When I was a younger analyst with less experience I took a very cavalier approach to the emotional aspects of investing. I viewed it as a simple matter of
“Don’t let emotions impact investment decisions”
Problem solved, right? One clean step.
Well, reality is a bit harder than that. Humans are inherently emotional creatures, and we may not even be aware of how our feelings (conscious or unconscious) enter the decision process.
Removing emotion from decision making isn’t about being the world’s greatest stoic, it is a matter of having processes in place to mitigate sentiment and emphasize calculated analytics.
With that in mind, here are 3 common ways in which emotions interfere with investment and how to correct them.
Emotional error #1: FOMO
There are thousands of investment vehicles. At any given time, some of them are going to be producing extraordinary returns that will undoubtedly be better than your returns. Fear of missing out tends to cause a massive influx of capital into stocks that are already up materially. People abandon whatever they were investing in to join the hot trend.
This is a well known phenomenon referred to as style drift. It affects retail and institutional investors alike. Money managers are particularly drawn toward chasing the hot area because it is much easier to raise assets under management (AUM) when putting yourself out as a manager of the sector that is already trendy.
However, style drift is an extremely risky style of investment because it opens up the possibility to hit cycle downturns without hitting cycle upturns.
Nearly every sector is inherently cyclical in its performance. Even defensive sectors are cyclical, just on a different schedule than the typical cyclical sectors.
An investor who sticks to their wheelhouse will experience both sides of the vicissitudes – the upswings and the downswings. So when they are down they will tend to rise back up when the sector hits its recovery.
Switching to the hot sector risks facing multiple downtrends in a row. The manager may have already hit a downside in their home sector and then they are potentially arriving at the start of a downside in the new hot sector.
Sometimes they can have brilliant timing or get lucky, but that sort of style drift is one of the major sources of permanent capital loss in the stock market.
How to fix FOMO
The cure to style drift requires conviction in one’s process, whatever that may be such that you can stick with it even when it is not working.
Cycles are long. Styles can be out of favor for years at a time, but it is far more dangerous to capitulate than to stick with it.
As a source of preserving conviction during downturns in one’s particular wheelhouse, I would encourage studying the history of mean reversion in the stock market. Mean reversion is a foundational force in investment that has been working for centuries. I would even posit that it is axiomatic. We have a full analysis of mean reversion in the REIT University section of Portfolio Income Solutions.
Emotional error #2: Hasty response to news
Anyone investing for a long period of time has undoubtedly woken up to major pieces of news affecting their stocks. These sudden changes trigger a flight or fight response.
There is a tendency to act quickly in an attempt to get out ahead of others if the news was bad, or to load up before others if the news was good.
That was likely a strategy that benefited vigilant investors 20 years ago, but it has since been made obsolete by technology. Algorithms are trained to scan news releases and automatically enter trades in response to certain word patterns. If a company substantially beats on earnings an algorithm will have already detected the beat and bought shares before you can even read the first paragraph of the earnings release.
You cannot out-speed the machines, so it probably is not wise to play the speed game.
How to better respond to major portfolio news
We take a 4-pronged approach:
- Know your stocks thoroughly before the news even arrives
- Analyze the fundamental impact of the news
- Observe the market response to the news
- Respond based on the delta between the market response and the fundamental impact.
The algorithms are extremely fast, but they can also be sloppy. Certain news items may seem like good news but actually are not once analyzed more deeply.
For example, a company might beat earnings by 15 cents/share which is a headline that sends the algorithms buying, but digging deeper into the report one could uncover that there was a 1-time gain of 20 cents/share in the quarter. Thus, on normalized earnings the company actually missed by 5 cents.
The initial market reaction will often be wrong, sometimes directionally and often in magnitude. Just pay attention to the delta between the response and the impact. If a stock is down 5% on news that only reduces fundamental value by 2%, that might be a buying opportunity.
Emotional error #3: Letting the tail wag the dog
Company X is trading up 50% over the last 2 years. There must be something great going on at the company, right?
No, that is the tail wagging the dog.
We are used to the observable numbers being the objective reality. If a sphygmomanometer reads 135/85, you have high blood pressure. You may have been exercising every day and feel great, but the numbers are the truth.
In the stock market, the observable numbers that update in real time are the market prices. Naturally, people have a tendency to treat market prices as observable data points. Market prices are viewed as the measure of a company’s health just as a sphygmomanometer measures our blood pressure.
The difference here is that the blood pressure reading is an objective physical direct measurement of the item in question while stock market prices only measure the opinions of market participants.
These opinions will often reflect the actual company performance, but they also include sentiment, emotion, and various other forms of noise that make it a terrible signal.
Thus, any trading activity in which one uses stock price movement as the barometer of a company’s success is allowing the emotions of others to affect your decisions.
How to fix it
We don’t think one should ignore market price movement. It often is a signal and in many cases it is correct.
Sometimes that 15% pop in market price is related to a buyer forming a toehold position just before the M&A announcement. It could be those with deep knowledge of the company’s operations buying in response to favorable trends that will positively impact upcoming earnings.
However, it is crucial to keep in mind the direction of causality.
- Strong fundamentals cause market price increase in the long run
- Strong market pricing does not cause a company to perform well
Sometimes market price movement is related to strong underlying fundamentals. Other times it is just random noise.
To avoid getting caught by the noise, market price movement should merely be seen as a time to reassess the fundamental thesis. Recheck to see if there is something going on causing the movement. Scour industry journals and whatever leading indicators can be found to assess the fair value change.
Don’t assume changes to fundamental value based on changes in market price.
Wrapping it up
Don’t make the mistake I made as a young investor of feeling like you have unlimited equanimity. Emotions do affect investment decisions, and it is wise to build in processes that account for them such that better overall choices can be made.
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