Investor Psychology - Managing Emotions
To be victorious against our inner demons, we must first put ourselves in an indomitable position. Managing our emotions to achieve superior investment returns, requires an appreciation of our flawed nature and designing systems to reduce risk.
A long history of price performance across asset classes, shows distinct out-performance of risk assets compared to cash. However, plenty of investors’ portfolios lag the market index and worst still, are negative over long time horizons. Even investors who invest in exchange traded funds or mutual funds, often under-perform these very instruments in a striking and persistent manner.
Professors Brad Barber and Terrance Odean in their paper, “The Behavior of Individual Investors”, found that Individual investors:
• Under-perform standard benchmarks
• Sell winning investments while holding onto losing investments
• Are heavily influenced by limited attention and past return performance in their purchase decisions
• Engage in naive reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain
• Tend to hold undiversified stock portfolios
Is the average person then incapable of making investment decisions for themselves? And if so, why not?
Human nature - Fear, greed and social herding
The biggest challenge facing investors lie in our very nature as human beings. Particularly, our emotions of fear and greed, leading to periods of excessive pessimism and overconfidence. This can apply to the broad market at times as it does to the individual, foreshadowing periods of market inefficiency.
Our eagerness to be accepted in social circles drives us to seek consensus, and results in herd-like behavior. Independent logical thinking is discarded, replaced by false comfort in numbers.
News media does not make it any easier. Incentivized to create drama and draw in readers, the media often takes extreme positions on issues that heightens our feelings of euphoria or fear. The greater our exposure to and believe in, the news we read and watch, the more challenged we are to rationalize issues independently.
I believe nobody that is human is completely devoid of such emotions, even the most successful investors. The degree to which we are influenced by it, is and can dramatically alter our investment outcomes.
Manage our emotions by managing our risk
As humans, we will invariably have to deal with the conflict between our emotional and logical minds. It simply isn’t enough to tell ourselves to be rational, we must create the conditions necessary for the logical mind to dominate. This can be achieved by controlling risks. Only when we are truly comfortable with the risks we take, can we make informed, logical decisions to best take advantage of market opportunities.
First, we should limit our investment account to an amount we are willing to lose. For example, if we had S$100k in liquid funds, I’d suggest not having more than S$50k in the investment account and of which not more than 60% (S$35k) be invested in risky assets (equities, REITs, commodities, high yield corporate bonds). This ensures we aren’t betting the farm and have a portion in safe-haven assets (treasuries, developed countries’ government bonds and cash), which can partially offset our risky asset losses and provide us the option of increasing our risky asset exposure during opportune times. This option is particularly valuable during market corrections which occur frequently, as it allows us to switch between safe-haven assets and risky assets.
For example, when equity prices rise, and treasuries fall, we can take some profit off equities and increase our treasuries exposure. Like-wise when equity prices fall, and treasuries rise, we can liquidate some treasuries to increase our equities exposure. Investors can get easy access to safe-havens through ETFs such as TLT (20+ year treasuries), IEF (7 to 10-year treasuries) and iGOV (developed countries’ government bonds).
Second, we should exercise patience and build positions slowly, not go “all in” as they say in poker. This way, we’ll be able to regularly lower our cost basis per share and increase our probability of profit. Suppose you’d like to acquire a $3k stake in Facebook and the price is currently at $160 per share. Instead of investing the full amount right away, you can queue $1k at $155 per share first. Subsequently, should the price fall to $150, queue another $1k at $145 and so on, until you reach your target exposure. In my experience, it is often prudent and advantageous to queue below market price, you’d be surprised at how often you get filled. If however, you filled at $155 per share and it went up to $165, you can re-evaluate other options to Facebook, and if it is still your preferred company, repeat at the higher price by queuing an additional $1k at $160 per share.
This technique adds value when our initial analysis proves wrong or the market suffers a correction. Because sharp moves to the downside are of higher magnitude than moves to the upside, we can capitalize on this risk asymmetry.
Third, we want to create portfolios that are truly diversified. Having 100 stocks in the US technology sector is a bad example of diversification. Country and sector correlations are remarkably strong, depending on the international exposure of the company (stocks which are more internationalized tend to have higher correlation with their sectors, while domestic-focused stocks tend to have higher correlation with their country’s index). Thus, it is optimal to have a basket of stocks and risky assets in different markets, a good mix between aggressive and defensive assets, and safe-haven assets to act as a hedge.
Defensive assets, not to be confused with safe-haven assets, tend to move in the same direction as the market, but to a lesser degree. For example, during a market meltdown of 20%, utility and consumer staple stocks are still expected to fall, but less than 20%. After all, our use of electricity or purchase of toilet paper are unlikely to change. Safe-haven assets such as US treasuries on the other hand, are expected to increase in value when the market falls due to lower expectations of future growth. An exception could be a market pullback during unexpected inflation spikes, which would see both risky and safe-haven bond assets fall.
Be logical, be opportunistic
Once we have established our risk management system, which provides us with peace of mind, we can turn to uncovering opportunities in the market while avoiding pit-traps other investors fall prey to. The next step is to create a portfolio strategy that is built on tried-and-tested methodologies and stick to it.
Instead of persistent disappointment and regret, we are better poised to capitalize on market moves to achieve satisfactory returns. Security selection is only a piece of the puzzle and must be complemented by sound and robust portfolio management systems, that capture statistical edges and are congruent with our nature as human beings.
As the saying goes: “To be victorious against our inner demons, we must first put ourselves in an indomitable position.”