The Psychology of a Rule Breaker in Good Markets and Bad

In this episode of Rule Breaker Investing, Motley Fool co-founder David Gardner shifts his focus away from the numbers game to a mental one. Picking good investments is, after all, only one part of growing your wealth. Another key aspect is maintaining the disciplined mind-set and emotional distance required to avoid making the wrong moves.

Speaking of picking good investments, he also reviews how The Fool has done at spotting the best long-term buys by reviewing the S&P 500's top stocks over the past decade, and discussing when and if they made it into various Foolish portfolios.

A full transcript follows the video.

This video was recorded on June 14, 2017.

Editor's note: At one point in the podcast, the math doesn't quite add up; 7,690% is not "100 ... or so" percentage points more than 7,497%. The Fool regrets the error.

David Gardner: Welcome back to Rule Breaker Investing. A pleasure to spend some time together this week. This week it's just going to be you and me and it's not going to be as long a talk as we normally might have.

Now last week, it wasn't just me. It was me with Zack Kanter, and I hope you enjoyed Zack; I think a lot of you did. We got some great feedback on the show. I'd love to have Zack back at some point in the future once again: one of those go-to guests, maybe, for Rule Breaker Investing. If you didn't get a chance to listen to Zack and me talk about the future last week, I would highly recommend you spend some portion of your future going back into the past and listening to that podcast.

This week I was queued up to do one of those non-stock, non-investing, arguably slightly self-indulgent podcasts. I was queuing up the "My Pet Peeves, Latest Volume." It's something I've enjoyed sharing maybe once a year -- just a list of a few pet peeves -- and that was feeling like a nice way to kick off summer. And then the market drop happened. And then I thought, "Maybe I won't do that. That feels a little bit offbeat this week." So what I decided is that I want to speak to just the market right now -- just a little bit -- and the psychology that we share as human beings around that and getting past that.

I want to try to be as highly relevant as I can to what you might be feeling right now if, like me, you watched your stock portfolio significantly drop on both Friday of last week and then Monday of this week. And, of course, I have no idea what the market will be doing today, as you hear this podcast, or tomorrow. I don't want to overfocus on a day or two of market trading.

However, when I watched my portfolio go down about 3% on Friday, and then watched it go down about 3% on Monday -- and so all of a sudden, I'm off 6% in two days -- I thought that's worth talking a little bit about. I hope that's not true of you. You probably don't invest with quite the aggressive, risk-taking approach that I take. Which, by the way, doesn't use any margin, and I'm not short anything.

The reason that I make bigger percentage moves than the market -- because neither the Nasdaq nor certainly the Dow moved like that on those two days, but I did -- is because I have rolled up winners in a few key stocks that if they drop 5%, that's really going to hurt my portfolio. Netflix (NFLX -1.50%) would be an example: I think Netflix was off about 5% on those consecutive days, so that's going to affect me, I hope, more than you.

As I thought about what I wanted to say, not just in this podcast but really, on Twitter -- and if you follow me @DavidGFool on Twitter you would have seen this a day or two ago -- I tweeted out one of my favorite lines that I've come up with to describe how I think about investing. And I saw it get a lot of likes, more than I was expecting, and so I decided, clearly we need to speak to where the market is right now.

You might already know this line from me, because this won't be the first time on Rule Breaker Investing that I've trotted out this quotation. But sometimes even hearing something again at a difficult time can be comforting, even if you thought you knew it in the first place. So here's the line: "The stock market always goes down faster than it goes up, but it always goes up more than it goes down." I'm going to say it again. "The stock market always goes down faster than it goes up, but it always goes up more than it goes down."

Now when I've mentioned this line in the past, I've often channeled my inner F. Scott Fitzgerald, and I'm going to do it again here, because one of Fitzgerald's memorable quotes...a beautiful writer...this is not from The Great Gatsby; I believe this is included in one his short stories that I didn't read. But if you just google "Fitzgerald quotes" this will always come up prominently, and here it is: "The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time, and still retain the ability to function."

In fact, because I didn't want to be too lazy or sloppy on this podcast, I'll just let you know it is from The Crack-Up, which was a collection of essays that Fitzgerald wrote and published in 1945. That's where that particular quote comes from.

