For most investors, the image staring back at them in the mirror is their own worst enemy when it comes to long-term investment success. This is because, as investors and as human beings, we often allow bias, emotions and overconfidence dictate our actions. Whether it is our penchant for insecurity or brashness, powerful emotions can take a costly toll on prudent investment decisions if not adequately managed.
In this third installment in our five-part series on identifying and working to resolve some of the most common investment portfolio mistakes, we will focus on how your emotions can affect your ability to maintain a sound investment strategy. Additionally, we’ll take a look at the best solution for these potential effects, learning how to navigate financial matters with the right balance of logic and confidence.
The Effect of Emotions in Investment Planning
In his book The Most Important Thing Illuminated, Howard Marks summarizes the influence of emotions best when he states, “Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.”
As such, a well-designed investment strategy, one that leaves no room for emotional influence, is logical, based on fact and statistics. It is focused on achieving long-term objectives within a tolerance for risk that the investor can assume. However, even the best-designed strategies are ineffective when they are not followed.
Two of the most influential emotions when it comes to investment planning and management, as mentioned by Marks, are greed and fear. These extremely powerful feelings conspire to knock investors off their planned course and are at the heart of many ill-advised investment decisions.
During rising market environments, investors convince themselves that they are more risk tolerant than they actually are. This gives them the green light to seek more return through risk taking activities.
During periods of market turmoil, fear becomes the dominant emotion. In this environment, investors’ tolerance for risk drops dramatically and their singular focus becomes loss protection. They become more risk adverse than their previously stated tolerance for risk.
As you can see, both greed and fear are reactionary emotions, meaning that they manifest themselves in the late stages of an environment. Greed takes hold after the market has appreciated significantly and fear takes hold after a significant market decline, thus reinforcing the wealth destroying pattern of buying high and selling low. Understanding this phenomenon is one of the reasons why Warren Buffett says he becomes “fearful when others are greedy and greedy when others are fearful.”
Another wealth destroying mistake investors make is investing as if the future can be accurately predicted. We covered a similar situation in part two of our series, which focused on how overestimating your portfolio’s return potential can increase risk and hurt your chances for success. Even so, if you turn on any morning business show, you will undoubtedly hear the talking heads articulately pontificate what the near future holds. They will happily provide you with their opinion on the direction of the equity market, when the Federal Reserve will raise interest rates and by how much, and what stocks will and won’t do well. Sometimes, they are right. More often, they are wrong. Viewed from afar, it seems game-like. Unfortunately, playing the game means you are gambling with your savings, not investing.
The reality, as we have mentioned countless times before, is that the future cannot be predicted with any degree of accuracy. Consistently accurate predictions would require an evaluation of all the variables, an understanding of how those variables will interrelate, and an accurate prediction of how investors will react. Said differently, it would require you to know the unknown and then accurately predict how investors would react to the unknown. In fact, history is littered with costly inaccurate predictions. These include analyst Whitney Tilson’s prediction that it was “virtually certain that Google’s stock [would] be highly disappointing to investors foolish enough to participate in its overhyped offering.” The actual outcome? Google it.
What Should Investors Do?
When it comes to prudent investment planning and management, the wisest method of proceeding is to simply ignore the noise. Over the short term, reactions to opinions such as these move markets. However, over the long term, investment fundamentals of value and diversification matter most. This is what famed investor Benjamin Graham meant when he said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
In other words, successful long term investing is a marathon, not a sprint. Sprinters focus on the short term and putting everything on the line for a short period of time in an effort to reach the finish line just before exhaustion sets in. For marathoners, it is about strategy, discipline, controlling emotional urges, focusing on the long-term goal, and executing a plan to get there. Ultimately, it is not about who is the fastest, but rather who can maintain their pace. When you evaluate how you invest, are you a sprinter or a marathoner?
If you still have questions or concerns regarding this topic or how to craft a efficient investment portfolio, reach out to our team of private wealth advisors—we would be happy to help. Be sure to keep an eye out for the next part of our series on common portfolio mistakes to continue learning how to avoid and manage these potentially costly errors.
Common Mistakes Investors Make in Their Portfolios:
- Are You Properly Defining and Managing Risk in Your Portfolio?
- Setting Realistic Objectives: How Overestimating Your Portfolio’s Return Potential Can Increase Your Risk and Hurt Your Chances For Success.
- Are You Letting Emotions and Overconfidence Alter Your Investment Strategy?
- Paying Too Much in Taxes? Two Ways to Manage Taxes in Your Portfolio
- Making Time Work for You in Your Investment Portfolio