If an investor acts while under an emotional state, it virtually guarantees that they will take actions that will be detrimental to their investing success.
There is an inverse correlation between emotions and investment success. The more emotional you are, the less likely you will succeed in investing. Conversely, the less emotional you are, the more likely you will succeed in investing.
Here are some common emotions that investors go through and the resulting consequences:
Example:
In every bull market, investors will jump on the bandwagon as they see others around them make money. Because they see so many people take part in this, they feel secure in being part of a large group.
It’s not surprising to find out that at the height of all bull markets, and therefore at the level where stocks are the most expensive and at risk of falling dramatically, the average investor will almost be fully invested in equities. Greed blinds investors of the dangers lurking around the corner.
Fear: The twin brother of greed, fear is easily the second most harmful emotion for investors as it wreaks havoc in all portfolios on its path. It misguides us to focus solely on the short-term setbacks and masks the unbelievable opportunities that are right under our nose.
Example:
In every bear market, investors will sell their stocks or equity mutual funds out of fear as they watch their portfolio drop in value. Unfortunately, their timing couldn’t be worse as they usually sell near the bottom of the market, essentially locking in their heavy losses.
As the stock market recovers, investors still shell-shocked usually miss the rally as they stay in cash or money market funds in order to sleep better at night. Fear can paralyze an investor to the point where they act out of desperation and panic instead of seizing the opportunity.
Hope: In our everyday life, having hope is good. It lifts our spirit when things look bleak; it gives us the courage to fight when we feel like giving up. Unfortunately, when it comes to investing, it’s best to check hope at the door. Hope can blind us from making rational decisions by making us overtly and unrealistically optimistic.
Example:
Have you ever noticed how infomercials always show how buying their products can lead us to drive a fancy car, own a luxury home, live a great lifestyle, etc. Infomercials are usually run late at night as people who are still up at that time are often at a difficult juncture in their life and need a large dose of hope.
When investors have high hopes of accumulating great wealth or having financial freedom or early retirement, they tend to only see the positive side of their investment decisions. This can be very dangerous as it leaves them in a vulnerable state and liable to be victims of all the scams out there that promote get-rich-quick schemes.
Anguish: The loss of money can be an unbearable source of stress and anguish. Seeing our portfolio dissolved in half can be a tremendously painful experience. This is even magnified for investors close to their retirement years.
Example:
Unfortunately, feeling bad doesn’t help us in resolving our problems. The sooner we get out of that feeling of anguish, the sooner we can get back on track. The more you focus on something, the more it expands. If your focus is constantly on how devastated you are because of your financial loss, your anguish will not leave you and your financial situation will also not change.
You need to redirect your focus to what you DO want to expand, which is the size of your portfolio. During a market downturn, a good strategy is to rebalance your asset mix by increasing your equity position and reducing your fixed income/cash component. This simple action allows you to buy additional stocks at cheap prices, which will accelerate the growth of your portfolio.
Exuberance: Alan Greenspan, the former Federal Reserve Chief, is famous for describing investor bullish sentiment in the late 1990 as “irrational exuberance”. Exuberance is what you get when you mix envy, greed, overconfidence and sprinkle some herd-like mentality. Investors under this state do not see any dangers; they cannot even fathom the thought of something being too good to be true. They are usually the last to join the party not knowing that the party ended just as they walked through the door.
Example:
At the height of any bubble, exuberance is easily noticeable. It’s when everyone seems to be in the “game”; everyone seems to be talking about and playing the “game”, from the cab driver to the local barber to the convenience store clerk.
The behavior of exuberant investors hasn’t changed over the past century; the only thing that changes over time is the game itself. The game can take on different forms; during the past decade, it has taken the forms of the internet mania, real estate boom and oil price surge.
Indifference: This emotion is sometimes difficult to identify in victims. They don’t seem to be upset or traumatized that they lost money but there’s a sense of avoidance or unawareness in them, a sense that they don’t care anymore.
Example:
After the dot com crash, many investors lost a big part of their life savings. They were so dismayed that they just stopped looking at their statements. Looking at the Book Value column and Market Value column on their statements was just too painful. Unfortunately, it appears many investors are in the same position after the recent recession, which explains why so many of them have left their money in cash or money market funds even as the market has recovered significantly since the lows of March 2009.