The reason I think that that's a great quote is because that's what we need to do as investors. Here are two things that are really great to keep in mind around any stock you're investing in -- the bull case and the bear case. The strengths and the weaknesses. Some people only see one of those.

Some people only see the strengths. They don't like it if somebody suggests they may have missed something. They don't like to go on a discussion board and hear somebody who's a bear talk down that stock. They only see the positives.

Other people have the opposite problem. They can't find anything that they like enough about a great company. They just see it's overvalued, or they don't believe the CEO has staying power -- whatever it is. And sometimes we miss some of the great companies of our times because we don't see the positives. But the test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time, and still retain the ability to function. Or, in this case, I'll say the ability to invest, to invest well, to hold over time that which deserves to be held.

"The stock market always goes down faster than it goes up." Let's parse this line briefly. So, I don't have any scientific proof of this. My second part of this line I will present scientific proof of, but this one, I don't.

However, based on my experience -- and perhaps you'd agree with me based on yours, too -- I watch things drop faster than they go up. I've watched the Nasdaq lose over 80% of its value inside of 18 months. I've never seen the Nasdaq gain over 80% in 18 months. I've watched the S&P 500 -- you have too, if you've been around the last 10 or 20 years -- get cut in half in a single year. I can't remember a time that the S&P 500 went up 50% or more in a single year. And that's just the overall market dynamics.

I suspect, by the way, if you go back -- if anybody wants to be a market historian or go to a database -- I suspect you're going to find that the drops that the market makes typically are larger drops in a single year than the gains the market makes. But whether or not that's true, I think most of us don't care as much about the market. We care about our individual stocks. And here, again, I've often watched a company come out with bad earnings and get cut in half, sometimes, overnight. Rarely would I ever see that stock -- or many stocks, frankly -- go up 50% in a day.

When does that happen? Well, it happens if a company gets bought out, sometimes, at a premium; a stock might jump that much. Or if it's a biotech company and it gets FDA [U.S. Food and Drug Administration] approval, you might see a huge move like that. But most of the time, unscientifically, admittedly -- I bet you agree with me -- I watch the drops happen faster than the ups. So that's that part of the line; we've parsed that.

The second part is "but the market always goes up more than it goes down," and that one's pretty easy to prove. Just look at a graph of the Dow Jones Industrial Average or the S&P 500 over time, and you will quickly see that, indeed, the market does go up more than it goes down. And the simple math of it is that on average, as we know, the market rises about 10% annualized over the years. Now certainly, in any given year, we know the market could drop 35% or go up 20%, but taken all in all, something that rises 10% on average from one year to the next: Yeah, that does "always go up more than it goes down."

First off, I hope that's comforting, because if you were like me, you watched your stocks lose value very quickly in just a couple of days in the past week, and if you're new to this, or if you have a lot riding on it, or you're right near retirement, you felt some stress, maybe more stress than you were expecting from that. But I hope my quotation lets you know that that's the way it works. That's the way things have always worked. And so let me shift, now, to why people don't get it. Why don't we understand that? Why is that a surprise? Why does it hurt? And I have two reasons quickly to share with you.

The first is, as psychologists tell us and as I've been wont to say in the past on Rule Breaker Investing, the pain of loss is three times the joy of gain. And that's been determined out there through behavioral economics, in the marketplace, psychological testing. We, as humans, experience -- for the same win or loss -- we experience the loss much harder than the win.

That's a big reason why people don't get it. And as I reflect on many appearances on television, radio, and the media over the years, I know that the time you're most likely to see my brother Tom, or me, or another Motley Fool analyst on a general news show, over the course of history, is whenever the market is getting pounded. And at a certain point, I kind of got sick of doing these media appearances, because you wouldn't get called in -- for ABC Nightly News or something on CNN or Charlie Rose -- you wouldn't get called in on those when the market's doing well, or just kind of placidly moving up over the course of time. You're only getting called in, we would find, when the market is experiencing extreme pain, and we need to speak to that.

