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Investor Emotion and Behavior

Emotion; a word that brings many images to mind. Some images are quite powerful — fear, greed, love, anger, grief. Some are less so — contentment, resignation, melancholy. It is interesting, yet often difficult, to observe someone else’s true emotions. Yet, it can be even more challenging to assess our own emotions — their causes, motivations, and resulting actions. Self-assessment takes practice and is a never ending process. In investing, this is certainly the case.

It is always important to assess the imbedded emotion in both the market and ourselves. We should at least endeavor to heighten our awareness of the prevailing emotional environment and maintain an even more acute focus on our own feelings. After years of observing sentiment, through both good times and bad, I have learned that the prevailing emotion of the moment can be very overwhelming at both market peaks and troughs, resulting in actions causing significant damage to individual’s financial situations.

How can you avoid the damaging effect of emotional decisions? I have found that maintaining a “forced” contrarian mindset is key. Investors look back on peak or trough events with perfect clarity. However, in the heat of the moment, emotions drive decisions; rational thinking is thrown to the wind. Yielding to these emotional moments leads to poor investment decision making over time. Yes, an emotional decision may be correct for a short period and is even likely to be the prevailing “wisdom” of the time, but it is often detrimental to the long-term outcome. Therefore, a “forced” or purposeful decision to ignore the crowd is essential. I describe this as a “forced” decision because I do not think this comes naturally; our contrarian “muscle” must be worked over time.

It is rare in the depths of a market bottoming process for a client to call saying they are fired up and ready to overweight stocks that are “on sale.” Alternatively, it is easy to get fired up for a 20 percent off holiday sale at our favorite retailer. We will flock to the electronics store or clothing retailer to get in on the “good deal.” However, it is quite a different emotion that grabs us when the market is down 20 percent. I would suggest that we treat a market decline more like a sale at our favorite department store — consider buying a little extra of whatever is “on sale” at the moment.

Of course, the emotion of those around us will warn to do the exact opposite. The “talking heads” on the financial shows will have everybody all lathered up and numerous “experts” and “forecasters” will be claiming all manner of things. Turn off the big screen, step back, and do a little self-assessment and crowd assessment. This is when we must exercise our contrarian muscle and go against the crowd.

This decision will likely result in some internal emotional dissonance for a least a short period of time, because it is impossible to call the exact turning point in the market. We must be prepared up front to deal with this uncertainty when making the contrarian decision. Our resolve will likely be tested before the market finally decides to turn in favor of our decision.

In the above example, I focused on a down market period. However, an up market can have its own set of emotional challenges. The euphoria of those around us will be running high. Our portfolios will be hitting new highs with no signs of an end in the upward trend. Watch out! This is just the time to begin thinking about trimming some gains and pocketing some funds into cash or safer alternatives. Again, exercise that contrarian “muscle” and stick with it despite the dissonance that will inevitably form as the market continues even higher in the short-term.

In short, ignore the crowd, self-assess, exercise that contrarian “muscle”, and resolve to stick out any short-term anxiety caused by going against the prevailing emotion of the broader marketplace.

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