3. Love Your Emotions, Don’t Trade Them

“They used to say about the Bourbons that they forgot nothing and they learned nothing, and I’ll say about the Wall Street people, typically, is that they learn nothing, and they forget everything.”

Benjamin Graham, 1976, Financial Analysts Journal

About 30 years ago, a study was undertaken looking at the driving habits of people in Sweden and the United States, and participants were polled specifically on how well they thought of themselves as drivers. More than 80 percent of drivers in the U.S. considered themselves above average. A similar survey taken five years later found a similar conclusion, with four out of five believing their skills exceeded that of the average driver.

A similar dynamic exists in people’s opinions of the U.S. Congress. For years, Congress as an institution has had abysmal ratings, ranging somewhere around a 20 percent approval rate. Yet when election season rolls around, most representatives are elected in a walk, with some facing little more than token opposition. Approval rates of 20 percent would suggest the opposite should occur, but people in general tend to remain more sympathetic to their own representative than the institution as a whole.

This kind of cognitive dissonance—identified as something called illusory superiority—can be viewed in the stock market as well, in the guise of investors who believe that they are superior traders than the average participant in markets. But it isn’t possible for 85 percent of the investing public to be a better-than-average investor; the zero-sum-game nature of the market means that everyone who makes gains is being offset by someone who is losing money. We think we can outsmart the markets, but the ability to do so over an extended period of time is exceedingly rare. This belief drives plenty of decisions in the stock market, particularly in this era of active trading, when share turnover on the New York Stock Exchange surpasses 100 percent (that is, most fund managers don’t hold any one stock for an entire year, turning over the entire portfolio within a 12-month period. And these are the managers supposedly trying to invest your money for the long term; so much for that.)

The generalized attitude we have—that we, somehow, will be able to avoid the pitfalls that so many other individuals fall into on a daily basis—is what helps produce volatility and allows savvier types to capitalize on the mistakes made by individuals, which are usually borne of emotion.

Most market professionals with only a modicum of understanding of behavioral science would tell you to “ignore your emotions.” But only computers and robots can do that, and computers gave us Long-Term Capital Management and excessive algorithmic trading that helped merely bad days turn into cascading losses in the summer and fall of 2008. Program trading, particularly high-frequency traders, were what gave us the “flash crash” in May of 2010, when major stocks briefly were quoted at a penny a share and the market lost 9 percent of its value in a matter of minutes. Excessive reactions to emotions can be killers for individual investors, but a person cannot divorce himself from his emotions entirely—sometimes they are sending out strong signals that it is indeed time to change course.

“You’re constantly sitting in front of a screen having [the market] declare whether you’re smart or not,” says Denise Shull, president of Trader Psyches, a consulting firm that helps investors understand their emotional reactions and how they can use them, rather than try to pretend they don’t exist. “The market goes right to our core of feeling good about ourselves or about our futures rather than not feeling good about ourselves or the futures...it does this in a way that nobody else does.”¹

The emotional, or gut-level responses that we have to developing situations in the market manifest themselves in a few basic, repeated mistakes. Among them:

• People hold onto their losers and sell their winners, rather than doing the opposite, as they should.

• Investors buy into sectors that have been performing well for a long period of time and carry a certain cachet, rather than ignoring such overvalued investments.

• People ignore their first, and best, instincts when it comes to a failing investment, Shull says, and only react when the weight of doing nothing becomes so loathsome that it starts to make them feel sick.

Market Meltdowns and Mental Breakdowns

The good news is that most of these emotional responses to developments in the market can be fought through a disciplined approach to investing that allows for little deviation. This is why professionals refer to a “sell discipline,” because it implies a regimented set of rules that cannot be ignored. Individuals often lack this, and so they go with mantras that have been absorbed that are not practiced, such as the much-discussed “buy for the long term” aphorism. Long-term investing is a fine approach, but only if an investor is willing to hold firm, rather than react to the short-term vagaries of what is happening in the equity market.

A number of people I spoke to in recent months talked of their experiences leading to the meltdown in the markets in late 2008. Some of them were smart enough to see problems developing earlier in the year, a few months after the market peaked in October 2007. They thought about selling shares, but elected not to, and often their original instinct was countermanded with a phone call to a trusted advisor (a brokerage representative or independent advisor) who counseled against making such a move because markets “tend to always come back.” While markets do, eventually, come back, it can help to avoid such bear markets if at all possible, even if one sets high bars to clear when deciding whether to sell or not: say, losses of 20 percent. Set a rule for yourself that when you are down 20 percent, you sell. Even that would have saved many an investor’s hide in the nasty, protracted bear market of 2007-2008. If individuals had put such a rule in place, they would have cut their losses because they would have had to follow it. They didn’t—so any explanation that seemed plausible (the subprime problems will be “contained,” the banking system isn’t going to melt down)—was enough to assuage many people, including those of you who wanted to believe things would be okay if you didn’t do anything.