At a certain point I just didn't want to participate in that, because that's not the big message. That's not the big point to me, and I don't want people only to see The Motley Fool when they're feeling a lot of pain because the market has just experienced a fast drop. So we've done a lot of appearances on CNBC and Bloomberg and others, and a lot of Motley Fool analysts continue to do that today. Those are the ones that just occur when an interesting story pops up about a given company, or some other aspect of investing.

We enjoy doing those and continue to do them, but I'm just pointing out those are usually financially oriented cable channels that are just going to have us on to talk about a given company. It's when you hit the general news -- and it's when, it's always because the market's dropped -- that I get a little tired of that. So that's kind of reason No. 1 that I think people don't really get it.

Reason No. 2 -- and this is particular to Rule Breaker Investing, to you and me as Rule Breakers -- is that it hurts because in the short term, often we're going to show negative returns much more readily and easily and painfully than positive gains. If, in fact, stocks do go down faster than they go up -- and as a Rule Breaker you're paying a premium to buy into a great company -- it's much more likely in the first six months that you're going to drop 25%, in my experience, all of a sudden, than that you're suddenly going to gain 25%.

In the short term, often we're going to show some negative numbers, or at least a mix. We'll have some winners and some losers. What has to happen is we have to let time pass. We have to find these good companies, be willing to overpay for them, buying their "overvalued" stocks, and sometimes take it on the chin with that first earnings report that surprises us because, darn it, it was a good report but why is the stock selling off? And it's because the report wasn't good enough, or the forward guidance wasn't great. And so all of a sudden, you're in the hole 18% on your shiny new Rule Breaker that you just bought. But five years or so later, since the market always goes up more than it goes down, you're going to find, quite often, that what didn't look so great that first three to six months looks quite a deal better three or five years later.

That's the nature of Rule Breaker investing, and unfortunately, as much as I like to talk about spiffy-pops and long-term winners -- and I'm going to get into that a little bit to end this episode this week -- it's not even that exciting to report on. No one's going to have us, typically, on CNBC to have us brag about how Priceline (BKNG 0.92%) has done since we've held it over the last 10 years. It's almost a nonstory, or boring. It isn't the stuff of being a market maven and getting quoted on television, these days, to passively watch something gain and win over time. It just sometimes sounds like bragging. As Rule Breakers we just need to understand that in the short term, we can take it on the chin; in the long term, we're going to win if we exhibit the all-important quality of patience.

[...]

"Stocks always go down faster than they go up, but they always go up more than they go down."

About this time every year for the last couple of years I've gotten a letter from Roger King of Tampa, Florida. Roger is a Motley Fool member. I've never met Roger, but I love his letters and I'm going to share with you the most recent one I got from him, which was in June of 2016. Roger, I'm hoping I'll get your 2017 version later this month. But I'm going to excerpt a little bit of Roger's letter to me in June of last year -- June 2016.

"Dear Motley Fool," he wrote. "This letter is an update of a letter that I wrote to you about this time last year." Attached: "The latest Fortune magazine, June 15, 2016, has 'The Best Investments for the Last 10 Years'" (that would have, at the time, been from 2005 through 2015) "of the 500 largest stocks in the U.S., the S&P 500."

I'm going to reveal those in a sec, but before I do this: The last time Roger sent me this note, the year before, triggered one of my favorite podcasts that I've gotten to do on Rule Breaker Investing. And what makes me sad is that you can't find that podcast readily these days, on either our own site or on something like iTunes. Take iTunes -- iTunes only retains the last 100 podcasts of each podcast that you want to look up on iTunes, so this one has now fallen below the fold. It was called "The Top 5 Stocks of the Past 10 Years." I did this one on July 29th of 2015. It was only 13 minutes long. It was a lot of fun, so I'm still going to plug it, and truly, if you want to just type in "Rule Breaker Investing Top 5 Stocks of the Past 10 Years" into [Alphabet's] Google, among the top three links you'll find this podcast, and I hope if you hadn't heard it before, that you'll listen to it. But I'm going to be channeling that same vibe with this week's podcast.

So what were the top five stocks of the past 10 years, through 2015, in last year's Fortune magazine edition?