Being indifferent is a dangerous place to be. For all problems that we have in life, the first step is always to recognize and admit we have a problem. Indifference doesn’t hurt, which is why it’s so dangerous. It doesn’t force us to admit we made mistakes and therefore, we cannot take the next step towards fixing the problem.
In a way, it’s better for an investor to be upset because this anger can serve as a wake-up call to start learning more about investing and take their financial destiny into their own hands.
The bottom line is this. You need to always be aware of the different faces of emotion that you go through as an investor during various market cycles so that you can take the appropriate steps and move in the right direction instead of letting your emotions dictate your decisions.
The different feelings we have as we go through the many stages and events in our life shape who we are. Emotions make us humans. But when it comes to investing, being emotional is equivalent to being blindfolded. It’s best to invest with your head and not with your heart.
Somehow, I think Mr. Spock would make an excellent investor.
Related posts:
Most Common Investing Mistakes - Part 5 (Keeping Losers, Selling Winners)
Most Common Investing Mistakes - Part 4 (Relying on Other People's Opinion)
Most Common Investing Mistakes - Part 3 (Focusing on Price Instead of Value)
Most Common Investing Mistakes - Part 2 (Following the Crowd)
Most Common Investing Mistakes - Part 1 (Overconfidence)
Excellent article! If GREED is bad, how do you explain the fact that Kevin O'Leary, one of the five Dragons in the TV show Dragons Den, is so successful? He's obviously all about greed. Thanks.
ReplyDelete- Pedro
Pedro,
ReplyDeleteGood point. Greed may very well be in Kevin O'Leary's genetic make up but what he has going for him is that he is a good businessman.
He will not make business/investment decisions based on greed, which at its core is rooted in emotions. He focuses only on the facts and the probability of success of any ventures he pursues.
In order to succeed in investing in stocks, it's essential for an investor to take a business approach like O'Leary and view buying a stock as acquiring a part-ownership in a company.
As Peter Lynch once said, in the short-term there may be no correlation between a company's success and its stock price. But over the long-term, there is a 100% correlation. This disparity is where the opportunity lies for smart investors.
O'Leary also seems very fond of DIVIDENDS, so I wonder: if an investor seeks dividends, is that in conflict with value investing where you hold a stock for the long term?
ReplyDeleteAlso, regarding your Peter Lynch quote, can you please explain how this correlation between stock price and long-term success? How does the price/earnings ratio fit into this?
Gracias,
- Pedro
Regarding dividends and value investing, there isn't really a conflict. Investors who seek dividends usually own these stocks for a long period of time since they're looking for passive income.
ReplyDeleteThe best dividend stocks to own are those where companies have a track record of increasing their dividends every year for many decades.
A rising dividend is a good sign as it means a company is doing well and is earning higher profits every year. This in turn will also increase its stock price.
To answer your question on how Peter Lynch's quote is related to the P/E ratio, look at it from this perspective. Over time, if a company can increase its earnings, it's stock price must also rise. The P/E ratio (often referred to as the multiple) is the stock price divided by earnings. If earnings increase and the P/E ratio stays the same or at the same historical level, then the stock price will increase.
ReplyDeleteInvestors often make the mistake of thinking in general terms and have rules such as: "when the P/E ratio is below X, it means stocks are cheap and I will buy and when the P/E ratio is above Y, they are expensive and I will sell."
For example, I often hear money managers and analysts say that in the current environment, the stock market's overall P/E ratio is too high and above the historical average and therefore, stocks are overvalued.
Yet, it's a mistake to focus on the P/E ratio as a whole and not on the individual components, the P and E. In a deep recession like the one we just had, it's normal for many companies, especially ciclical ones to have depressed earnings. Therefore, their P/E ratio will be artificially high since the denominator (E) is temporarily low.
As the economy recovers and these companies' earnings go back to normal levels, the P/E ratio will decrease and go back to a normal level but it will be too late as investors will have missed a tremendous opportunity to buy undervalued stocks.
I'm actually in the process of explaining different valuation methods, including the P/E ratio method and will be posting these tools shortly in the Resource Center section. Stay tuned!