Beating the Investment Roller Coaster
As investors and traders, at times we are often our own worst enemy. Almost everyone, even the greats, will concede that investing can be an emotional rollercoaster. Many of these greats have also come to the understanding that containing emotions is critical to success.
Investing: The Emotional Rollercoaster – Got the T-Shirt?
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In behavioral finance, it’s been said that 80% of investing is psychological. And, a lot of work has been done to understand the cognitive biases that lead investors to act irrationally and in self-destructive ways (there’s a bias called Get-Evenitis). Let’s look at a few, shall we? If we can understand some of these, we might be able to avoid or contain them.
Confirmation Bias – Think Clearly
“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham
In simple terms, it’s wishful thinking. Confirmation bias is the tendency to interpret new information only to reinforce existing beliefs – often at the expense of missing new insights.
This hampers our ability to be honest with ourselves, especially when the evidence clearly says we’re wrong. The solution is to strive to get perspective. To this point, Ned Davis, another successful investor and market analyst, titled his popular book “Being Right or Making Money”. Which sounds better?
Herd Instinct – Think Differently
“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” – Warren Buffett
It can often feel better doing what everyone else is doing. Afterall, how can they all be wrong? It’s not always irrational. But at the same time, herding has been attributed to the cause of manias and bubbles.
Taking time to remove oneself from news and opinions can allow for perspective and to see if the environment is extreme. Buffett puts it this way, “Be fearful when others are greedy and greedy when others are fearful”.
Overconfidence – Humility Is Crucial
“Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.” – Carl Richards
Overconfidence is when we overestimate our own abilities. It’s seen the most when the markets are on the rise, after a series of great trades or correct calls. The idea is that you’ve “got it”. Don’t let the sweet taste of success cloud judgement! Failing to do further research or overextending oneself can lead to big losses.
Overconfidence can take our minds off making solid decisions and managing risk. Sure, markets can trend much longer than we anticipate, but we must be prepared for when things inevitably change.
Favorite Longshot Bias – Boring Is Good
“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” – Jason Zweig
Favorite Longshot Bias is about favoring situations where the odds are stacked against us, but if we could win, it would be big time. The excitement of winning big is so appealing it distracts from making more realistic decisions.
Greed is tough to deal with because we humans have an ingrained desire pushing us to do better. Better is great as long as it’s in-fact better. “Pigs get slaughtered” is a saying on Wall Street that sums up those who let greed get the best of them.
Successful investors are often quoted using the word “boring” in describing their process for making consistently good decisions. If boring leads to successful investing — bring it on!
Anchoring – Don’t Dwell On The Past
“View anything that has happened up to the present point in time as history. Care about what you’re going to do from the next moment on.” – Paul Tudor Jones
Anchoring Bias is simply sticking to an original reference point. It leads to making decisions based on the past only.
So how can this play out? If an investor buys a stock and it immediately goes down, they may not sell it according to plan. Instead, they wait until it gets back to break even and then sell. They have anchored a decision on the initial price. It can also cause hesitation, for example making it hard to buy a stock that has been going up.
Objective research fosters rational decisions. To be objective, it’s best not to focus on the past.
Disposition Effect – Resolve, Consistency & The Big Picture
“In investing, what is comfortable is rarely profitable.” – Robert Arnott
Turning a paper profit into real profits makes us happy, but we shy away from turning a paper loss into a real loss. Selling winners for small profits and letting losers become large can be a recipe for disaster.
Sticking to a predefined strategy helps me immensely with this one. First, if you don’t have a strategy, do some research and find one that works for you. Know the reason for buying and under what circumstances to sell.
Feel the urge to sell? Review the process before taking action. Has the reason to sell happened? If not, review your decision. Be systematic about it.
I Am My Own Solution
“By failing to prepare, you are preparing to fail.” – Benjamin Franklin
Investing often involves making decisions under stress. However—with a well-outlined plan—those decisions can be made more easily. By providing the opportunity to slow down and act with a clearer head, emotional fallout can be reduced. Paul Tudor Jones sums it up best, “The better you can make decisions ahead of time, the better your results will be”.
Carson Dahlberg, CMT
Author & Co-founder of Northington Dahlberg Research
Carson comes to Optuma bringing nearly 20 years of experience in the financial markets involved in technical and quantitative trading, research and education. Carson has worked for several notable firms: Morgan Stanley, Wachovia Securities, Wells Fargo, and Schaeffer’s Investment Research. In addition, he is the co-founder of Northington Dahlberg Research, a quantitative driven, volatility-based research firm, and was the Director of the CMTinstitute (an online program to assist financial professionals in the passing of the CMT examination process).
Carson is presently a Director at Large on the Board of the Market Technicians Association and serves the Market Technicians Association (MTA) in various capacities. He was the founder and first Chapter Chair of the Charlotte Chapter for the MTA. His involvement with being the Committee Chair for the Ethics Committee has led to an updated and globally relevant ethics offering for the designation. In the past, he has served on the Admissions Committee, was the Board Liaison for the Journal of Technical Analysis Committee, and was the Director of the CMTinstitute.
Carson received a degree in Chemistry from the University of Cincinnati and was awarded the Chartered Market Technician designation in January of 2008.