Emotional control in investing

As we leave 2022 behind, it’s traditional for many of us to review our performance over the last twelve months. I thoroughly enjoy reading these reviews and as usual there has been a wide spread of results across the board. A small number of investors I follow managed to turn a profit, my 11% loss seems to be about standard, but some investors seem to be down 30, 40 or even 50% for the year. The reporting on these results has been equally variable and this got me thinking about emotional control – particularly detachment – in investing.

So many investors get excited by the potential of investing that they lose their emotional control. They dream of making millions of pounds, 50% annualised returns, and picking the next Amazon. They watch a few videos, open an account, and then think they can be really good in just a few weeks. The problem is that these expectations are totally unrealistic – they lead to overexuberance and elation, poor risk management, and inevitable losses.

When the losses arrive, these same investors then lose confidence. They become paralysed with indecision or even worse, double down on a ‘gambling’ mentality, trying twice as hard to make up their losses. This often compounds bad habits, causing more damage to their portfolio and often creating catastrophic losses from which they never recover.

A huge part of avoiding this cycle is the ability to cultivate – and maintain – emotional control. An investor should neither be elated nor depressed by their profit and loss account and portfolio. They should be viewed for what they are; numbers on a screen and managed as such. They don’t care if you’re happy and they don’t care if you’re sad.

The Importance of Building Emotional Control

I find emotional control to be an essential skill for investing. Feeling elated one day and depressed the next is exhausting, both mentally and physically, and an exhausted investor is a useless investor. Being emotionally detached from your portfolio and individual positions is critical to your ability to perform well.

First of all never give yourself a profit target. I have a percentage target I aim for (15% annualised) but the fact that this in annualised means that in a given year, I have very little concern about my performance – I might overperform my target, I might underperform my target, but I’m tracking my portfolio over decades, not months. This relieves me of pressure trying to force my performance if I’m having a rough year. If I’m having a good year, that’s nice, but if I’m not, I don’t force myself to ‘make up’ the gap.

Relieving myself of this pressure means that when a position moves against me, I can look at it more objectively. What is the underlying company doing? Do I like their strategy and business model? Are they financially robust? How are they positioned in the wider economy? Giving myself time to step back and look at the business is essential – it helps to prevent me from selling strong companies at low prices.

Likewise, if I’m struggling to find opportunities, I have little pressure to ‘force’ myself into companies that I think are overvalued, which have poor fundamentals, or which are suffering from weak price action.

Be Comfortable with Losses

Every investor has lost money on positions – it’s simply an inevitable part of investing. Losing 10 or 15 percent of a holding isn’t the end of the world. Even losing 70 or 80 percent isn’t the end of the world if the holding makes up a small part of the overall portfolio. The problems begin to arise when all your positions are losing 70 or 80%, or when you have a small number of holdings. Effectively, you haven’t committed to building a real portfolio and are instead likely gambling on a highly correlated, low-quality basket of equities.

This gambling mentality is greatly compounded by the ‘need’ to generate a profit target. If you need to make £50,000 a year to pay the bills, your behaviour will be affected by an intense emotional pressure whenever you feel you will miss that target. The larger the sum of money, both objectively and relative to the size of your portfolio, the worse that pressure becomes.

With a £10,000,000 portfolio, you only need a 0.5% return to generate the required profit but with a £100,000 portfolio, you would need to generate a 50% to make that same profit. In the former situation, you would likely feel relatively calm about making the profit you need but in the latter, you would be forced to pursue highly risky, speculative ‘trades’ in the hope of achieving your goal.

The problem for many younger and new investors, of course, is that their portfolios are worth nowhere near £100,000, let alone £10,000,000. This depresses the absolute value of their returns and causes the less patient ones to take on more of a ‘gambling’ mindset.