Well, the No. 5 stock is XPO Logistics (XPO -9.36%), which rose 25.9% over the previous 10 years. That is not a company that I've ever recommended or owned. I do want to say two things briefly about XPO Logistics. One is that it had been added to our services in 2015. In the interests of full disclosure, my brother Tom in Stock Advisor recommended the stock in January of 2015, and I'm happy to say for Tom that it's up 60% since then, and it's about 33% ahead of the S&P 500. So great call, Tom Gardner, in January of 2015. That's one of the two things I want to say about XPO Logistics.

The second thing I want to say is that I hate XPO Logistics, and here's why. I think I may have said this last Christmas, but one of my big gifts last year for my family was going to be basically a NordicTrack. I ordered it well ahead of time on Amazon (AMZN 1.97%). And XPO Logistics starts to inform me about a week before it's due -- which I had just a couple of days before Christmas -- that it has been lost somewhere in one of their warehouses and they can't tell me whether they'll find it or not. And they wouldn't find it, the record will show, for about two and a half more weeks. So, I had to take what was going to be a big reveal, and had to make it a little postcard to my family members that it's still on its way.

Anyway, I don't like XPO Logistics very much, but I'm delighted to know that they've returned value to shareholders, and apparently delivered frequently and well enough that it's the fifth best-performing stock on the S&P 500 for the 10 years 2005-2015. So thus much for No. 5.

The No. 4 performing stock over those past 10 years was Apple (AAPL 0.17%). Apple returned 27.1% from 2005 to 2015 annualized, which rolls up to a pretty awesome number. A lot of us now know, a few years later, that Apple's basically the largest public company in the world, and so just think of the size that Apple started from 10-plus years ago to rack up those kinds of returns and become as large as it is today. So, some good news for Stock Advisor members. You know that Apple is one of my stock picks. I'm sorry to say that I don't have it from 2005, but I am happy to tell you that I first recommended it in January of 2008. It is a seven-bagger since then, way ahead of the market -- hundreds and hundreds of percentage points ahead. So we had that one, No. 4.

The No. 3 best-performing stock of the last 10 years is Amazon. Amazon is up 30.6% annualized over that 10-year period. By the way, since Roger's letter of last June, I'm pretty sure Amazon's done well over the succeeding year, so we're talking about major ups for this stock over the last 11 years or so. Amazon is No. 3 among the S&P 500 for its performance. I'm happy to say with this one -- if you're a Stock Advisor member you know this -- we've held Amazon since September of 2002. It is a 63-bagger for Motley Fool Stock Advisor members who were around back when we started Stock Advisor and who've shown a lot of patience ever since. And that's way ahead of the market by about 6,000% or so. That's No. 3.

The No. 2 best-performing stock on the S&P 500 over the last 10 years is Netflix. Netflix is up an annualized 40.3% as printed in that Fortune magazine issue dated June 15, 2016. Netflix has done pretty well over the succeeding year since, by the way. This is another company that Motley Fool Stock Advisor members will know well. My longest-standing Netflix recommendation was opened up on October of 2004. That stock is up about 65 times in value. I'm really happy to say that my brother Tom saw a good thing and recommended it, as well, to Stock Advisor members. In fact, I've had a lot of people come up to me over the years and say, "You know, Dave, I didn't buy it when you recommended it, but when Tom recommended it, that's when I finally bought -- because when the two brothers agree, that's a signal for me, and I'm OK with that." And I say it a little bit with a giggle. But Tom recommended it three years later, June of 2007: [it's] been a tremendous return for him, a 54-bagger for him as well. So, I'm just here to say we had that one. We had No. 2.

The No. 1 performing stock on the S&P 500 over the past 10 years is Priceline. Priceline, over those 10 years, returned 49.9% annualized from 2005 to 2015. And there might be a theme developing. You might start seeing a thread here. I'm really happy to say that if you're a Stock Advisor member of long standing you know this, because I first recommended it on May 21st of 2004 at $23.71. So with Priceline, today, trading at $1,846 -- yeah, it's been an awesome investment. In fact, it's up 77 times in value: 7,690%. That's 7,497% ahead of the market, which maybe is up about 100% or so since 2004.

