Taking emotion out of investingThe fear of 2008 (equity markets down 40%) and the hope in 2009 (equity markets upover 41% from March through August) have seemingly given way to an emotion wemight call "resignation".Despite market gains through December and January, the road has been bumpy, andwe have witnessed an investment environment that has been challenging for allparticipants.A common theme is that many clients we see identify that they are "unsure about thefuture"— that is, unsure about the markets, worried about inflation (or deflation),unsettled by global politics, or nervous about the impact of government policy.These concerns have affected investors perspective on their financial future and theirdecisions regarding current investment.To put it simply, "emotion" has driven the actions of the average investor.A recent Yahoo Finance web article: “A Far from Random Walk on Wall Street”, offers aglaring example of how the popular financial media have locked onto the pessimisticcurrent view.The article cites examples of bad investment experiences among individuals, andincludes interviews with Burton Malkiel and investment managers who are concernedabout the publics perception of shares.It claims that many people have lost faith in the stock market, and that a generation ofinvestors may have become alienated from stocks, similar to what happened followingthe Great Depression.1We have seen this emotion in the industry data as well.According to Morningstar, in the United States, retail equity fund flows over the thirty-sixmonths to November 2010, have been a negative $414 billion, with $132 billion of theseoutflows occurring in the last twelve months.2Clearly, a lack of discipline combined with an emotional response to the market hasinfluenced client behaviour. This is affecting the total return and accumulation of wealththat investors should be getting from the capital markets.
Although emotion is not easy to combat, it should not go unchecked. To be a successful investor, you have to first confirm that market prognostications are not influencing your emotions. Beyond that, there are a few important steps to observe:1. Maintain a sense of history. Every investing generation at some point has had multiple reasons to "sit on the sidelines until things become clearer." Concerns about economic growth, inflation, governmental actions, and war have all taken a toll on the investor psyche over the last one hundred years. A simple review of history quickly makes one realize that it is not just our current period when prospects have looked questionable. The 1970s brought double-digit inflation, gas lines, and concerns about war. Yet, this stressful period was followed by tremendous equity returns (1981–1998).2. Remove investor "emotion." Take the opportunity to redirect your activity away from the emotion associated with current market conditions. Review and reaffirm exactly what you are looking to achieve. It is possible that some adjustment might need to be made to your original goals and objectives due to changes in family situation, retirement, charitable intentions, or other planning issues. But only undertake this with a rational consideration of the long-term plan.3. Recognize the potential of the moment. That does not mean "timing" markets. But when the equity market drops, there is a simple statement that can always be made. Lower prices equal a higher expected return. When there is apparent difficulty or distress in any market, the fact that prices have been driven lower suggests that expected returns on that asset also move higher. The key is to recognize the risk and the opportunity inherent in any difficult market. In short, you need to tame the emotion of the moment to enhance the long term investment experience.
The Seven Immutable Laws of Investing.They are as follows: 1. Always insist on a margin of safety 2. This time is never different 3. Be patient 4. Be contrarian 5. Risk is the permanent loss of capital, never a number 6. Be careful of leverage 7. Never invest in something you don’t understand1. Always Insist on a Margin of SafetyValuation is the closest thing to the law of gravity that we have in finance. It is theprimary determinant of long-term returns.However, the objective of investment (in general) is not to buy at fair value, but topurchase with a margin of safety.This reflects that any estimate of fair value is just that: an estimate, not a precise figure,so the margin of safety provides a much-needed cushion against errors andmisfortunes.When investors violate Law 1 by investing with no margin of safety, they risk theprospect of the permanent loss of capital.2. This Time Is Never DifferentSir John Templeton defined “this time is different” as the four most dangerous words ininvestment. Whenever you hear talk of a new era, you should behave as Circeinstructed Ulysses to when he and his crew approached the Sirens: have a friend tieyou to a mast.
