Overview – Emotions and Investing Are Like Oil and Water
“Investing” is sometimes associated with being a very quantitative activity, and no doubt it is. Every investor will have to go over a company’s financials and other bits of numerical data before arriving at an investment decision.
While quantitative skills are a must-have for any investor, many overlook the emotional side of investing, and how emotions can affect an investor’s behaviours and decision-making ability.
Just like oil and water, emotions and investing share a similar relationship: they don’t mix, no matter how hard you force them to. Whenever an investor tries to force this incompatible relationship to work, the result is usually disastrous.
In this article, we will go over how emotions can adversely affect an investor’s ability to make sound decisions, and how to prevent that from happening.
Short-term Frenzy, Long-term Calm
Benjamin Graham, the author of the highly-acclaimed books Security Analysis and The Intelligent Investor, shared the following insight about the stock market:
“In the short run, the market is a voting machine but in the long term it is a weighing machine.”
Benjamin Graham
Let’s unravel the wisdom hidden in this simple yet powerful quote.
By “voting machine”, Graham is talking about the short-term glamour and hype surrounding a stock or group of stocks.
A classic example of this is the Dot-Com bubble. Put briefly, the Dot-Com bubble was a period in the mid-1990s to the early 2000s where the stock prices of internet-related companies were astronomically high.
Many of these companies during this time didn’t even turn a profit: simply being associated with the internet was enough to make your company worth millions seemingly overnight.
This is what Graham meant by the market being a voting machine: people were purchasing internet stocks simply because everyone else was doing so and because buying internet stocks was the hot trend at the time. Hardly anyone took the time to sit down and check if all the hype was justified.
Instead of using their heads to make sound decisions, investors instead opt to listen to their emotions and the ramblings of others to decide what to do next.
As time passes, the hype dies down and investors begin to look at companies through a more sober lens. Metrics such as earnings growth, free cash flow, and ratios take on greater importance than popularity.
This is when the market becomes a weighing machine: a company’s prospects are evaluated more objectively using more quantitative measures of investment merit, not the subjective feelings of other people.
Back to our dot-com example, recall that many of these companies did not turn a profit, or had very little revenue.
As time passed, the weak business fundamentals of these companies started to show: they burned through their cash too quickly and could not sustain their operations.
This ultimately led to the dot-com bubble bursting, causing many companies to either go out of business or see their stock prices get decimated. Surely you can imagine what happened to the fortunes of the people who pumped lots of money into these speculative companies.
Long-term investment success means having the ability to properly analyze companies without succumbing to short-term emotional swings. Keep your emotions in check, perform rational analysis, and your portfolio will flourish.
The Importance of Disciplining Your Emotions as an Investor
A characteristic that separates great investors from average investors (and speculators) is their ability to approach investing rationally and objectively.
These investors can look at the facts and financials of a company without succumbing to their emotions, and subsequently, emotional thinking. We are emotional beings, yes, but if you do not learn to discipline and contain your emotions, they will get the best of you.
The stock market, in the short term, is arguably one of the most “emotional” entities in existence.
A slight sign of optimism, whether it’s strong earnings reports, a decrease in unemployment, or a new trade deal being signed, can all lead to the market ticking upward. Similarly, the slightest sign of trouble can easily erase any gains made previously.
Great investors understand this, and as a result, don’t let the short-term mood swings of the market affect their strategies and decision-making. They know that over time logic will eventually prevail, the hard part is not succumbing to your emotions and make a rash decision while you wait for that to happen.
Not only are great investors incredibly rational, but they are also not afraid of being contrarians.
It is so easy to get caught up in the day-to-day drama of the market; many investors and speculators base their buy and sell decisions on these incredibly short-term changes. Do not be like this!
Warren Buffett once said: “be fearful when others are greedy and be greedy when others are fearful”. At face value, this advice seems simple enough, but in practice, there will be times when this advice is not easy to follow, especially when the market and other investors overwhelmingly push a certain narrative on you.