Don\’t get Greedy

This brings me back to emotional control – greed is just as powerful an emotion as exuberance and can be just as damaging. If you take your £10,000 and compound it at 15% a year for thirty years, you’d end with over £875,000. That’s excluding any additional capital you add to the pot. Of course, achieving that 15% annual return is much harder if you have a few catastrophic losses en-route, losing 50 or 60% of your capital a few times over.

Preventing those catastrophic losses requires discipline. Avoiding loss-making companies is a good start; especially holding a huge basket of them thinking that is ‘spreading your risk’. Diversifying your portfolio across sectors and regions and maintaining that diversification across market cycles. Keeping a cool head when the market is collapsing and not selling out of good companies at depressed prices.

Some of the most frustrating behaviours I see in retail investors are along the ‘panic/obstinacy’ spectrum. When a position moves against a retail investor, I typically either see panic;

  • Constant monitoring of a position/portfolio
  • Regret for making the investment
  • Intense desire to exit the position

or obstinacy

  • Doubling down on research to reiterate thesis for purchase
  • Blaming ‘the market’ for being wrong
  • Refusal to accept the loss by selling down or exiting the position
  • Occasionally even buying more to average down

These behaviours are hugely destructive to the well-being of the portfolio and ironically tend to reinforce the losses that the investor is facing. The refusal to cut their losses enables the position to further weaken, losing more capital, and buying more increases the ‘risk on the table’ by increasing their ownership of a failing position.

The irony is that despite their prevalence in retail investors, these emotions are completely useless in objectively assessing the relative merits of investing in a company and the risk associated with doing so. Instead, an investor should ask themselves;

  1. What specific events relating to this company could be influencing this movement?
  2. What macroeconomic/industry events could be influencing this movement?
  3. What broad market events could be influencing this movement?
  4. Accounting for these events, what do I think the holding is worth?
  5. What is my degree of certainty for that valuation?
  6. How long am I willing to wait to reach that valuation?
  7. What happens if I’m wrong and how will I know?
  8. If I’m wrong, what will happen to my overall portfolio?
  9. Do I have alternative opportunities for my remaining capital that are worth more than this?

None of these questions have a ‘feeling’ aspect to them. A good company has some fundamental characteristics such as growth, profitability, low levels of debt and strong ability to service debt. Many investors make the mistake of investing in ‘story’ stocks which are described as exciting opportunities. Unlike the cold and clinical description of quality, these stocks are often described in glowing terms of revolutionising an industry or transforming a market.

These narratives help stimulate investor’s ‘feelings’ about the company. Instead of assessing the opportunity in clinical, detached terms, the investor ends up becoming emotionally engaged with their holdings and focussing on the wrong things;

  • Potential for positive outcomes from binary events (a vaccine test is successful)
  • Money that could be made if the share multi-bags
  • Perceived popularity of the company
  • PR material produced by brokers and company executives
  • The ‘stress’ of having a paper loss or missing out on a potential gain

Unlike the rational, quantitative focus of the detached investor, the emotional investor then makes decisions based on a combination of false narratives and emotions.

Emotional Control is Critical for Investors

By comparison, I find it easy to keep detached from my companies and from my profit and loss. I don’t really care if I have to take a loss on a position – it happens and as long as it happens less frequently than I take a profit, I’m OK. I don’t ‘love’ companies, I own them. If one doesn’t work out, then I’m willing to let it go. Likewise, when a company is doing well and I’m in profit, I look to protect that profit. It doesn’t bother me if I leave some money on the table and although I do the best I can to maximise my investing profits, it’s an inevitable part of the process than I’ll sell out of some holdings too early.

My review and planning cycle helps keep me emotionally detached by taking me through a repeatable series of steps to assess my holdings. When I come to a decision to sell a holding, I do so based on the facts I have available, rather than my ‘feelings’ about the company. Wasting mental energy getting excited or feeling depressed over a company’s prospects does you no favours as an investor. If you’ve noticed panic/obstinate behaviours in yourself similar to those I’ve set out above, you could do worse things than trying to eliminate them in 2023. Always seek to be always objective about your portfolio and individual holdings.

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