Successful investors are able to ignore their emotions when they make a financial decision. This is particularly true with shares. In this synopsis of an essay ‘The Emotions of Risk’ by Richard A. Geist, a psychologist, we think about some of the different kinds of emotions we feel about our investments. Recognizing these emotions and their likely sources can help us improve our decision making skills.
The result of any investment decision is always uncertain because of these unpredictable factors:
- the company and its management;
- other investors in the marketplace;
- the randomness of world events; and
- the psychological reactions of investors and our own reactions to the above factors.
An investors attitude depends on experience. Someone born on the plains expects the ground to always be even, constant, predictable. Someone born in the mountains is much more careful when he goes for a walk, expecting a landslide at every incautious step. It’s the same with investors, some have had an easy ride, others have memories of disaster. They carry their experiences with them as if what happened in the past will continue into the future forever without end.
Definitions of Risk
The way we measure risk is by volatility. If a company’s price is always falling and rising by 20% more than the market, then it is a risky, or volatile, investment. Investors who buy volatile stocks need to be compensated by expecting a higher reward than they would get from the general market (market return).
When looking back at our trading results, in addition to the profit or loss, we should also think about:
- how long the investment lasted;
- how greatly the loss of the investment would have affected our wellbeing;
- the amount of fear we experienced; and
- how much volatility we accepted
among other things.
Some techniques we can use to lower the chance of loss include:
- dollar cost averaging;
- low expenses;
- minimum turnover;
- careful asset allocation;
- buying with a margin of safety;
- sell disciplines;
- careful fundamental evaluation; and
- valuation of companies.
The Psychological Capacity for Assuming Risk
There are two types of risk: systemic risk and company risk.
Systemic risk includes factors such as interest rates, inflation and credit crunches. These are the unavoidable risks which come simply from being in the market.
Company risk includes all the factors that affect individual companies, such as management, product, services, industry and business decisions.
Company risk can be diversified away by owning 10 to 15 stocks in different industries. but this is no guarantee against loss, only against losing everything at once.
How much risk you are willing to take depends on your age, income, savings, future needs for cash, investment time horizon etc.
Grandiosity is defined as a strong belief in one’s greatness, abilities, knowledge or character. Whether this delusion leads to catastrophic loss or significant achievement depends on how well the grandiosity is integrated to the investor’s rational and realistic motives.
Daedalus and Icarus
A long time ago, back in the days of Ancient Greek mythology there was a great engineer named Daedalus. He was contracted by King Minos of Crete to build the Labyrinth. Some time after finishing the Labyrinth, Daedalus helped Theseus kill the Minotaur (the monster that lived in the center of the Labyrinth). Daedalus knew King Minos would not be happy about this, so he needed to get out of Crete before he could be arrested.
Daedalus couldn’t escape from Crete by land because it is an island. He couldn’t escape by sea because no captain wanted to risk making Minos angry. Then he got the idea to escape by air.
He built two sets of wings from wax and feathers and gave one set to his son, Icarus. Before they set off he warned Icarus: Keep a steady height. If you fly too low the sea spray will clog your feathers and they will weigh you down and you will drown. If you fly too high, the heat of the sun will melt the wax and your wings will fall apart.
When they started, the wings worked very well. The shepherds in the fields and the fishermen in their boats looked up in amazement. They thought Daedalus and Icarus were gods.
But Icarus was having too much fun. He flew higher and higher until the heat of the sun became so strong the wax in his wings melted and he plunged into the sea.
Daedalus continued flying at a moderate height, there was nothing he could do to save his son. Eventually he arrived home in Sicily. He built a temple to Apollo and hung his wings there as an offering to the god. The wings stayed there for a very long time, but eventually there was a fire and they were lost. You can still visit the remains of the temple, though.
When an investor is running hot, like Icarus he thinks he can do no wrong.
Shame and Humiliation
Just as the simple people thought Daedalus and Icarus were gods, so are investors exposed to public scrutiny. Quarterly performance records are examined by clients, competitors and employers, all with a short term view. An investor can fail not only to others but to himself. Those who are able to accept that three or four stock picks out of ten will fail usually make better returns than those who fear admitting their mistakes. If you don’t admit you made a mistake, you cannot learn from it.
Anxiety comes with every investment decision because the results are never certain. You can feel anxiety in many different ways. It may appear as:
- shifts in tone or posture;
- difficulties in communicating;
- a lump in your throat;
- a sinking feeling in your stomach.
It affects our secondary process thinking – the logical, rational means of problem solving. We regress to relying on primary process thinking –we start to rely on our emotions.
Investors who are using their primary process are more likely to be influenced by rumors and tips, especially when there is no other information available. This behavior is often made worse by newspaper pundits and internet chat rooms where stock manipulators are active.
The Experience of Time
Time is both objective and subjective. Objectively, seven days is a week. But a week at work seems to last forever while a week’s holiday seems to be over in a flash.
Those who experience time as passing quickly tend to tolerate volatility better than those who experience it slowly. They are more patient. Not knowing how long they will need to wait for an investment to mature can cause impatient people to feel out of control. They are more likely to act too soon.
Everyone experiences the loss of a loved one and other emotional losses. If you have not resolved these losses, you tend to blindly eliminate losing investments in the face of downside volatility. This is why many analysts downgrade stocks after they have already tanked. It is why some investors sell at the bottom. They have a psychological need to rid themselves of the loss without understanding whether the fundamentals warrant it. This often happens on the anniversary of a former loss.
Acknowledging our losses and integrating this knowledge into our trading style will help us avoid this type of panic. We should also avoid trading on the anniversary of a loss.
The Need to be Part of the Herd
In the days when people lived in tribal societies, being part of a group was essential for survival. It is an adaptive, protective mechanism, built in to the human psyche. We borrow strength, knowledge and power from our leaders and we feel secure among others.
To invest well, we need to go against this natural instinct.
Implications of Changing Definitions
Speculation and bull markets. What drives a bull market is not greed but grandiosity. When prices keep rising, investors feel like Icarus did. This is fine, but only if they know the risks and are following a rational plan.
Small Cap Investing is Risky. This is because small caps are more volatile. But small caps are also less prone to group think. Institutions avoid them due to their low liquidity. The managing director of a small cap company will often spare the time to chat with small investors.
However, the lack of information makes an investor more subject to the influence of tipsters. They take more time and energy to research and if we don’t research we tend to fill the empty spaces in our knowledge with optimistic fantasy.
There is also more need for patience with small caps as they take longer for their projects to mature. Volatility encourages sales at low prices.
- don’t let mistakes threaten their self worth. They remain confident after a loss. They don’t blame themselves or others. They understand where they went wrong and learn from their mistakes.
- enjoy the process of investing. The intellectual challenge replaces worries about loss
- are disengaged from market fluctuations. However, too much denial can reduce the accurate assessment of reality.
- establish a strong connection with another trader or traders.
- think of themselves as outsiders. They are not loners but they have the feeling in themselves that they do not fit in with general society.