The unavoidable combination of investing & emotion

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Everyone will say you this: in order to become a better investor, don’t let emotion overtake your decisions. But, we’re human beings. We are made out of emotion (mostly) and with everything you do, even the little things, you will feel something. So how on earth can you invest without listening to your guts, that little voice in your head or your straight out feelings?

And what drives these emotions, is it really something we can shut down?

Imagine this:

You’ve bought 50 shares of the company Wells Fargo, a nice solid financial institution that operates globally and will pay you a nice dividend every quarter. When you bought the shares, the stock price was below their 52-week average and after some research, you found it a good value for you money. You’re content.

Then, a few weeks later, you read in the news that a big scandal is the source of the stock price spiraling down. What happened?  You might feel shock and awe, and are doubting to sell the stock. Or you’re interest is triggered to dive a bit further in this news, you could buy some more with these low prices…

What will you do? Or better, what will you feel?

The stories around us, and the things people are telling us, are evoking feelings inside us. It makes you think about what you’ve done or are planning to do. It’s easy to ignore the scandal if you never heard of the company. But, when you’re money is involved it’s not that easy to shut it out.

It also works the other way around. Last friday there was the news involving the possible take over of Unilever by Kraft Heinz, resulting in a major share price increase for Unilever.

We own some of Unilever shares in our portfolio. Did we feel anything? Heck yes. I immediately checked the stock price, and… did nothing. Why should I?

Beating the market?

You can never time the market. Period. Investors are the driving force behind the fluctuations in the market (or very fast computers) and their actions are either based on emotions and/or available news (and probably both at the same time).

There is an ‘exception’ in the case of the supercomputers, that base their buying and selling on the market itself. But looking closely, if it’s based on the market swings itself, which is driven by news and emotions, they are inevitably connected.

It’s a general saying that shutting out emotions can make you a better investor. But how do you do that?

When looking for more stable returns, dividend investing is one way of doing it. More or less. It’s never a guaranteed success, but at least you will get paid in the form of dividends every few months. When doing it long enough you can build up a wealthy portfolio which generates a nice additional income stream.

So what will you do when I ask you this question?

If you could buy an asset that pays a 24-cent dividend every four weeks for 60 weeks, 15 dividends in all. Then it disappears. It’s a guaranteed investment. Would you do it? 

A bunch of economist used this scenario to set up multiple experiments over the years. They used some volunteers, give them money and shares, paying a dividend circulating in rounds. And repeating it. Then they watched what happened…

The underlying statement was that the fundamental value of a stock or company is already defined. Namely the expected future dividend stream at any given time. (Which a lot of models use to calculate the fair value of a stock.) And you could control the environment because you created the experiment yourself.

Before these experiments took place, the expectation was that the trading price would stick close to the expected value. No bubbles, no market roller-coasters rides, no crashes and no emotions.

In 1980 Vernon Smith started to set up these kind of experiments for the first time. And what happened was the following: it formed a bubble and crashed, repeatedly.

It’s not about the underlying value of a stock, but what somebody is willing to pay you for it. And many make us of this. They try to buy low and sell high. Which creates the bubble. 

Even when people know a bubble crashed, they form a new one. People are then expecting a next bubble again, and try to earn money from it. Resulting in the volatile markets we know today. Where every event (Trump?) can form a next bubble or crash.

This kind of behavior is a human thing, even if the markets would be controlled by economist in an experiment setting. An efficient market just doesn’t exists. Humans behave irrationally, and so does Mr. Market.

 Riding the waves

We know that bubbles and crashes happen. Like everybody else. And by knowing this fact, people tend to make use of it. Or at least try. Again, by aiming to buy low and sell high. But predictions about how high the markets will go, or what the lowest point will be are mostly wrong. Investors that are riding these waves of highs and lows are often called momentum traders. A lucky few might earn a very good nest egg, most will not.

They try to sell out on stocks before the crash happens, which on it’s own will result in the crash to happen sooner rather than later.

So we know markets behave inefficient, that investors or persons will be lead by emotions like greed or fear. And the info that is available to them, like knowing a crash happened before, will impact their decisions.

Even when you don’t try to time the market, you will feel emotions. So what to do with them… Well, nothing. Don’t shut it out, but also don’t base any decisions on them. Just ride it out. If you’re willing to buy a stock because you believe the company is even bigger in 20 years? You can still buy it 1 year from now. The momentum of buying and selling is lost.

Long term investing is often called bored, because the intense thrill of riding the waves is being flattened out over the years. Even more so for investing in ETF’s.

With dividend investing, investors look for the underlying fair value of a stock, and aim to buy it for a lower price. Isn’t this the same behavior as momentum investors show us? Well, once you understand the implications of these decisions, they don’t matter as much anymore. This is because the long term effects are greater the the short term gains or losses.

Personally we often feel a lot of emotions when it comes to investing. We try not to act on it, but can not totally shut it out. We accept that some of the choices we make, will be effected by emotions. There are 2 things we do in order to minimize our choices being affected by emotions: have patient and perform our own research.

So, we know that humans, and I mean every single person, can’t shut out emotions, even if they try. Have you ever done something with investing in the rush of an emotion?

7 thoughts on “The unavoidable combination of investing & emotion

  1. Interesting post. I guess I’ll read a bit more about the Vernon Smith experiments…
    From my side I’m really trying hard excluding emotions from my investment decisions. In the past it always has been a bad advisor. It doesn’t mean that the rally in Unilever didn’t put a smile on my face 🙂

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  2. To answer your last question: hell yeah! Regretted it and did not do stocks for about 3 years. Then figured out the long term view….
    Still, was tempted to sell UNA at it’s peak a week ago…..but did not. Trying not to gamble but build a long term portfolio 🙂 But it is hard to keep emotions out, no debate there!
    We do use the basic tricks like limit orders for most individual stocks and continuous buying of index funds. Is working out well at the moment.

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  3. My emotions last summer did cost me 1000USD…! That hurts.

    I feel it difficult to remove the emotions. Hence, I like my investments to be automated. There is one part that is not yet automated, and ti is causing a lot of trouble…

    I use a play portfolio to direct some of the emotions. That helps.

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  4. I actually bought WFC days before the scandal broke and I was nervous but I hung on. I am glad I did because it has gone up despite the news. I did have a few moments of panic last January and reallocated part of my portfolio, and it cost me some serious dividends. Live and learn. Emotion is part of investing. You will be successful if you have 10 panic attacks and only react once or twice. It is a numbers game. I think over time you get better at resisting the urge to react and sell etc …Good post, thanks for sharing.

    -Brian

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  5. Got burned a bit holding some put options on UVXY last year, bought them thinking I could cash in on some spikes in volatility but it ended up being stressful holding them and eventually selling for a loss.

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  6. Hi Divnomics,
    Good post. I did not know those experiments and I will certainly read up on them. One way to control your emotions could be to allow yourself not to sell/buy more than 10% or so of an existing position to satisfy the urge to do something. Of course it’s even better if you can control it completely but it does. It have to be a yes or no decision.
    I will always remember that I bought shares of a company around March 2009 only to sell them after a 10% gain thinking that it was just one of those bear market rallies. I could have made multiple times my money if I only would have held on.
    Regards,
    DIB

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