Making Money with your Mindset
When it comes to investing, the study of what makes us tick is fascinating. While our industry is generally perceived to be one dominated by hard numbers and solid data, it is especially true and interesting that our mind plays such a strong role in investing. When it comes to investment decisions our behavior is often erratic and contradictory and we make bad decisions for no good reason at all.
What is particularly alarming, and what people need to grasp, is that they are often unaware of their bad decisions. To fully understand the investment markets we must first understand our own irrationalities. This is every bit, and more, valuable than being able to analyze a balance sheet and income statement of a company.
Few aspects of human existence are more emotion-laden than our relationship with money. And the obvious two emotions that drive our decisions are fear and greed. Investors frequently buy or sell into markets at foolish prices, far above or below their intrinsic values. In short, investor emotion has much more to do with the values of the market than do the fundamentals.
Anyone who hopes to participate profitably in the market, therefore, must allow for the impact of emotion. This is a two-sided issue: 1) maintaining control over your own emotions and 2) being alert for those times when other investor’s emotion-driven decisions present you with a golden opportunity.
The combination of economics and psychology is known as behavioral finance. We find there are certain characteristics or temperaments of true and successful investors.
The successful investor is often the person who has achieved a calm, patient and rational temperament. Unsuccessful investors express the opposite temperament. They are anxious, impatient and irrational. Their worst enemy is not the stock market, but themselves. It is possible that they may well have superior abilities in mathematics, finance and accounting, but if they cannot master their own emotions, they are not properly suited to profit from the investment process. These negative characteristics are known as the emotional quicksand of the market.
Successful investors are calm. They know that market prices are influenced by all manners of forces, both reasonable and unreasonable, and will fall as well as rise. That includes investments they own. When that happens, they react with poise. Conversely, true investors also remain calm in the face of what we might call the mob influence. When everyone is on the “can’t miss the party” phase, no one is in a position to profit. True investors do not worry about missing the party; they worry about coming to the party unprepared.
Successful investors are patient. Instead of being swept along in the enthusiasm of the crowd, true investors wait for the right opportunity. They say NO more often than yes. Being able to say no provides a tremendous advantage for an investor.
Successful investors are rational. They approach the market from a base of clear thinking. They are neither excessively pessimistic nor irrationally optimistic. Instead, they are logical and rational.
People habitually tend to dislike markets that are in their best interests and favor those markets that continually put them at a disadvantage. They feel optimistic when market prices are rising and pessimistic when prices are going down. That means they typically sell at low prices and buy at high prices which is exactly the opposite of what we are taught to do.
Undue optimism rears its head when investors carelessly assume that somehow fate will smile on them and their stock choice will be the one in a hundred that really takes off. It is especially prevalent in bull markets, when high expectations are commonplace. Optimists see no need to do the fundamental research and analysis that would bring to light the real long-term winners because the short-term numbers are so seductive.
Undue pessimism, whether directed at one company or the market in general, motivates investors to sell at exactly the wrong time. In other words, true investors are pleased when the rest of the world turns pessimistic, because they see it for what it really is: a perfect time to buy good companies at bargain prices. Pessimism is the most common cause of low prices. Optimism is the enemy of the rational buyer.
Behavioral Finance is a relatively new field of study but what we are learning is fascinating, as well as exceptionally useful to smart investors. It can be observed that people often make foolish mistakes and illogical assumptions when dealing with their own financial affairs. When it comes to investing, emotions are very real in the sense that they affect people’s behavior and thus ultimately affect market prices.
People tend to overreact to bad news and react slowly to good news. This overemphasis on the short term is called “myopia” which is the term for nearsightedness. Successful investors need a certain kind of temperament.
The road is always bumpy, and knowing the right path to take is often counterintuitive. The stock market’s constant gyrations can be unsettling to investors and make them act and react in irrational ways. You need to be on the lookout for these emotions and be prepared to act sensibly even when your instincts may strongly call for the opposite behavior.
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