The past week has seen some big swings in the market. No doubt some readers felt a bit overwhelmed, maybe even panicked, while others kept their cool. It’s so easy to say we should take the emotion out of investing, but what does that really mean? And how does an investor reliably separate emotion from objectivity? In all the notes over the years, I’ve never written much about the psychology of investing. Luckily I have some help this week.
In his most recent letter, Howard Marks, manager of Oaktree Capital, wrote in depth about the investor mindset. His notes have been making the rounds, and I’ve selected some key excerpts in italics below.
One of the most significant factors keeping investors from reaching appropriate conclusions is their tendency to assess the world with emotionalism rather than objectivity. Their failings take two primary forms: selective perception and skewed interpretation. In other words, sometimes they take note of only positive events and ignore the negative ones, and sometimes the opposite is true. And sometimes they view events in a positive light, and sometimes it’s negative.
The bottom line is that investor psychology rarely gives equal weight to both favourable and unfavourable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment.
According to Marks, investor psychology is the product of two factors. First, what information we choose to observe, and second, how we choose to observe it. Our brains have evolved to make this process feel so automatic – we absorb what’s in front of us and then judge it in an instant. But as investors we need to re-automate the process, slow it down, and realize we have two choices to make. In the same way we can choose to listen to hip hop or classical, we can choose to open up the Financial Times or doomsday blogs like Zero Hedge. Seeking out the source of information is step one. Further, we can choose to take that information, regardless of its source, with reverence or with a grain of salt. Consciously making these choices about perception and interpretation slows down the whole thinking process, but that’s the point. The investor’s goal is to reach a more considered and comprehensive view than his or her peers.
Marks continues in his note:
It’s particularly painful when investors recognize that they know far less than they had thought about how the world works. It’s important to remain moderate as to confidence, but instead it’s usually the case that confidence – like other emotions – swings radically.
This last point is his most important. Even after we realize that we are in control of what we view and how we view it, the final step is to self-assess our own confidence in our view. In other words, understanding what we choose to believe is equally as important as how firmly we choose to believe it. Not only do average investors swing from optimism to pessimism, but they swing from self-confidence to self-doubt. To borrow the words of Kipling, you need to “trust yourself when all men doubt you, but make allowance for their doubting too.”
I’ll be first to admit it’s very hard to overcome our own psychology. Humans are wired to be emotional and that’s just the biology of it. But with a lot of practice, or by keeping an investment journal, or by following a systematic investment approach, there are key areas investors can learn to set themselves apart:
Mindfulness. Consider what information you choose to view, and how you are viewing it. Acceptance of others. Understand that most investors around you are irrational. Build in room for error in their judgement.
Acceptance of yourself. No matter how much research you do, your outlook is biased. Build in room for error in your own judgement.
In the end, your portfolio will thank you for it. Take it from Warren Buffett’s partner Charlie Munger:
It’s kind of fun to sit there and outthink people who are way smarter than you are because you’ve trained yourself to be more objective and more multidisciplinary. Furthermore, there is a lot of money in it, as I can testify from my own personal experience.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.