This does not mean you should ignore the market and other investors completely: part of any sound investment analysis involves looking at opposing views and evaluating their merits.
The problem is when you come across opposing views and you allow them to immediately invalidate your own position, simply because you were scared of going against popular opinion.
It’s easy to say “stand against the tide”, but it’s very hard, if not impossible, to do that if you don’t have the emotional discipline needed to stand firmly by your decisions and analytical work.
So, great investors are those who are incredibly rational and are not afraid to stand against the tide, thanks in part to their superb emotional control.
These investors are also capable of doing something incredibly well: not falling in love with their investments.
Imagine purchasing shares for the first time: chances are you remember exactly which company whose shares you first purchased, and all the reasons why you thought this company made an excellent investment.
Fast forward 10 years: this company is now on its last legs, revenues have been steadily decreasing, debt is starting to pile up, and management has publicly announced they are seriously considering declaring bankruptcy.
While the great investor would have cut their losses and sold long ago, the emotional investor may refuse to sell simply because this company was their first investment, and they refuse to accept the grim reality.
Great investors understand that investments are not things we should feel emotionally attached to – investments come and go, some retain their merit for decades while some degrade over time.
Becoming too emotionally attached to one when it’s clearly best to sell will only hurt your portfolio the longer you hold onto it. When your analysis suggests that it’s time to sell a certain investment, then you better sell.
Ways to Keep Your Emotions at Bay
It’s easy to say “don’t get emotional” when investing, but everyone handles their emotions differently, and as a result, there is no one-size-fits-all approach to prevent emotional investing.
That’s not to say that every investor requires a highly personalized framework to keep their emotions in check: there are relatively simple ways that many investors can follow and implement without much hassle. Here are some ways to keep emotions at bay as an investor:
Cut Out the Noise
The Information Age has, for better or for worse, a profound impact on our daily lives.
Anyone with access to the internet can easily obtain the information they want when they want it. Unless that information happens to be tightly held corporate secrets or highly classified government documents, chances are most people can get the information they’re looking for on the web.
Investors can check stock prices, read company financials, receive company news, and place buy & sell orders all at the push of a few buttons. All an investor needs to do to access information is to search for it.
However, easy access to an abundance of information has its drawbacks.
Investors are now more susceptible to being inundated with too much information, leading to them losing their cool and reverting to emotional responses.
An example is March 2020, right after the World Health Organization declared the COVID-19 pandemic and countries around the world quickly instituted lockdowns.
Because of this, stock markets around the world were decimated. Almost every day in March the financial news got progressively worse. Record market lows, mass selloffs, negative oil prices, climbing unemployment: every day seemed to be a race to the bottom.
No doubt, investors who followed financial news closely during this time would have been bombarded with the same stories from a variety of sources, all reporting the same doom and gloom.
An emotional investor would have allowed this flood of information to get to their heads, lose their composure, and proceed to panic sell.
Having access to and analyzing high-quality information is part of any investor’s recipe for success, but many overlook this simple yet powerful fact: you do not need to know everything going on with the economy and stock market every single day.
A lot happens in the economy and stock market on a given day: IPOs are issued, companies merge, earnings are released, consumer spending reports are published, among so many other things.
Not all the news reported in a single day will be relevant to your investments or your decisions, so why stress out over things that don’t affect you in any way?
To prevent information overload, limit the number of news sources you get your financial information from, and stop checking so frequently. Reading from a few news sources every morning is more than enough for your daily dose of investment and financial information.
Everything else will likely be information that has little to no effect on your investments. You don’t need to listen to everyone’s story or opinion: cut out the noise, focus on what you can control, and keep a level head.
Perform Your Own Investment Analysis
When evaluating a company to invest in, please do not do the following procedure: search “should I buy ___”, find some articles titled “why you should buy ___”, read other articles telling you to buy, then proceed to buy.
Conversely, when looking to sell some of your shares do not search “should I sell ___”, find a few points convincing you to sell, then proceed to sell.
