To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd. You have to have a stomach to withstand the volatility of the stock markets. So says Hedge Fund Manager William Ackman in this selection from his Floating University lecture.

William Ackman: Let’s talk a little bit about the psychology of investing. So we’ve talked about some of the technical factors, how to think about what a business is worth.  You want to buy a business at a reasonable price.  You want to buy a business that is going to exist forever, that has barriers to entry, where it’s going to be difficult for people to compete with you, but all those things are important, but even—and a lot of investors follow those principles.  The problem is that when they put them into practice and there is a panic in the world and the stock market is heading down every day and they’re watching the value of their IRA or their investment account decline the natural tendency is sort of to do the opposite of what makes sense.  Generally it makes sense to be a buyer when everyone else is selling and probably be a seller when everyone else is buying, but just human tendencies, the tendency of the natural lemming-like tendency when everyone else is selling you want to be doing the same thing encourages you as an investor to make mistakes, so a lot of people sold into the crash of ’87 when in fact they should have been a buyer in that kind of environment.  

So that’s why I talked before a little bit about why it’s very important to be comfortable.  You want to be financially comfortable.  If you have student loans you want to have a manageable amount of debt.  You probably don’t want to be paying any—you don’t want to have any revolving credit card debt outstanding.  You want to have some money in the bank because if you’re comfortable then the money that you’re risking in the stock market is not going to affect your lifestyle in the short term.  As long as you don’t need that money tomorrow you can afford to deal with the fluctuations of the stock market and the fluctuations, depending on who you are can have a big impact on you.  People tend to feel rich when the stocks are going up.  They tend to feel poor when the stocks are going down and the reality is the stock market in the short term is what Ben Graham or even Warren Buffet called a voting machine.  Really stock prices reflect what people think in the very short term.  If affects the supply and demand for investors, buying and selling stocks in the short term.  Over the long term however, stocks tend to reflect the value of the businesses they own.  So if you’re buying businesses at attractive prices and you’re owning them over long periods of time and those businesses are growing in value you’re going to make money over a long period of time as long as you’re not forced to sell at any one period of time.

To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd.  When the stock market is going down every day you’re natural tendency is to want to sell.  When the stock market is actually going up every day your natural tendency is to want to buy, so in bubbles you probably should be a seller.  In busts you should probably be a buyer and you have to have that kind of a discipline.  You have to have a stomach to withstand the volatility of the stock markets.  

The key way to have a stomach to withstand the volatility of the stock market is to be secure yourself.  You’ve got to feel comfortable that you’ve got enough money in the bank that you don’t need what you have invested unless—for many years.  That’s a key factor.  

Number two, you have to recognize that the stock market in the short term is what we call a voting machine.  It really represents the whims of people in the short term.  Stock prices are affected by many things, by events going on in the world that really have nothing to do with the value of certain companies that you’re investing in, so you’ve got to just accept the fact that what you own can go down meaningfully in value after you buy it.  That doesn’t necessarily mean you’ve made an investment mistake.  It’s just the nature of the volatility of the stock market.

How do you get comfortable? You don’t just buy a stock because you like the name of the company.  You do your own research.  You get a good understanding of the business.  You make sure it’s a business that you understand.  You make sure the price you’re paying is reasonable relative to the earnings of the company.