Mastering Emotions
“We must recognize the psychology of the speculator militates strongly against the speculator. For, by relation of cause and effect, he is most optimistic when prices are highest and most despondent when they are at bottom. Hence, in the nature of things, only the exceptional speculator can prove successful, and no one has a logical right to believe that he will succeed where most of his companions must fail.”
–Benjamin Graham & David Dodd, 1934
Preparation & Skills
If there is one overriding problem cited by successful investors through history that keep the vast majority of amateur investors from entering their ranks, it is that investors are emotional beings that get caught up in the temporary emotions of the stock market. They too often give in to unfocused motivations and peer pressure that compromises otherwise sound investment plans. Every investor needs to understand the psychological influences that will play upon them as they compete in the market, or be forever at their mercy.
The first step toward mastering the game of stock investing is to master ones emotions. To do so, you must know yourself and spend ample time preparing for a lifetime of investing BEFORE jumping into the game. Do you have enough cash set aside to tend to your other life needs while your money rides waves of market emotions? Do you have the courage and persistence necessary to buy when others are selling. Only the most prepared minds and the strongest psyche will be able to buy during an agonizing bear market when pessimism is so intense that every news report forecasts continued doom and gloom. Do you have the will to stick to your investing strategy when all your friends are riding a euphoric optimism wave that promises them quick profits? Are you able to sell while everyone else is buying, just when the future looks its brightest?
Unlike nearly every other discipline, stock market investing has little science. It remains more art, even after 200 years of application. It requires few if any special skills. All are free to compete on relatively equal footing. Outcomes can never be guaranteed. No tests or experiments can be applied to test each strategy. Some of the most powerful tools include common sense and basic understandings of classic theories and historical references.
Contageous Linear Thinking
Our vision of what lies ahead is colored by recent events. We’re programmed for extrapolation. The human mind just works that way. When there is a downward trend in a market or an industry sector or an individual stock’s price, most investors see this “out of favor” status as being perpetuated indefinately. This is almost never the case, as some impossible to predict event turns the tide and what was cold yesterday becomes hot today.
You don’t have to go back far for examples of quick reversals of popular market psychology. In mid 1998, the Singapore market index had sunk from 2,500 to 800 as the entire Asian region was mired in recession. Fear had driven currencies to dramatic lows, and stock values followed. TV and print media “experts” openly predicted the markets would experience a “protracted 5-year recovery” at best. Many investors (and all speculators)–unable to weather the financial and psychological strain–bailed out.
In time, less time than anyone would have imagined, they regretted their sell decisions. By the end of 1998 the Singapore market index had shot straight up to pass 2,100, nearly trippling it’s value in just a few months. Again and again, the market refuses to be predictable. No matter how pessimistic or optimistic the mood, no matter how sure the “experts” are the trend is in an early phase and will continue for some time–the market has the uncanny ability to turn on a dime and head off in unexpected directions.
What Motivates You?
Why are you in the stock market? The obvious answer is “to make money,” but that’s not always the case. You need to honestly answer this question in order to design an effective investing strategy. Many investors are pragmatically saving to fund their retirement years, or in order to retire sooner than most. Others invest as a social activity, thus the explosion in popularity of investing clubs. Still others invest to gain self-esteem as they are able to discuss recent market events with intelligent comments and even brag about wise investments in their favorite stock at just the right time.
There are also those who invest as a core part of their life. Just as artists blend new combinations on their pallets and musicians experiment with chords, some investors are “in their element” when they are designing portfolios. These intense investors are constantly looking for new knowledge that can help them understand what makes a business tick, what makes a market move, what makes a portfolio perform. They relish the challenge that comes with “beating the index.” It’s not a game, it’s a way of life.
Where Do You Fit?
Managing the human side of investing means assessing where you are along life’s path, the resources you have available, the financial commitments you face, and the goals you’d like to reach. Your ability to participate in the stock market might be limited by your need to put food on the table, clothe your kids, put a roof over their heads, and provide for their education. Let’s take a look at 4 stages of life you may be fitting into today..
Consumers: By choice, or necessity, consumers spend their money. They live from hand to mouth. Perhaps all their money just covers the essentials of life. Perhaps they have extra cash, but are compulsive spenders, the “shop ’till you drop” type. Consumers operate on a very short time horizon. When they have money, they spend money. They have no concern for inflation and what tomorrow will bring, because they’re buying today. They have no interest in investing for the future. A stock portfolio would be but a dream.
Savers: The key difference between a consumer & a saver is their time horizon and income flows. Savers have the necessities of life covered and want to put the extra away for future needs. They have low tolerance for risk. Their goals might include a house, education and retirement. Despite the long-term nature of their objectives, they are not comfortable with the risk involved in achieving market returns. They tend toward fixed deposits, maybe bonds, but equities are just too risky.
Speculators: Unlike savers, speculators have a short-term outlook. If their stock achieves a price target in 5 minutes, they sell and move on to something else. They may praise a company’s management, products and long-term prospects for growth–but if the stock wavers for a moment, they dump it without a second thought. They are willing to take on risk in exchange for a chance at quick gains. They fancy themselves as superb stock pickers with an uncanny ability to anticipate the next Microsoft. Steady growth and dividends make them yawn. Start-ups, little known companies with a story, firms with unproven but exciting products all catch their eye. Tips & rumors rule their day.
Investors: Anyone with means beyond the Comsumer should be an Investor. They prize carefully designed plans that strike a happy balance between the need for creating and growing wealth while controlling risks. They take a long view, look for price appreciation, and realize that with no risk there is no glory. They are constantly trying to optimize the risk/reward trade-offs. They devise highly disciplined ways of identifying how much risk is being taken and how much reward can be expected. Once portfolios are constructed, they are often passed down to the next generation and may never be sold. Investors tend to be rational. They look to the stock market for quality businesses, learn all they can about them, buy them when they are offered at bargain prices, and seldom sell.
Success Is About Planning
Successful investing doesn’t begin with a call to your broker. It starts with a “psychological checkup” to understand why you’re investing and if you’re prepared for it. There’s really no point in launching a financial plan if you don’t first know yourself as an investor. As sure as there’s a buyer for every seller, the market will have its highs and lows. Some drops will be drastic, some gains will be head-snappers, but most will be in between. If they makes you scared, or excited…you’re beginning to learn more about yourself. Keeping your head when others are panicing often leads to oversized profits.
In the end, it’s not enough simply to identify a strategy, even if it’s a great one…equally important is your capacity to stick by that plan when those inevitable market swings occur. Failure to understand your position on the Consumer-Saver-Speculator-Investor scale also decreases your chances for victory. Before you put your money on the line, ask yourself the tough question: Why? And make sure the answers are consistent with your inner self and your financial means. Keep your emotions in check, set long-term objectives, and maintain adequate cash reserves for times of turbulence. Let us end this first Master Investor article as we began it…a quote from Graham & Dodd:
“…we seem to be on firm ground in repeating the old aphorisms that in speculation when to buy–and sell–is more important than what to buy, and also that almost by mathematical law more speculators must lose than can profit.”
Note: Some materials in this series are extracted from an excellent book by Charles E. Babin & William J. Donovan called Investing Secrets of the Masters, McGraw-Hill, 2000, ISBN 0-07-134100-5.
