Controlling the Pendulum of Emotions

Ian Cassel Blog, Educational 2 Comments

When I read long-form investing articles I copy and paste the portions I connect with into word documents and categorize them into folders. I’ve accumulated around 500 files in 85 different categories. I have files for “ROIC”, “long-term”, “concentrated”, “position sizing”, “averaging down”, “averaging up”, “fear”, “jealousy”, “over-confidence”, etc. It is honestly a tangled mess of folders and files, but it’s my tangled mess. I go back to them often for research and reflection. 

Joe Koster of recently shared a passage from Howard Marks memo “On the Couch”, from January 2016. I ended up reading the entire letter and was drawn to Marks idea of the “investment pendulum” or what I would call the pendulum of emotions. Given the volatile state of the market I thought I would share a few excerpts that I’ve reflected on and filed away.

Excerpts from On the Couch:   

One of the most notable behavioral traits among investors is their tendency to overlook negatives or understate their significance for a while, and then eventually to capitulate and overreact to them on the downside. I attribute a lot of this to psychological failings and the rest to the inability to appreciate the true significance of events. 

As negatives accumulate – whether they surface for the first time or just are finally recognized as significant – eventually a time comes when they can no longer be ignored, and instead they come to be treated as being of overwhelming importance. 

Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what’s going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. 

Almost 25 years ago, in my second memo (“First Quarter Performance,” April 1991), I introduced the concept of the investment pendulum:

Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later.”

One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. In other words, sometimes they take note of only positive events and ignore the negative ones, and sometimes the opposite is true. And sometimes they view events in a positive light, and sometimes it’s negative. But rarely are their perceptions and interpretations balanced and neutral. 

Investor psychology rarely gives equal weight to both favorable and unfavorable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. Most developments have both helpful and harmful aspects. But investors generally obsess about one or the other rather than consider both.

It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall and risk to increase. But then, for some reason – perhaps the arrival of a tipping point – they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise and risk to decrease. Notably, each group of phenomena tends to happen in unison, and the swing from one to the other often goes far beyond what reason might call for. 

That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” The pendulum careens from one extreme to the other, spending almost no time at “the happy medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation. 

To explain why these bipolar episodes occur, I want to spend a little time on some of the factors behind investor psychology. For the most part they’re easily observed and dissected, and not mysterious. I discussed some of them in “It’s Not Easy”: 

Emotion is one of the investor’s greatest enemies. Fear makes it hard to remain optimistic about holdings whose prices are plummeting, just as envy makes it hard to refrain from buying the appreciating assets that everyone else is enjoying owning. Confidence is one of the key emotions, and I attribute a lot of the market’s recent volatility to a swing from too much of it a short while ago to too little more recently. The swing may [result] from disillusionment: it’s particularly painful when investors recognize that they know far less than they had thought about how the world works. It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically. 

The difficulty of understanding events, their significance and their potential ramifications comes in good part from the kinks in investors’ psyches, and it contributes to – and feeds back to exacerbate – investors’ responses. Thus investors tend to emphasize just the positives or the negatives much more often than they take a balanced, objective approach. And they tend to become optimistic and eager to buy when good news, positively interpreted, has forced prices up . . . and vice versa. All of this is obvious (especially in retrospect), and thus equally obviously, understanding and dealing with it presents a potential way to improve results. 

Notions of market efficiency – the idea that most assets are priced “right” – are based on belief in investor rationality and objectivity. But certainly those traits are little seen in real life. “Inefficiencies” – in everyday language, “mispricings” – stem from biases against one asset or in favor of another: legal, cultural, informational, and especially behavioral and emotional. The first three of these exist much less nowadays than they did 30 or 40 years ago, but the latter two still rear their head from time to time. And I’m sure they always will. 

My Prescription 

To help investors deal with their potential for “human error,” this shrink would prescribe a number of elements that can help with the task: 

·  The first essential element in coping with markets’ irrationality is understanding. The importance of psychology and its influence on markets must be recognized and dealt with. 

·  The second key lies in controlling one’s emotions. An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings. Thus it is absolutely essential to keep optimism and fear in the appropriate balance. 

·  Emotional self-control isn’t enough. It’s also important to have control over one’s circumstances. For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings. Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance. At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions. 

·  And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool. Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa

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Comments 2

  1. Fantastic article. I like that you keep files that include both “averaging down” and “averaging up.”

    I’ve long felt that that there are two rhythms that matter in investing, or in speculating — your rhythm and that of the market. If your rhythm is the same as the market, over time you’ll perform like the market. You should probably save your time and effort and buy an index. Or a good mutual fund, although good is a subjective conclusion. I’ve worked for many mutual fund managers over the years. One of the ones that impressed me as smartest has dramatically underperformed one that I think of as barely average. The reason — the one with the exception performance bought stocks that treat their employees well. That’s it. That forced him to focus on high-margin businesses, which forced him into technology — companies with a lot of intellectual capital. The brilliant investor focused on value. And earned returns that are substantially lower in the average year, although in a great year outperformed the other guy.

    If your rhythm reacts to the market, you’ll lose. If it is designed to profit from the market, from the emotional swings, because the swings are greater than the actual financial performance of companies, you’ll outperform the market. It is like in boxing or football. He who imposes his rhythm on the game, prevails. Maybe that applies to chess and basketball too.

    Some other thoughts on the subject:

    • if you know more than the market about the stocks you invest in, you can concentrate your holdings. The smaller your edge, the more you need to diversify. Jim Simons earns tremendous returns with a tiny edge. Tiny but reliable. He’s highly-diversified. Tepper knows more about the stocks he invests in than the market does, at least in the stocks he invests in. He has a more significant edge than Simons. He’s concentrated.
    • Over time, Simons significantly outperforms Tepper, although both are in the top 1% of all investors in terms of performance.
    • If you know more than the market, you should average down. If you know less, average up. In general. I actually follow a computer-driven analysis that determines what prices over the last 13 years (a complete market cycle?) in good or great companies indicate the odds are in my favor, and what prices indicate that shorting weak companies put the odds in my favor. So I guess I don’t exactly follow my own know more/know less dictum. But I kind of so, and I definitely follow the principle of it is important to have a rhythm that profits from the market’s emotional swings, one way or another.
    • If you cannot predict the market or the economy, which I cannot, the ultimate test of your analytical ability is to maintain a portfolio that is half long and half short, and to significantly outperform the market with that hedged position in both the short and long term. Hedged portfolios reduce risk for those that can’t predict the market, and reduce returns for those that can.
    • Stanley Drunkenmiller has an interesting take on the subject if you watch his YouTube videos — the subject of what the market knows versus what economists or other predictors know or indicate.

  2. Hello Ian,

    I remember reading this Memo when it came out in 2016. At the time one stock in my concentrated portfolio had dramatically fell from all-time high, following a competitor patent-infringement lawsuit.

    At the time I believed it was overdone, but my little experience in the matter made my foundations’ weak (read: blind) spots apparent. Reading this Memo and learning about the “Investment Pendulum” analogy (also referring to Graham’s Mr. Market Analogy) helped my grip to my conviction to hold (and even buy more).

    That decision impacted significantly my returns for the past few years. With what’s happening as of late concerning fear of a global pandemic, it’s a very timely reminder to stay cool and assess fundamental changes (yes, there are some). But also a reminder that one needs to assess how and where mass psychological factors are pushing prices with regards to these changes, and if the reaction is over/under done.

    I’ve come to believe that some of the best opportunities lies in these moments.

    Thank you for the reminder,

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