3. Be PatientPatience is integral to any value-based approach on many levels. As Ben Grahamwrote, “Undervaluation caused by neglect or prejudice may persist for an inconvenientlylong time, and the same applies to inflated prices caused by over-enthusiasm orartificial stimulants.”However, patience is in rare supply. As Keynes noted long ago, “Compared with theirpredecessors, modern investors concentrate too much on annual, quarterly, or evenmonthly valuations of what they hold, and on capital appreciation… and too little onimmediate yield … and intrinsic worth.”If we replace Keynes’s “quarterly” and “monthly” with “daily” and “minute-by-minute,”then we have today’s world.Patience is also required when investors are faced with an unappealing opportunity set.Many investors seem to suffer from an “action bias” – a desire to do something.However, when there is nothing to do, the best plan is usually to do nothing.Stand at the crease and wait for the fat ball.4. Be ContrarianKeynes also said that “The central principle of investment is to go contrary to thegeneral opinion, on the grounds that if everyone agreed about its merit, the investmentis inevitably too dear and therefore unattractive.”Adhering to a value approach will tend to lead you to be a contrarian naturally, as youwill be buying when others are selling and assets are cheap, and selling when othersare buying and assets are expensive.Humans are prone to herd because it is always warmer and safer in the middle of theherd. Indeed, our brains are wired to make us social animals. We feel the pain of socialexclusion in the same parts of the brain where we feel real physical pain. So being acontrarian is a little bit like having your arm broken on a regular basis.
5. Risk Is the Permanent Loss of Capital, Never a NumberThe obsession with the quantification of risk (beta, standard deviation, etc.) hasreplaced a more fundamental, intuitive, and important approach to the subject. Riskclearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce itto a single figure.To my mind, the permanent impairment of capital can arise from three sources: 1)valuation risk – you pay too much for an asset; 2) fundamental risk – there areunderlying problems with the asset that you are buying (i.e. value traps); and 3)financing risk – leverage.6. Be careful of LeverageLeverage is a dangerous beast. It can’t ever turn a bad investment good, but it can turna good investment bad.Simply piling leverage onto an investment with a small return doesn’t transform it into agood idea. Leverage has a darker side from a value perspective as well: it has thepotential to turn a good investment into a bad one!Leverage can limit your staying power and transform a temporary impairment (i.e., pricevolatility) into a permanent impairment of capital.As J.K. Galbraith put it, “The world of finance hails the invention of the wheel over andover again, often in a slightly more unstable version.”Anyone with familiarity of the junk bond debacle of the late 80s/early 90s couldn’t havehelped but see the striking parallels with the mortgage alchemy of recent years!Whenever you see a financial product or strategy with its foundations in leverage, yourfirst reaction should be scepticism, not delight.
7. Never Invest in Something You Don’t UnderstandThis seems to be just good old, plain common sense. If something seems too good tobe true, it probably is.The financial industry has perfected the art of turning the simple into the complex, andin doing so managed to extract fees for itself!If you can’t see through the investment concept and get to the heart of the process, thenyou probably shouldn’t be investing in it.A recent client email nicely sums up what I am referring to...". . . I frequently find myself in conversations on investing—rarely initiated by me—butthis is certainly on peoples minds. Times are scary; people are uncertain anduncomfortable and have taken drastic actions with their investments. Once upon a time,I would have cited a list of very different reasons for using your services. Now it is clearto me that I use your services because your approach brings comfort, clarity and solaceto my financial future. I dont feel emotional about my investments; I feel smart about myinvestments. I just let them work for me as this is far easier than regularly engaging inchaotic markets, watching them constantly and feeling a persistent angst. That goesboth for these "despondent times" as well as when markets are flying high, when manypeople seem to come out of the woodwork to preach about missing this or thatopportunity. . . ."The ability to remove emotion from the investing decision is a valuable skill and one ofthe most crucial parts in the investment journey.1. "Special Report: A far from random walk from Wall Street," Yahoo Finance,http://finance.yahoo.com/news/Special-report-A-far-from-rb-1962957476.html?x=0&sec=topStories&pos=8&asset=&ccode.2. US and international retail equity fund flows. Source: Morningstar.