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EQ is the key to successful investing

May 29, 2009 14:37 IST

Compared to managing one's emotions in the face of a charging bull or a clawing bear, managing investments is a piece of cake. But then, successful investment management and emotional management is often the same thing. Unfortunately, this lesson can take a lifetime to learn, and it is virtually impossible to teach it to someone who has not made stupid mistakes, expensive missteps, and embarrassing pronouncements. Roiling emotions are the drivers at market extremes and those who can keep their emotions in check end up winners...

Stories of lemmings enthusiastically following one another off cliffs are scientifically untrue. Evidently, this fallacy came into vogue thanks to the fertile minds at Disney, who decided that it would be a heartrending plot-twist if thousands of these cute creatures plunged to their deaths in a film - an animated film, of course.

Fortunately for those in Punditland, however, this oft-applied investor metaphor appears to hold true. Lemmings do, in fact, migrate in thundering (or at least tittering) herds when food becomes scarce. But instead of plunging off cliffs en masse, they will follow one another into any body of water in their way, swimming into eternity, if that's what it takes, in search of nourishment.

Just like investors in the grip of upside fever or downside fear.

Lemmings have an excuse, though: They are biologically programmed to follow one another around in search of food, so their behavior is unavoidable. Investors, on the other hand, operate on a higher level of consciousness and are capable of rational decisions. Theoretically, anyway. The reason investors keep swimming, even when they are in way over their heads and they know it, is herd psychology.

Much has been written about investor psychology and emotion in the markets, and just as much has been ignored. No matter how many times it happens, investors - on Wall Street as well as Main Street - get caught up in the emotion of the market: the thrill of the chase when times are good - despondency and sloth when times are bad. They come to believe that the good times or the bad times will last forever.

No matter how many times this hypothesis is proved wrong, a large percentage of investors will inevitably behave, to their peril and eventual sorrow, as if it were one of the truths of the universe. And worse, this belief can become a self-fulfilling prophecy that actually expands a bubble beyond all proportion or elongates a bear market.

Why do investors behave this way? Emotion, pure and simple, fueled by those old standbys, fear and greed.

Compared to managing one's emotions in the face of a charging bull or a clawing bear, managing investments is a piece of cake. But then, successful investment management and emotional management is often the same thing. Unfortunately, this lesson can take a lifetime to learn, and it is virtually impossible to teach it to someone who has not made stupid mistakes, expensive missteps, and embarrassing pronouncements.

Of the above, I have certainly made my share, but I am willing to share my tales of bumps and bruises to help you avoid following the same misguided trail.

Learning from Experience

Younger investors have only the bull-to-bear market transition of 2001 and 2007 as proof of the detrimental power of emotions. Indeed, this was a brutal but essential lesson in life for these newcomers, whose experience was that markets simply went up about 20 percent year after year. But those investors who have been around longer can point to lessons painfully learned in other market cycles.

"How Worried Should You Be?"
(
Business Week, 1998)

For example, by the late 1990s, some investors (myself among them) who had earned or lost their share of grey hair during other bubbles and busts began to get nervous. The headline above simply heralded a dip in the Dow, but with valuations stretched to the limit and the world caught in an IPO frenzy, the market showed all the warning signs of a speculative trap.

It was at this point that all the lessons learned about emotion and groupthink in the markets became both vivid and valuable to me. It didn't take a genius to realize that dot-com companies selling for 200 times sales (who cared about earnings?) might not be a bargain or that something could be amiss when investors bid up the price of an IPO threefold in the first few hours of trading.

Certain phrases resonated with ones I had heard in bygone days... "This time it's different ..., old valuation models don't make sense in today's economy. This economy is recession-proof," and worst of all, "Market corrections just don't happen anymore."

Oh yeah? Where were the Nifty 50 now? And weren't they supposedly recession-proof, too? And hadn't overvalued oil stocks climbed to 31 percent of the S&P 500 twenty years ago, just as technology stocks were in 1999? Didn't the stratospheric, rise in US stock indexes have a spooky resemblance to what had happened in Japan a decade earlier?

But the laws of logic seemed to have been repealed. Investment fundamentals were old hat, obsolete. Common sense had become nonsense. Emotion was the currency that propelled the market, and there seemed to be no limit to how much emotion was available.

There also seemed no limit to the resistance that the press, investment professionals, or individual investors had to the naysayers. But with huge sums of money flowing into equity mutual funds (and mostly into growth and aggressive growth funds at that), the market and ecstatic managers were awash in liquidity that had to go somewhere.

Retail investors were happy because their retirement plans looked like solid gold and shone brighter every day. And with publications like Business Week saying, in January 2000, "This spectacular boom was not built on smoke and mirrors," what could go wrong?

Hindsight may be 20/20, but some find it hard to believe what they see in the present. Commentators have offered many rational explanations for what happened in 2001, but "rational" was not the operative word then. Nor was it in 2004 The market was as mired in negativity as it was hopped up on adrenaline less than three years earlier.

Where were the folks who, back then, were touting another year of 25 percent returns? They claimed to be looking at horrible numbers and studying a wretched economy. But might they not also have been listening to a Greek chorus of dirge-singing groupthinkers? They might have been better off studying their own psyches.

The most common investment tool today is not the computer, but the same tool it was thirty-five years ago: the rear-view mirror. Investors all too often look back at where they have just been and mistake it for where they are going.

Stocks went up (or lost) 25 percent last year, so they will this year, too. XYZ Fund earned a five-star (or two star) rating last year, so it will this year, too. Bonds were a great strategic alternative three years ago, so they must be now, even though interest rates have already been sliced in half.

Evidence to the contrary - not to mention common sense - is mistrusted, and confirming evidence is accepted uncritically. In the up-and-down world of the financial markets, it becomes an insidious and expensive cycle of buy high and sell low that is likely to be played out in future generations as well.

To make matters worse, going against the grain is not only tough, but fraught with its own potential costs and errors. For instance, I became skeptical of the boom about eighteen months before the bubble burst. And 1 most assuredly took a favorable view of the market months before the eventual bottom.

Both confirmed another lesson: The earlier you speak up about an out-of-whack market, the. longer the market has to make you look foolish and trash your credibility before it eventually cooperates.

Even so, among the most valuable lessons of the past few years is this one: It is better to pass up the last 25 percent of a bubble market than to lose 80 percent when it bursts. The same is true of recoveries. More money will always be made by buying low - even if stocks still have not bottomed out - and selling high than the other way around.

It sounds so simple: Buy low and sell high. It has always been the cardinal rule of investing.

But it is the hardest one to follow when trapped in a herd of charging lemmings.

Top 10 warning signs that you are losing your perspective

10. You listen closely to cab drivers, your brother-in-law, or famous athletes when they talk about the market.

9. You claim to be a long-term investor, but you have your cell phone programmed to alert you when one of your stocks moves up or down 3 percent.

8. You think about mortgaging your house to buy more stock because the Dow is so high, or . . .

7. You refuse to buy more stock because the Dow is just too low.

6. You start throwing around terms like "yield curve" and "valuation" in everyday conversation.

5. You think about ordering a Bloomberg terminal for your home.

4. You start turning on the TV at 3 A.M. to see in real time where Hong Kong is closing.

3. You start turning off the evening news so you won't have to see the Dow.

2. You catch yourself saying "This time it's different.  ..."

And the #1 sign that you are in real trouble:

1. You start to think that you're an infallible investor.


(Excerpt from: Investing Under Fire  edited by Alan R. Ackerman. Published by Vision Books)

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