Investing with your head, not your heart

Veteran investor Warren Buffett, in the preface he wrote for the fourth edition of The Intelligent Investor by his mentor Benjamin Graham, tackles the issue of emotions in investing: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.

John Bogle, the founder of the Vanguard Group once remarked: “If I have learned anything from my 52 years in this marvelous field, it is that, for a given individual or institution, the emotions of investing have destroyed far more potential investment returns than the economics of investing have ever dreamed of destroying.

The old cartoon character Pogo famously commented: “We have met the enemy and he is us. Pogo could well have been describing investors who can be their own worst enemy with emotions betraying sound financial advice and judgement.

Recently, a caller on Talk Radio 702, talking about the suspected pyramid scheme, MMM, said “People should stop commenting from outside, they should come inside first. The problem is that most people don’t understand the ideology of MMM. I am invested in MMM. My mother is also invested. We believe in the ideology of MMM and we get our 30% [return] per month. The “ideology of MMM – talk about emotions!

As a certified financial planner, I believe that one of the most valuable lessons I can impart to investors is making them aware of their emotions when investing. An investor, blind to real dangers of their emotions when investing, would soon be a money-losing investor!

What can investors and financial advisors do?
Emotions turn rational investors into irrational investors. Emotions in investing are the typical downfall for most investors – they can blind them to reality. One of the financial advisers’ key roles is to help investors separate their emotions from reality and steer them on the path of rational investing to avoid emotions jeopardising well developed, diversified long-term financial plans.

Good financial advisers assist individuals in developing financial plans that incorporates investor’s values, needs, and wants in order to reach their goals.

One of the things investors should strive for is those in times of tough financial conditions and market turbulence; reason, discipline, and objectivity triumphs over emotions. Financial advisers can help investors, especially those new to investing, deal effectively with their emotions by making them aware of the emotions they are likely to experience.

Examples of common investing emotions that lead to mistakes
Euphoria – The delight of asset prices going up day after day or getting 30% per month from MMM makes success seem self-perpetuating.

Fear – When an ugly day (or week or month) brings falling market prices, an investor can be tempted to sell everything and “go to cash, missing an opportunity as the market rebounds.

Overconfidence – In a rising market, an investor may believe his or her own superior abilities are causing the gains. It is easy to ignore warning signs or the need for caution. This is so true even for “investment'' like 'MMM'.

Denial – An investor watching an asset drop in price may be reluctant to sell and recognize a loss. Selling a depreciated asset goes against an emotional tendency not to admit failure.

Greed – In any market, the allure of “more'' can entice an investor like seeking only more growth in a share without the related risk or more ’30 percents’ from 'MMM' without thinking about the consequences of less people joining the scheme in future.

Ben Graham, the father of value investing, once warned, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.

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