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Using Emotions to Your Advantage

As human beings we all experience emotions. However, acting in the way that those emotions dictate can be one of the worst things an investor can do as it usually hurts returns and sometimes it hurts them significantly.

As human beings we all experience emotions. However, acting in the way that those emotions dictate can be one of the worst things an investor can do as it usually hurts returns and sometimes it hurts them significantly. I’m going to tell you about some ways you can overcome your emotions and use the emotions of the masses to your advantage.

In investing you can be too euphoric or too pessimistic. Acting on euphopria can cause you to buy at or near the top whereas being too pessimistic can cause you to capitulate and sell at or near the bottom.  Our emotions can also cause us to be impatient and sell too early. The 14 Stages Of Investing Psychology does a great job of depicting and explaining how the cycle of emotions often evolves. 

Emotions are often the body’s natural reaction to danger (risks) and success or expectations of success. A peculiarity of the stock market is that the participants in the market often have the same emotions. For example, just think about how you felt on December 24, 2018 when the stock market bottomed. Were you thinking that the market was going to go up or go down from there? I bet most of you thought it was going down as there were “too many risks.” Many people had sold already or were selling when fear was at the maximum. After that, there weren’t as many people to sell and stocks moved back up.

There is an interesting study by Charlie Bilello (@charliebilello) on the performance of the markets after CNBC does a “Markets in Turmoil” special. You can see the performance [HERE] and the full article [HERE]. Note that the performance 12 months out is astounding. Remember that the media likes to report how investors are feeling and fear sells. So when there is massive fear it is the ideal time for the media to capitalize on fear.

When volatility picks up, I like to tune into the media. If most people have the same sentiment, it is usually a good bet to do the opposite. Now I’m generally not proposing market timing. However if you have cash to deploy and everyone is screaming sell, it usually is a good time to be looking around for good values and deploying cash. Likewise if everyone is bullish and complacent, it is often a good time to be trimming positions. More often than not with investing you need to do the opposite of what your emotions are telling you to do.

I find that writing down my thesis for a holding is a good defense for my emotions. When my emotions are telling me to sell, I review the company to see how it is really stacking up against my thesis. The hard part of this often is to have the wisdom to know when your thesis was just wrong, when the data points just show a slight deviation of the path you thought would happen, or when the path has changed but the company is still good. The article Conviction to Hold provides some insight into this topic.

As a part of the thesis I find that writing projected valuations and the associated risks for the stock to be a good defense against my emotions. When you have projected valuations you have a better idea of when to sell. I find when euphoria by the holders of a stock is high along with a high valuation relative to my expectations, it is usually a good time to trim my holdings in a stock. 

As an individual investor, you have an advantage because you can have cash as a position. Institutions generally don’t have that luxury so they are forced to go with the herd over the cliff when valuations get nutty. Having cash when markets crash helps you to be less emotional because you can take advantage of the drop in prices. Again, I’m not proposing market timing but rather am suggesting investors be aware of valuations and act accordingly.

Your emotions and view of risks are a product of your personality and experiences. One of my favorite quotes is by Don Coxe which states: “The most exciting returns are to be had from an asset class where those who know it best, love it least, because they have been burnt the worst.” Being aware of how your past experiences impact your emotions can help you to deal with those emotions.

Morgan Housel (@morganhousel) gave an outstanding presentation at the MicroCap Leadership Summit in 2017. You can listen to it [HERE]. Morgan is also giving another presentation at our 2019 MicroCap Leadership Summit. Morgan’s presentation from 2017 is entitled “What Other Industries Teach Us About Investing” and discusses several different stories. The stories show how experiences, biases, misconceptions, culture, and perception of risk impact behavior and outcomes. I’m going to conclude this article with what he said near the end of the presentation. He stated:

[blockquote type=”left” style=”border: none”]To wrap this up, I think if there is something that underlines all of these stories today, it’s that the biggest risk to you as an investor is yourself and your own biases, your own misconceptions, your own behaviors that impact your returns as an investor. When people talk about risk, they talk about, what is the economy doing? What is the Fed going to do? What is the CEO of the company I own going to do? And those are all risks. I think they absolutely compare to the risks that you yourself pose to yourself as an investor.

And for some people, that’s kind of a difficult realization, to know that you are maybe taking all these actions that hurt yourself. To me, I think it’s one of the most optimistic realizations in investing, because you can’t control what the economy’s going to do next. You can’t control what the Fed is going to do next. The only thing you can control in investing is your own behaviors. And when you realize that the one thing you can control is the thing that makes the biggest difference over time that, I think, is a pretty optimistic realization.[/blockquote]

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