Coming up on ten years ago, during the Oh-My-Goodness-The-Sky-Really-Is-Falling-This-Is-The-Big-One-Retreat-To-The-Bunker-And-Hunker-Down era, a friend of mine I’ll call Dwayne for the purpose of this post, liquidated his healthy, six-figure investment account.
It was 2008, Lehman Brothers had collapsed, Bear Stearns had collapsed, Merrill Lynch had collapsed, panic swept through Wall Street and Main Street, global financial markets teetered, tottered, wobbled, and reeled, and conventional wisdom had reckoned the end of capitalism to be nigh.
Dwayne, certain that impending Armageddon would leave fiat currencies worthless, resolved to eliminate perceived financial danger. He would protect himself and his family by using much of his cash stash to buy gold. Speaking with me about his intentions, Dwayne insisted not only that his actions were perfectly reasonable, they were also the only sane path forward.
Brushing aside my assertions that fear was driving an extreme, irrational response to cyclical market gyrations he, in turn, charged me with misguided hope for the future. Whether fear or hope, the fact is that underlying both of our ways of thinking were, dare I say it, feelings.
Whoa Whoa Whoa Feelings
At their core, investment decisions are emotional decisions. And, unfortunately for investors, irrational, short-term thinking too commonly supercedes logic and reason. The result? We buy or sell a security not based on objective, diligent research but moreso rooted in emotional responses triggered by screaming headlines, doom and gloom pundits or chicken little next door.
Why is it do difficult to block out these meddlesome emotions?
The answer lies partly in the perpetual tug o’ war between two radically different parts of our brain. While the prefrontal cortex wires us for rational, long-term thinking, the limbic system is geared to short-term emotions leading to irrational decisions.
Being human, and being predisposed to fluctuating degrees of emotional bias, we will (make no mistake about it) mess up here or there.
So, for those investors not blessed with Vulcan heritage (for those readers not familiar with Mr. Spock / Star Trek, think ice in your veins), how do you rein in wayward behaviour for the purpose of minimizing risk and maximizing profit?
Striving for Clarity
Modifying our behaviour (be it investment or otherwise) is not a simple task. If it were, there would be a whole lot more champion investors weighing in on scale with Ben Graham, Irving Kahn, Warren Buffett and Peter Lynch.
Famously, Buffett is quoted as saying,
“The secret of getting rich on Wall Street is you try to be greedy when others are fearful and fearful when others are greedy.”
Aside from his other talents, Buffett understands that emotions play an integral role in investing. For the rest of us mere mortals, we would be wise to emulate the Omaha Oracle and, gulp, get in touch with our feelings (the ‘gulp’ is for the guys, given the guy tendency to shy away from f, f, f … feelings).
A useful starting point is the Investor’s Cycle of Emotions. The Cycle helps to shed light on (a) the kinds of events responsible for activating certain investment related emotions; and (b) how these emotions may affect our decision-making behavior:
- Optimism. We buy when feeling positive about the future.
- Excitement. Paper gains reinforce belief in ourinvesting prowess. We consider how this new money may be put to use.
- Thrill. When gains grow, overconfidence sets in.
- Euphoria. As gains continue, we begin ignoring risk and expect each investment to be successful. Here we encounter maximum financial risk.
- Anxiety. Incurring unrealized losses as investment values decrease we rationalize that, being long-term investors, our investments will ultimately bear fruit.
- Denial. Markets slide. Investments go into free fall. We bravely maintain confidence in our investment choices and hold onto hope that values will rebound.
- Fear. The markets unrelenting descent brings confusion. We begin to doubt our investments will ever again increase in value.
- Panic. Frozen, we do not know what to do.
- Capitulation. Convinced that our portfolio has suffered irreversible damage, as a matter of eliminating risk to ensure survival, we sell everything.
- Despondency. We decide never to make another stock market investment. Here, when the herd is despondent, we encounter maximum financial opportunity. [for example, when Warren Buffett agreed to loan $5 Billion to Goldman Sachs during the height of the Great Recession. Three years later, with the recovery underway, Goldman Sachs paid back the loan and Buffett pocketed a tidy $3.7 Billion profit].
- Depression. We try to makes sense of what we believe to be our foolish actions.
- Hope. Time heals. Eventually, clouds disperse and we attribute our loss to the reality of experiencing a down cycle. We start looking for new opportunity.
- Relief. Tentatively, we re-enter the stock market. Our investments turn profitable. Faith returns. The Cycle begins anew.
Sound exhausting? Familiar? In capitalist markets like our own, this scenario plays out time and again because it’s not a matter of if markets go down, but when.