Just to throw a little bit more brother love out there, I'm happy to say that my brother Tom recognized Priceline's greatness in 2012 and so, once again, he's found another winner for members -- and I'm sure some of you waited not to buy on Dave's recommendation, but when Tom also recommended it, too. And if so, you're certainly happy, because you've made a three-bagger over these five years or so. So there are the facts. And the beautiful story is that we've had the top four performers on the S&P 500 over the past 10 years, and in every case except the first one that I mentioned, which is the No. 4 performer, Apple, we've had that stock for well more than 10 years.

Longtime Rule Breaker Investing fans will remember a podcast where I talked about FANG, because people a lot of the time were talking about Facebook, and Amazon, and Netflix, and Google, and those are the Four Horsemen, the four big stocks you have to own. This was a popular acronym people were using. Well, there was a little bit of FANG but not that much FANG in those four, because they go PNAA -- so pin-aah -- PNAA, apparently, better than FANG.

My serious point about FANG, when I did that podcast a year or two ago, was not whether you had those stocks in your portfolio, but really: "What's your FANG score," I asked. Sum up the number of years in total that you've owned any of these stocks, and that's your score, and let's have that conversation.

If we were to do our score for these four -- and this is really the critical point to achieving returns like the ones I'm talking about -- we've held Apple for nine years, we've held Amazon for 15, we've held Netflix for 13, and Priceline for 15. And if my math is right, 9 + 15 + 13 + 15 comes to the grand total of 52. So that's my PNAA score.

I highly encourage you, not necessarily to go out and chase FANG stocks, or PNAA stocks, but to ask yourself: Are you positioning yourself for these kinds of returns by being patient enough to be willing to hold companies for that long? Because the way that these big-time results are racked up, completely apart from whether you found these stocks or not in the first place, is: Did you hold them through what were some very hard times and ultimately some very great times?

So, it's a point no doubt I've made many times before on Rule Breaker Investing, and I'll make it again. But in a week in which a lot of people maybe needed to hear "stocks always go down faster than they go up," I wanted to make sure you understand, and can see the benefits of holding through times when stocks go down faster than they go up.

I want to thank Roger King, again, for sending his letter. And Roger, if you're hearing me right now, I don't follow Fortune magazine. I'm assuming that issue comes out again sometime this month. So whether it's Roger, or any of my other friends on Twitter: If you want to send us the most recent results, we'll get to review them again and see if we're still nailing, consistently, the top three performers on the S&P 500 over 10-year periods, and that we have them as actively covered stocks in Motley Fool Stock Advisor.

That's what it's all about in the end, isn't it? Performance and long-term performance. There are even more important things in life. But for Rule Breaker Investing, for our category of podcast, for the subject that we at The Motley Fool are focused on, I can't think of something that I could do much better than that for you, my listener -- for you, our members, here at The Motley Fool -- [than] to find and give you the best stocks of our time.

Next week's podcast: Well, I'm not sure they're going to be the best stocks of our time, but it's one of those podcasts where every nine or 10 or so, I pick five stocks, score them, hold ourselves accountable. I'll figure out my theme in the week ahead. But, yup, next week it's going to be five stock picks.

In the meantime, you can check out past episodes of Rule Breaker Investing and all of The Motley Fool podcasts at our podcast center, podcasts.fool.com. You can check out something I've been talking a fair amount about [in] this particular episode, Motley Fool Stock Advisor, our flagship service. A new issue of Stock Advisor comes out the third Friday of every month with two new stock recommendations from me and, yes, my brother Tom Gardner. Check it out by going to our podcast center. Scroll to the bottom of the page. That's podcasts.fool.com.

And on a personal note to close, if you haven't already, please subscribe to this podcast on iTunes or Spotify. You can follow us on Twitter at @RBIPodcast. And finally, I hope you'll give us a review. Throw me some stars. Let us know how we're doing; I read every comment.

Thanks a lot. Talk to you next week. Fool on!

As always, people on this program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Learn more about Rule Breaker Investing at RBI.fool.com.