Overcoming Emotionality

Part 2 of 10

If there is one roadblock to successful investing that is timelier than any other, it would be this one. Emotionality! With the broader S&P 500 losing nearly 7% in October and the DOW index dropping 1,300 points, or 5% in October, there is cause for fear. November was relatively flat for the indexes and December has turned out to be a total meltdown.

The combination of tariffs, interest rate hikes, political unrest in Central Europe and the continued political division in the United States, which now includes a government shutdown, the light at the end of the tunnel is an oncoming freight train. And it appears that we have no way to get off the tracks. It is the perfect storm and none of us can shelter in place.

With all of this uncertainty, there is little doubt that the pressure of a recession is mounting. Fear is all around us and the most important thing to keep in mind is this. “Investing is emotional… It can’t be, but it is.” Let me unpack that a little bit before addressing the broader topic of emotionality and how to overcome this particular roadblock.

First, Investing is emotional. Just as the market responds to Geo-political events, investors tend to be driven by emotions, with fear being the primary driver of most investing decisions. Now it is important to develop the following core value when it comes to emotions. Emotions are real, and you have to acknowledge them, but emotions are also real bad decision makers. Decisions that follow emotional inputs often lead to losses.

Investing is as much of a psychological game as it is a financial game. You can learn how to play fear if you understand that Geo-political events can spoke the market into deep discounts on good companies. However, in order to play fear, you have to understand the types of fears you, as an individual investor will experience during times of market volatility.

There are four primary fears (in no particular order concerning the current market volatility) that an individual investor can, and often will, experience over the course of his or her investing lifetime. The first fear is known as FOMO, or the Fear of Missing Out. If an investor has been sitting on the sidelines, meaning that he or she has a lot of cash, he or she might become fearful about missing out on a market rally.

When the market is in full growth mode, an investor needs to be more cautious because it is easier to make bad decisions. It is hard not to get caught up in market exuberance. When the market is hot, there are always people warning of a correction, which makes it harder for the investor to know when to enter the market. This obfuscation is directly related to the second type of fear; FOGI (pronounced “faux gee”), or the Fear of Getting In.

When the fear of getting in is greater than the fear of missing out, the investor will miss market opportunities. When the fear of missing out is greater than the fear of getting in, the investor can end up overpaying for a stock. This principle is known as the pain / pleasure threshold.

This principle basically states that when the pleasure derived from an action is greater than the pain associated with the action, a person is more likely to commit to the action. However, when the pain of an action is greater than the pleasure derived from the action, the person is more likely to abstain from the action.

Applying this philosophy to FOMO and FOGI, when the fear of missing out is greater than the fear of getting in, an investor is more likely to make an investment. When the fear of getting in is greater than the fear of missing out, the investor is more likely to abstain from investing. This principle can be applied broader when the market experiences any emotion associated with investing.

When you think about it, FOMO and FOGI are truly opposite fears. However, there is another set of fears that are common ancestors. FOGO, or the Fear of Getting Out and FOSI, or the Fear of Staying In, have their root in the fear of losing money; even money that is not yet realized by the investor.

Let’s assume that you purchased a stock at $35 per share. The following week the stock drops 6.5% to $32.275 per share on bad forward guidance. You had purchased 500 shares for a total of $17,500. You investment is now only worth $16,137.50 for a total, one day loss of $1,362.50. FOGO, the fear of getting out, will cause an investor to hold the stock until it comes back to at least the purchase cost before selling. FOSI, the fear of staying in, says to the investor “cut your losses and run.” Both of these fears are driven by the exact same root; the fear of losing money.

If you stay in, the stock might rebound and if you had sold it, you would have lost the money (the emotion of regret, which I will discuss later).  If you get out, you guarantee a loss, but not as bad as it could be. Jim Cramer often says “Your first loss, is your best loss.” I do not necessarily agree with that philosophy, but it does have some validity if you invest with emotions.

The fundamentals of a company do not change hour to hour. The valuation of a company does not change hour to hour. What does change from hour to hour are the emotions that drive investing decisions. You need not fear market downturns nor should you try to ride a cresting wave. The best way to begin to overcome the roadblock of emotionality is to begin to understand the drivers and invest appropriately.

Whenever there is a Geo-political event, you can bet portfolio managers are going to react. News that is perceived as negative will result in a sell-off and news that is perceived to be positive will result in a market run-up. Usually this happens disproportionately to the news. In other words, money managers tend to over-react in an effort to satisfy the IGMBYGY rule. That is the “I’ll Get Mine Before You Get Yours” rule.

They sell on perceived negative news to capture gains or they buy on perceived good news to get in early before the market runs-up. Warren Buffett says “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” which amounts to “Buy when everyone else is selling and sell when everyone else is buying.”

Therefore, the best days to buy tend to be when the markets are selling off and the best times to sell are when the markets are euphoric. However, it is rarely good to sell a winning stock on an up day or to buy a losing stock on a down day. You have to do your homework and make wise buying decisions devoid of emotional drivers.

So, how does an investor overcome the veritable plethora of emotional drivers that lead to bad investment decisions? Three simple things.

1.                Know thyself. Temperament can limit one’s ability to overcome emotionality. It is about balance. Using your head and using your gut in unison will cause you to not follow the herd mentality of the market makers. The best word picture I have heard is this. Be the center of the teeter-totter where neither up-ness nor down-ness exists, but both run through.

2.                Know the markets. If you can anticipate how the market is going to react to Geo-political events, you can learn when to buy and sell to increase your success. The key to knowing yourself is honesty. The key to knowing the markets is study. If you take the time to study the markets and how Geo-political, financial, and other world events affect the markets, you have the potential to become a successful investor.

3.                Know the company. Knowing the markets happens on the macro level. It is the big picture or the 35,000 foot view. Knowing the company is the micro level. It is the down in the weeds, where the rubber meets the road view. If you are invested in a company, it is in your best interest to stay current on the news and direction of the company.

Worry and anxiety can foster the four forms of fear; FOMO, FOGI, FOGO, and FOSI. Ironically, fear can foster a stranger emotion known as regret. If you have the fear of missing out and you invest heavily, without doing your homework, you might end up regretting doing so. This regret will then drive you to sell at a non-advantageous time.

You have to learn to not have any regrets. Don’t regret staying in a losing position too long. Never regret exiting a winning position too early. Jim Cramer has a great saying that I believe reduces the level of regret in these two scenarios. He says “Bulls make money, Bears make money, and Pigs get slaughtered.” It is okay to exit a position and move on. A gain is a win and a loss is a lesson. Both can be invaluable.

Fear and exuberance are the two basic emotions investors can experience. If you understand the fundamentals of the company and learn how to read the market and its reactions to geo-political events, you will be able to overcome these two emotions. 

You overcome fear with knowledge. You overcome exuberance with patience. You overcome depression with encouragement. You overcome doubt with the confidence in the strategy you are executing and you overcome the urge to quit by marking the progress you are making.

The final thought is this. The best way to navigate the emotional swings in the market is to have a strategy that remains consistent through the market cycles of fear and euphoria. Strategy is the “dollar-cost-averaging” of market emotions as it flattens out the sine wave. Emotions cause money to impact your life. Strategy causes you to impact your money.