Now, I’m not saying that loss may be avoided simply by cultivating awareness of your emotional responses. But I am saying that, if you know how the typical investor’s emotions play out when bulls stampede or herds blindly rush for exits, then you’ll be in a stronger mental position to dodge infection of fear, act rationally and productively manage your portfolio.
Taming the Limbic System, Maximizing Investment Dollars
Because excessive emotional reactions will make for an unhappy investor, the best you can do is learn to understand and effectively manage your emotions.
Alternatively, farming out decision making to an objective, emotionally detached Robo-Advisor or one of the human variety, may be worth looking into. Whatever you choose, keeping a lid on detrimental emotions is important.
One of these destructive mental states is GREED. Left unharnessed, greed is powerful. And when greed takes over, when logic is shunted to a corner and we watch an investment run up 25%, 50%, 100%, 200%, and continue holding on because we’re hoping for more so we can buy that new car or take that European vacation, we perilously ignore the unlikely repeal of the law of gravity.
So how do you soften the penchant for wanting more? Focus on risk management. Focus on the possibility of losing instead of winning. Focus on satisfying your needs instead of wants. Ask yourself whether, based on prudent research, you would make an investment at the current price. If not, then let reason be your guide, stay disciplined to your exit strategy and listen to the voice imploring u to ‘sell’ when your target price flashes green.
Another harmful way of thinking involves OVERCONFIDENCE. Research shows that close to 75% of people judge themselves better than average at, well, everything. Of course, by definition, about half of any group must be less than average.
In the realm of investing, overconfidence leads investors to take on more risk than initially anticipated, commonly deviating from a methodically crafted investment plan only to be trampled by emotions gone wild.
And when stocks go down, emotions again push reason to the sidelines. Investors continue to hold, often believing that by not selling they will avoid the pain and regret of having made a poor investment decision and embarrassment of reporting a loss on their tax return, or telling their accountant or spouse.
First comes losses, second comes pain, third comes regret.
Behavioral finance experts claim that the prevalence of fear of regret stems from people’s unwillingness to accept responsibility for pain they caused themselves. And when you’re stuck in the regret phase, you’re mired in the past, beating yourself up, and unable to get back in the game.
Since wallowing doesn’t benefit anyone, for your own well being, it’s essential to ride out regret by learning to accept loss, accept mistakes, and acknowledge the fact that even well-researched investments may, and will on occasion, turn sour. Once you’re moving forward, remember to carry with you lessons learned and, in the future, stick to an investment plan honed during a period of calm reflection.
Hope is not a Strategy
Too many folks are prone to chasing investments whose value is going up. According to research, we become overly optimistic about past stock market winners and excessively pessimistic about past losers.
Apparently, neither optimism nor pessimism is justified since, over time, extreme winners underperform and extreme losers outperform. Yet, we can’t help ourselves. Maybe we’re just too excited to hop on for the ride, carried away by the hope that we’re going to hit it big.
Consider this little gem:
As of March 13, 2017, a company called Stemcell United (ASX:SCU) was effectively worthless trading at one penny on the Australian Stock Exchange. Then, on March 14, 2017, the company issues a press release stating, “SCU to pursue opportunities in Medicinal Cannabis sector.’
Well, this general, vague, zero details statement was enough for speculators to move the price to $1.09 on March 14. That’s right, from one penny to $1.09 in one day. Insane. Still, before the day was out, the stock closed at 41 cents. And as of yesterday, the stock was priced at 13 cents.
The outrageous stock price movement had nothing to do with company fundamentals: the company has no revenue, sells no product and offers no service. But what it did have was a statement saying that it would enter the potentially lucrative marijuana industry. And that was enough to fuel the dreams of hordes of speculators.
The point being: whether you’re buying a penny stock or a behemoth like Apple (NASDAQ:AAPL), you’ve got to look in the side view mirror, the one where it says that past performance gives no indication of future returns. Then look ahead and keep in mind that investments should be made on the basis of solid business fundamentals and favorable prospects, not because hopes and dreams spurred us to the bottom of an investor pile on.
Embrace the Rational Path
Human nature is inherently paradoxical.
Impulses and emotions clash against reason, contributing to adverse investment decisions. As investors, our goal is to discipline the mind such that we recognize emotional reactions and learn to manage their potentially harmful consequences. And though there is more than one path to investing success, all include abiding by decision-making emphasizing cold logic rather than runaway emotions.
Whatever path you choose, consider what ninety-three year old Charlie Munger, Berkshire Hathaway vice-chairman, said when asked how he became such a successful investor: “I’m rational.”