Monday, April 04, 2011

Emotional Investing: How Fear & Greed can impact your bottom line

By Rajiv Hargunani

The wild swings in the financial markets over the past 15 years have caused investors mindset to shift from extreme optimism (at the beginning of 2000) to extreme pessimism (around March 2009). What is the reason behind this extreme display of emotions? One answer could be volatility, which is an inherent feature of the stock market.

Investors need to realize that for the most part, the financial markets are neither rational nor efficient. Most often, the markets appear to ignore what you think is the appropriate direction based on your logic and reasoning. Markets move up and down based on a multitude of factors, only some of which are tangible and/or quantifiable i.e. company’s balance sheet, revenue, earnings etc. Equally important are the intangible factors such as hopes, wishes, fear and greed of investors like us, human psychology and behavior (where no one wants to lose any money). Add to this the herd mentality factor where no-one wants to be left out. In the vicious cycle of boom and bust they have collectively made and lost fortunes.

Wouldn’t it be great if we could get away from this emotional cycle? Understanding this cycle can help investors avoid the market roller coaster and focus their attention on their financial goals.

Let us take a closer look at this cycle of emotions and see if we can identify points at which we should get off or wait.

Think back to the mid 90s. The markets were just cranking up from the mild recession in 1994 and technology, specifically the internet, was about to change our lives. The seeds of optimism were sown and investors were getting comfortable with their investments and even accepting, maybe unknowingly, the higher risks. As stock prices continued their rise, the optimism changed to excitement and eventually reached the euphoria stage. At this point, the investor felt they knew what was happening in the markets, could rationalize any contrarian argument and pretty much believed that this time was truly different. Risk management was tossed out of the window and greed began to sub-consciously dominate investment decisions. Why wait for 20 years to retire when you could achieve that in 5? The markets could only go in one direction and the thought of going “all-in” i.e. 100% invested in high beta growth stocks was the rage.

The laws of gravity apply to the stock market as well. Markets cannot rise forever - they do go through periodic corrections & declines.  When the markets start their initial descent, the late comers who got in at the top start feeling anxious and the folks who missed the ride in the first place are convinced that this is god-sent opportunity to get in before the train leaves the station. As the markets continue their downward cycle, anxiety quickly turns to denial. Hey wait a minute. This can’t be happening!!! The investors thought the markets were only supposed to go in one direction. This decline was contrary to what they had been told and what they believed in Doubt starts to creep in about the validity of their super-bull argument. Denial quickly turns to fear. At this point the thought of achieving mega returns starts to fade, and the idea of simply breaking-even seems to be the flavor of the day. For the late comers, they are now carrying paper losses on their books, but for the early investors, it is quite possible they have given up their mega profits and are now staring at some losses. If the markets continue their fall, fear quickly morphs into desperation & panic and the thought of salvaging some principal (along with their pride) now dominates their thought process. Capitulation is on hand, investors may sell at a loss and the game of justification of their actions begins.

Emotions of Greed, Fear and Pride are in control of your investment decisions. Researchers (Daniel Kahneman & Amos Tversky) have found that the feeling associated with losing $10, is twice more painful and unpleasant than the feeling of pleasure associated with gaining a similar amount. Is that because a loss forces us to acknowledge that we made a “bad” decision? To avoid acknowledging the mistake we hold on to the investment out of pride. As long as the loss is on paper, we can hope and wish for the investment to come back to break even and thereby restore our pride.  Investments should not be about our pride and ego. It should be the vehicle that takes us to our financial goals.

We buy high out of greed, out of not-wanting-to-get-left-behind. We sell low out of fear. This is the exact opposite of what we should do and we know this on a subconscious level. Smart investors realize they have seen this movie before and therefore knew how it ended? They had read about the Dutch Tulip mania (from 1634 to 1638), the South Sea Bubble (1720), the roaring 20s in the U.S. and of course the Japanese markets in the late 80s. They become aware when Greed starts to be pervasive, book their profits and stay away from the eventual bursting of the bubble.

Here are some tips that can help you break away from the cycle of emotional investing:

1- Use Common Sense: Forget Gold, Oil & Silver. This may be the most precious commodity out there in volatile markets. Fortunately we all have plenty of it; we just forget to use it at the most important time. Using common sense means having a plan for your investments, following sound disciplines of investing such as risk management, efficient asset allocation, rebalancing etc.

2- Don’t strike out: Having concentrated positions or trying to hit home runs on every pitch is a recipe for disaster. Be in the game for the next pitch.

3 - Don’t get emotional: There is no room for hope, prayer, gut-feel, intuition, superstition, greed or fear in your investments or your decision making process.

4 - Don’t over analyze: The market will do what it often does i.e. frustrate the maximum number of investors.

5 - Stay in your comfort zone: Invest only in names and ideas you are comfortable with. Being in control over & having a sense of comfort with your investments will keep you away from the enemies of the individual investor i.e. greed & fear.

6 - Be Patient: Patience can be your best friend in volatile times. Warren Buffet has amassed enormous wealth by following two important rules of investing.

• Rule # 1 - Don’t lose money

• Rule # 2 - See Rule # 1

When Buffet buys something after he has done his due diligence, he is willing to stick with his investment until it makes him money. In 45 years, Berkshire Hathaway has returned a phenomenal 49,000% to its shareholders. I am sure, Buffet had some losses on the way, but the fact that stands out to me is, he never let one position destroy his portfolio. From 1965, he has had only two losing years, 2001 & 2008, both very tough years in the markets. Check out the attached performance of his company, Berkshire Hathaway vs. the S&P 500. Berkshire Hathaway class A shares closed on 03/02/2011 at $127400.00 per share (Source: Berkshire Hathaway Annual Letter )

Sir Isaac Newton was one of the investors who lost his shirt in the South Sea Bubble of 1720 and he said “I can calculate the motions of heavenly bodies, but not the madness of people”. 

It is possible to calculate the madness of the financial markets to the extent of minimizing the impact on your portfolio.  Just like all good habits require a fair amount of discipline, investing is just the same. It is definitely not a game where you try your luck. It is a means of preserving and/or growing your assets over time. All it takes is control over your emotions, the right tools and in some cases the right advisor.

 

Other articles by Rajiv Hargunani:

• Inflation: What it means & how to protect our investments
• Early Distributions From Retirement Plans
• Profit From Your Losses
• A New Approach to Making Money: Buy and “Know when to sell”
• Health Insurance:  Decisions, Decisions
• Common Insurance Mistakes - Are YOU making one?   
• Managing Risk in Volatile Markets
• 2010 Roth IRA Conversion – To do Or Not to Do
• Changing Jobs? Don’t let your 401(k) slip away

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Rajiv Hargunani and not necessarily those of RJFS or Raymond James. Rajiv Hargunani, Raymond James Financial Services, Inc., its affiliates, officers, directors or branch offices may in the normal course of business have a position in the securities mentioned in this report. All stock prices are quoted as of 03/02/2011. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Past performance may not be indicative of future results.

 

Copyright 2009-2012 Pravasi Herald All Rights Reserved