Great Investors Understand Emotions

In last month’s article, we celebrated America’s greatness. Today, we discuss a critical skill for the great investor to develop: understanding emotions.

Emotions and Behavior

As you may remember from your high school science classes, the human brain is made up of two halves, known as hemispheres. The left side of the brain is the analytical side, and its primary function is analysis, linear and logical thinking, and evaluation of facts. The right side of the brain is the “emotional” side, and its primary function is imagination, feelings visualization, intuition, and creativity.

Most people think that investing is a left-brain pursuit, governed by the dry analysis of facts. Great investors, like Warren Buffett’s partner Charlie Munger, understand that investing is actually a right-brain exercise, more about human emotions and the behaviors that stem from those emotions. When it comes to investing, understanding human emotion is by far more important than understanding interest rates, dividend yields, and GDP calculations.

Popular culture tells us that there are two emotions that rule the investment markets: fear and greed. This wisdom is only half true. Fear is obviously one of the two dominant human emotions in investing, but the second is not greed, it is something else altogether.

Fear: Version 1

Fear is the most fundamental human emotion, it and can wreak havoc on our outcomes as investors. Short-term movements in company prices can be extremely volatile, and it seems that investors always have a reason to fear that their equity portfolio is about to take a dive and experience a permanent loss. These fears are natural and are hardwired in all of us, even the most talented and disciplined investors in the world. It is natural to feel this fear, but it is a mistake when we allow the fear to influence our behavior and induce action.

Fear: Version 2

Greed is actually just another form of fear. Greed is the fear of missing out, believing that someone else, somewhere else is making more money. The behaviors that spring from this type of fear are no less dangerous.

In our view, successful long-term investing always begins with the goals of the investor and is achieved through the execution of a written financial and investment plan. An investment portfolio must always be nothing more than the servant to the goals of the financial plan and should focus on proven tools like asset allocation and diversification to accomplish those goals.

The fear of missing out compels us to do more and to find a better way. It whispers in our ear that it is not good enough to capture the rewards of the market, we must outperform the market. It causes our focus to shift away from our financial goals and onto the market itself. It makes us believe that we don’t need to be tied to tired old disciplines like asset allocation and diversification. This pursuit does nothing but distract us from our goals and our plan, and it opens us up to every classic emotional and behavioral mistake in the book.

Greed was on full display during the “Dot Com Bubble” of 1996-1999, when it was not unusual for new technology stock IPOs to rise by 100 percent or more in a single day, and scores of investors made the fatal mistake of allowing their euphoric emotions to take over. Perhaps the best example was a doctor in California who was convinced that the stock of Pets.com would skyrocket. Since he didn’t have any investment capital immediately available, he used his credit card to finance his purchase of a large position in the stock. Inevitably, the great Bull Markets in history have all been slaughtered in a glorious melt-up of optimistic euphoria. The bubble popped and Pets.com went bankrupt in November 2000, leaving the doctor with a worthless investment but still owing a 16 percent APR on his large credit card balance.

Regret

It is now time to reveal the second dominant emotion that rules the world of investing, which is regret – for having made a stupid investing mistake that may have a lifetime impact on your financial wellbeing.

Our good doctor in California likely struggles with regret as he considers the giant financial hole he dug for himself. Just like every investor who thinks they can outsmart the market, and who eventually succumbs to the siren song of “outperformance.” Most people think that it is the job of a financial advisor to maximize your short-term return, but it’s not. It is our job to help minimize your long-term regret.

In Case You Missed It

This news was probably quite easy to miss, given the financial media’s recent fixation with reporting bad news, but is worth repeating here. On June 7, 2018, the Federal Reserve released its estimate for household net worth in America, which now exceeds One Hundred Trillion Dollars. In case that number is not breathtaking enough by itself, it is also incredible in relation to the fact that it is also roughly 50 percent higher than this same figure in 2007, before the great recession of 2008.  In addition, the Fed also reported that the U.S. Households’ Leverage (household debt as a percentage of total assets) is at a 30-year low.

The American household has never been wealthier, and it is less indebted than any time in the last 30 years. We are experiencing a time of unprecedented wealth and prosperity in this country, although you wouldn’t know it by turning on CNBC or opening the Wall Street Journal.

Having a Plan

The very best investors have a disciplined approach to making portfolio decisions, and they always stick to their plan, no matter what the rest of the world is doing. They have a mature emotional temperament during both the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.

No predictions.  Just hard work, patience, and discipline.