Keep calm and carry on 10 ways to curb investing emotions
Self-knowledge, discipline and taking deep breaths can help you avoid making mistakes
SELF-CONTROL IS ALL THE MORE VITAL GIVEN THAT OUR COMPULSIONS CONSPIRE TO DEFEAT US AS TRADERS
THOSE WHO BELIEVE THERE’S NOTHING TO FEAR ARE KIDDING THEMSELVES. BUT DON’T LET FEAR OVERWHELM YOU
Emotions are a common obstacle to investment success. Even the most rational people are prone to making poor investment decisions based on an overemotional reaction to information.
So it may be useful to have a few guiding principles to help rein in emotions. Here are 10. The first is to know yourself. “A series of market decisions does add up, believe it or not, to a kind of personality portrait,” says Adam Smith in The Money
Game. “You are — face it — a bunch of emotions, prejudices and twitches, and this is all very well as long as you know it.
“If you are not automatically applying a mechanical formula, then you are operating in this area of intuition, and if you are going to operate with intuition — or judgment — then it follows that the first thing you have to know is yourself.”
What is your risk tolerance? Is safety of principal with some level of return sufficient? Can you handle staying in when everyone else is jumping ship?
There’s no room for pride in this kind of self-analysis. Unfortunately, there are huge cognitive frailties that make it hard for us to acquire certain insights about ourselves.
Second, don’t act too quickly. Reacting immediately to emotional triggers can be an immense mistake. Take a deep breath and stabilise the overwhelming impulse. There are undoubtedly times when you can’t be quick enough to act, but more often than not you’re more likely to end up wishing you hadn’t been in such a rush.
Still, deal swiftly with your failures. Investors often develop an unhealthy attachment to a stock. Thinking of your stocks as rentals, rather than purchases, is one way to create the emotional distance necessary to remain objective about decisions to sell or keep existing holdings.
Third, avoid making the easy choice. “There’s a bunch of hard work involved with investing,” said John Bogle, “but it has nothing to do with market action; it has to do with understanding what something is worth now and judging how much it is likely to change — within a range — over longer time frames.
“That’s hard to do well. It’s about knowing what you don’t know. It’s about owning sound assets, bought at fair or better prices, while minimising frictional costs and mistakes.”
Information that has an emotional effect gobbles up attention. Dry information is ignored. But it’s dangerous to become captive to a story and important to complete research to determine any flaws in the narrative.
Fourth, don’t chase yesterday’s winners. We invariably expect recent successes or failures to continue into the future. We are unduly influenced by recent news and undervalue long-term averages or trends. But performance often reverts to the mean, and chasing last year’s winners frequently leads to a vicious cycle of lagging performance and excessive turnover.
Fifth, beware crowded trades. Popular trades have a way of becoming too popular, as investors burnt by the technology bubble, the Brics craze, and the “carry” trades have discovered. Reversals of fortune can be particularly painful for those who are among the last into a crowded trade.
To paraphrase James Rozoff, sheep only need one flock, but people need two: one to belong to and another to blame when it all goes wrong.
Sixth, be disciplined. “The one thing I can think of that most affects both trading and investing has to be self-discipline,” says Joe Ross of Trading Educators. “Being disciplined is fully 50% of the job of trading or investing. I don’t care how good your system is, without the discipline needed to follow it through you don’t have much chance of success.
“Discipline involves self-control. Self-control is all the more vital given that all our natural compulsions conspire to defeat us as traders.”
Seventh, be afraid but not too afraid. Those who believe there’s nothing to fear from markets are kidding themselves. But don’t let the fear of loss overwhelm you.
Eighth, avoid the gambling impulse. The gambling compulsion is a huge detriment to longterm success in investing. You will do far better by thinking about a stock as a proportional share of a business to be bought and retained or sold as appropriate to changing circumstances rather than as mere pieces of paper to gamble with.
Ninth, avoid confirmation bias. We are all experts at only hearing what we want to hear — the market place is full of information, news, rumours and gossip and we easily fall into the trap of cherry-picking the facts that suit our position. One way to overcome this may be to reduce the overall amount of information we try to process — this is a case of where less is more.
Tenth, don’t fall prey to the overconfidence bias.
According to Gerald Ashley at St Mawgan & Co, the key lies in acknowledging that we have no special insight when looking at a market. We may analyse a forgotten corner and therefore have more information than our competitors, but that doesn’t mean that we have an unassailable advantage.