If becoming wealthy through investing was as easy as following the opinions of others, everyone would be a multi-millionaire or billionaire. Unfortunately, that is not the case.
Any time you are considering a company to invest in, always draw your own conclusions based on your own analysis.
If you ask 10 investors to analyze a company – giving them all the same materials to analyze – chances are you will get 10 different conclusions.
Some of the conclusions may have overlapping points explaining why you should or should not buy/sell, but there will still be slight differences. How would you know which of these conclusions are the most believable? This is where your own analysis comes in.
Performing your own analysis and drawing your own conclusions clearly demarcates your sentiment about a given investment operation and allows you to compare your sentiments with others.
Let’s say you decide that, based on your detective work, a company is worth investing in. You can compare your analysis with others who also believe you should buy by checking to see if others identified similar strong points, or brought up some compelling reasons you had previously not thought about.
Performing your own analysis allows you to better evaluate and understand opposing views: the opposition may have excellent counterpoints that force you to stop and re-think your analysis.
Understanding the sentiment of other investors is meaningless if you do not firmly establish your own position first.
Reading other investors’ analyses serves to challenge your assumptions, forcing you to take a step back and fill any holes in your analysis, not as irrefutable advice that you should take at face value.
Don’t Check Your Portfolio Every Day, But Don’t Forget About It Either
Some investors believe that they need to check their portfolios every day because not doing so will lead to them missing a major news update, a sharp decline in stock prices, or some other event that will cause their portfolios to lose its value.
Some investors spend countless hours stressing over every annual report, quarterly earnings report, and news article that relates to the companies they own.
This obsession with checking the minute-by-minute activity of your portfolio is a recipe for emotional disaster.
Instead of focusing on the long-term prospects of the companies they own, these hyper-obsessed investors lose sleep over the slightest signs of trouble and will be the first to dump all their shares when bad news translates to a slight decrease in stock price.
Every stock experiences daily ebbs and flows in its prices, so day-to-day stock movement is usually nothing to worry about unless you are a day trader.
Assuming you’ve done your analysis and have checked the validity of your conclusions, then the daily movement of your portfolio’s stock prices should be of very little concern to you.
There is a false notion that investing in the stock market is 100% “passive”: once you’ve purchased shares of the companies you want, you simply need to sit back, relax and collect dividends or sell for capital gains.
There are investment products that require almost no supervision, such as index funds, but any investor who picks, analyzes, and invests in individual companies is most definitely not investing passively since they put in the time, effort, and energy to manage their portfolios.
Not checking your portfolio at all is just as bad as checking it too frequently. Investors who take a “buy and forget” approach become complacent, believing that their investments will only go up.
These investors are in for a shock when they learn that some of their investments have gone sour.
Just because a company has positive prospects at the time of your analysis does not mean that it is bulletproof: unexpected events happen, competitors grow larger, and companies that were once thought of as untouchable sometimes may find themselves upended.
There was a time when investors thought that Sears was untouchable and had nothing but a bright future ahead of it, but it eventually faded into obscurity. Now, the decline of Sears was years in the making, but investors could’ve salvaged their money if they took the time to assess what was going on through the years.
If checking your portfolio too frequently and not checking at all are both equally bad, then that leaves one last option: check occasionally.
How often you choose to check your portfolio is mostly a matter of preference: some investors check every two weeks, every month, every two months, etc.
It doesn’t matter how often you choose to check on your portfolio; what matters is that the frequency of your checks is enough so that you have a good handle on how your portfolio is doing, while at the same time not becoming too paranoid about the routine fluctuations in your portfolio’s value.
Wrapping Up
Allowing your emotions to dictate your investment activities is a recipe for disaster and, ultimately, financial ruin.
The best investors are those who understand that, although we are all emotional beings, we must learn to keep our emotions in check when money is involved.
Stay level-headed, look at data rationally, cut out unnecessary noise, perform your own analysis, and check your portfolio occasionally: these simple yet powerful practices will increase your likelihood of maintaining a healthy portfolio for years (and even decades) to come.
