With incredible market volatility today, being an emotionally powerful investor is the ultimate desire of many investors today. "Should have, would have, could have" are used too frequently in the investment community. In this article, we explore the psychology of investing, backed by observations and real-life stock market examples. We conclude our analysis by answering “How to Be an Emotionally Powerful Investor”.
We start with a simple question.
What do the recent coronavirus-induced panic buying toilet paper craze, the March 2020 sell-off in the stock market, and the 2019 Asia bubble tea fever all have in common?
Everyone has a momentum in them, if you pay close enough attention. For example, behavioural momentum is use to build motivation among children through requesting task that are easy for a child before a difficult one.
More evidently, momentum investing is part of everyday life of the stock market. In a nutshell, this is betting that recent winners will remain winners and the recent losers will remain losers.
It’s worth highlighting that one of the most popular momentum exchange-traded fund (ETF), iShares Edge MSCI USA Momentum Factor ETF, launched in 2013, has a total asset of ~$8 billion, at the time of writing.
99 problems but FOMO ain't one
Fear of missing out, better known as FOMO, describes “a feeling of worry that an interesting or exciting event is happening somewhere else” could be an explanation. Interestingly, FOMO does not discriminate against any age groups.
It generally takes place when something you don’t own increase in value rapidly. What happens next is you’re convinced that this is the next big thing and hop on the momentum train.
This leads to the observation that investors often do not practice what they preach, resulting to buying high and selling low. Antoniou et al. (2013) argue that momentum stems from classic cognitive dissonance where investors react properly to news which confirms their beliefs but underreact to news that disconfirms their beliefs.
The need to always "feel good"
Imagine how would you feel, if you bought something today for £10, was £5 yesterday and £15 tomorrow? Naturally, you would think that you’re right and made the right decision. Similarly, if you bought it at £10, fell to £5 the next day, how would you feel? The likelihood of you selling is high because it gives you the perception that you got it wrong.
Likewise, if iPhone was retailing for $99 instead of $499 for its 4GB model when it first launched, would Apple have sold >2.2billion units till date?
What would your guess be? More or less? The answer is actually less clear-cut. How about the perception that pricing was creating its own demand, hence, the “feel good” factor of owning an iPhone in the first place?
Personally, whenever I need a new phone, I look for discounted refurbished phones that is one or two years old. Less competition, cheaper and does the job. But I digress.
The point I want to put across is that we often make decisions based on what we feel rather than what we think. This impedes good investing behaviour.
Hedging your emotions
“It’s just emotions taking me over”, a familiar chorus, regularly heard on trading floors. On the contrary, emotions are rarely the issue, it’s often the consequences that is worrying. For example, a consequence of being too attached to a stock is that you would probably lose a big chunk of rationality when it comes to making decisions.
Today, many would agree that market participants has grown less patient. Fund managers are forced to consistently produce return on a short-term basis (at least in the hedge fund world). This is unsustainable. They are faced with the cold hard truth – “There is no such thing as permanent capital” (unless of course, you’re in family office).
It’s not hard to imagine that the need to outperform in the short-term, the lack of permanent capital and stock market volatility has elevated emotions to one of the key characteristics of the stock market. Well-known market anomalies such as “Sell in May and go away”, Santa Claus Rally, and the weekend effect are a reminder that the market is not immune to emotions.
How to be an emotionally powerful investor?
Firstly, having a well-thought through investment framework is a good starting point. For an investor, organising information in an efficient and accurate manner is key. That’s exactly what you can achieve with a good framework.
It also serves as a guideline during challenging times. You should always consider your investment time horizon as part of your process, are you in the stock for 2 days or 20 years?
In my early days, my investment time horizon was a moving target and I have a non-existent investment framework. As a result, I panicked and cut my losses when a stock I owned halved within 2 months due to an unforeseen supply chain disruption.
Sure enough, I missed the boat when it tripled in the next 12 months. The lesson here was not having a framework to process the information efficiently and accurately. Above all, a framework doesn’t always lead to the optimal decision, but it sure helps you avoid poor ones!
Secondly, understanding your emotional capital. Embracing uncertainty is the name of the game. Making an investment decision requires understanding your goals and risk appetite. For instance, investors seeking stable income shouldn’t be invested in crypto currency. Investors need to have reasonable expectations and comfort over its defined investment time horizon.
Last but not least, know what you’re investing in. To be prepared is half the victory. This is what differentiates between an investor and a gambler. A well-researched idea is one that allows investors to make the optimal decisions during challenging times. Taking my example above, I panicked and sold because I lack understanding in the stock I own. I was a gambler and paid the price.
Don’t avoid your emotions, embrace and adapt as part of your investment style. I’ll leave you with this: “Follow your heart but take your brain with you”. Happy investing!