fantasy world of the
investor. While not eliminating emotion from their investment decisions,
successful investors appear to have the capacity to decenter from themselves.
Decentering is a learned process whereby, in the middle of emotional turmoil,
we step back and begin to incorporate disparate opinions by asking how other
viewpoints and theories could alter our perceptions, what could be right
or reasonable about others' views or convictions about a stock or management.
In other words, the investor participates in a silent dialogue with the
market in which new, more complete meanings begin to emerge. For example,
market events and company events frequently evoke isolated emotional states.
The Dow drops 250 points and we feel pessimistic and angry, as if the long
awaited bear market is beginning, even though there are numerous market
indicators which would allow one to feel positive and optimistic at the
same time. A favorite company reports unusually good earnings for the quarter
and we feel ecstatic about its future prospects and want to buy more stock,
despite the fact there are several financial ratios indicating trouble ahead.
In each case we experience isolated emotional states that give us very different
clues than if we were looking at a whole picture. Without the capacity for
decentering from these emotional states, one is more likely to pay attention
to just one of those feelings and act on it with blatant disregard for the
other emotions being experienced. This is a common reason for investors
getting whipsawed by the market.
The Successful Investor:
Comfortable Self-Reflection
There
is much evidence in both the academic and clinical psychology literature
that as the ambiguity of an external stimulus increases, we are more likely
to interpret and organize its meaning according to the themes that structure
our own subjective world. This phenomenon is familiar to every child who
lies on the grass and perceives specific objects in the vague cloud formations
above. Almost by definition, micro-cap investment decisions are made with
a dearth of information that is at best ambiguous. Especially in the micro-cap
market where there is no reliable history of earnings and revenues, forecasts
are often nothing more than projections of the investor's own subjective
reactions to a company's services or products.
If
the micro-cap external data is highly ambiguous, it increases the likelihood
that much of our "understanding" of our investments is shaped
by the idiosyncratic lenses we use to make meaning out of the external data.
The successful micro-cap investor has some awareness of his or her lenses
or organizing patterns. For example, one of the common organizing patterns
that some investors experience is: "something I own is more valuable
than something I don't own." The investor who filters life through
this organizing pattern will often have trouble selling a stock until it
has retreated far below his or her original mental stop price. This is because
the feeling of ownership makes the company seem more valuable than it actually
is to an objective observer. It is the capacity to comfortably reflect on
one's organizing patterns as they emerge from repetitive investment decisions
that contributes to being a successful micro-cap investor.
The Successful Investor:
De-coupling Risk from Loss
Most
successful micro-cap investors appear to discern risk differently than the
average investor. Rather than viewing risk as either chance or consequence
of loss, they seem to experience it as de-coupled from loss. They are closer
to John Maynard Keynes' 1921 statement that "most of our decisions
to do something positive can only be taken as a result of animal spiritsand
not as the outcome of a weighted average of quantitative benefits multiplied
by qualitative probabilities."
Successful
micro-cap investors do not eschew risk, but they certainly seem to emphasize
the possibility of reward over risk. What substitutes for risk is the intellectual
challenge of studying products, services, and management. This intellectual
challenge allows for failure while turning decision making into an art that
is enjoyed for its own sakean art that is accompanied by a strong belief
in their own capacities. This is why many successful micro-cap investors
avoid diversification as a method for minimizing risk. These investors seem
to know that, as Peter Bernstein once said, "diversification doesn't
prevent loss; it just prevents loss all at once." Successful micro-cap
investors have enough confidence in their own research and decision making
that they can concentrate their investments to take advantage of their own
investment judgment.
Do I Have What It Takes?
To
decide whether the micro-cap market is the right place for you to invest,
try asking yourself the following questions.
1. Am I capable of intuitive, inductive, imaginative
thinking?
2. Do I feel comfortable and have the courage to
follow my own convictions?
3. Can I tolerate making mistakes and be willing
to analyze them?
4. Am I able to step back from emotional turmoil
and separate facts from emotion?
5. Do I understand the idiosyncratic lenses through
which I'm likely to view the world?
6. Am I able to view risk as an intellectual challenge
to solve rather than fear it as chance of loss?
If
you are able to answer positively to these questions, you are emotionally
ready to take on the task and challenge of micro-cap investing.
Editor's Note: Richard Geist culls through thousands of small-cap and
micro-cap investment opportunities to select only a few, each possessing
those unique investment qualities likely to propel a reasonable investment
into a lifetime fortune. His analysis is found in Richard Geist's Strategic
Investing, 1905 Beacon St., Waban, MA 02468, 1 year, 12 issues, $157.
1-800-414-7235.
Mr. Geist co-authored with Lawrence
Lifson, The Psychology of Investing, 208 pgs, $29.95, John Wiley
& Sons, Inc., which is the first comprehensive book to apply
psychology theory to a broad range of investment topics which sit at the
interface between human emotions and financial decision-making. Drawing
on the invaluable wisdom and cutting-edge research of top experts in an
area of ever-increasing interest and importance, it describes how both group
dynamics and an individual's personal psychology affect investment decisions.
This authoritative and practical
book features contributions from professional psychologists, psychiatrists,
academics, and investment practitioners who are among the leading thinkers
and teachers in their field. Among those sharing their innovative ideas
and far-reaching thoughts on topics such as contrarian theory, momentum
strategies, and investor overreactions are faculty members from Harvard
Medical School and Harvard Business School, columnists from Forbes magazine,
publishers of investment newsletters, and authors of investment-related
books.
Groundbreaking in the way it explores
the connection between psychology and investment performance, it is essential
reading for anyone seeking insight into this unique relationship.