However, the primary word from investment advisors did not tend to suggest lightening up on holdings to reflect a client’s concern. Instead, they were told, more or less, not to worry about it, because markets will rebound eventually. But of course you should worry about it! It’s your money! Just as the advisor is worried about his wellbeing (which involves keeping as much of your assets as possible), so should you be worried about your position, too.

And here we come to another part of the deprogramming process: Understanding when to trust your own emotions, for one, and to reject investment advice that a broker’s parrot could have memorized and repeated to you, ad nauseam. For many people, the very idea of losing money is anathema—so when you’re confronted with the fact that your portfolio is staring you in the face, with 20 percent losses across the board, you want to believe that these losses aren’t real. You tell yourself the losses didn’t really happen because you didn’t sell your stocks, and therefore they’re just “paper” losses. (Do people feel this way about gains? Of course not. Gains are always tangible; losses don’t count, sort of like how people rationalize going off their diets by saying the cookies they’re eating don’t count because they’re not sitting down at a table to eat them, or some other silly notion.)

Invariably many of these investors ended up selling, getting out of their portfolio at the worst possible time—when their emotional state was most frayed, and when they had become completely divorced from the reality of the market. By this time, their response to the advisor is probably one of visceral hatred—and they’re getting out of stocks to save their hide and stick it to the jerk who didn’t have any real insight despite having an education in these matters. It’s those times that professional money managers (good ones, anyway) scoop up what they regard as undervalued stock. And now, unlike before, when your losses were on paper, those 30 or 40 percent losses are real, and they could have been minimized.

Certain psychological responses to certain developments are understandable. People don’t like to lose money, and they particularly don’t like to lose money that they believed, based on a paper statement of stock holdings, was rightfully theirs, even though those profits were ephemeral. “When you have a paper profit but then you’ve lost that profit, that is a harder fear for people to handle than [simply] losing money,” says Trader Psyches President Denise Shull. Essentially, investors are more willing to accept or rationalize an investing loss if it never made money—a stock purchased at $20 that then falls off to $5 before the investor sells it produces a less psychologically traumatic response than the stock that goes from $20 to $50 and then back to $5. That’s because the latter scenario introduces regret, and Shull says the fear of regret is stronger than the fear of losing money.

The way such situations play out manifest themselves in the aftermath of bear markets, particularly bear markets in a particular sector that has been hit harder than the rest. The Nasdaq Stock Market rocketed to an all-time high in March 2000 before succumbing and losing more than 75 percent of its value, but in the period before the index finally hit bottom in 2003, there were a series of short rallies that boosted that index by 10 to 20 percent but were ultimately done in by further selling pressure. But some of the thinking behind the rallies following the great tech wreck came about as investors tried to rationalize earlier losses and convince themselves using a fallacy that a once-high stock price is a benchmark that can be referenced further down the road. (Often these rallies were built on the losses of others—a 2004 research report points out that investors tend to shy away from repurchasing stocks that they have lost money in. However, investors also tend to gravitate to “the subset of stocks that catch their attention,”² and that generally includes those stocks that are in the news.

As a result, people who have been involved heavily in buying and selling the technology sector might have continued to buy in that area, but instead of buying a money-losing JDS Uniphase they moved on to Juniper Networks or some other “related” stock because it was cheap. Once-strong stocks that collapsed bounced back for a time as investors decided to jump back in, but the gains didn’t hold. That’s the case for large-cap tech such as Microsoft, which is treading water years after hitting a peak, and smaller names like Broadcom or JDS Uniphase, which are still nowhere near their previously lofty heights.

“Getevenitis” Disease

There are a great many hackneyed clichés spoken in the market—within them, there are a few truths. One that many investors cling to, at least in their mind, is this: “Let your winners run, and sell your losers.” It’s a time-honored tool of portfolio management, but most investors screw this up, and end up doing the opposite—selling their winners and hanging onto the losers. “People treat losses differently than they treat gains,” says hedge fund manager Eric Crittenden. “We’re hard-wired to crave positive feedback, so we like to book gains. But we’re willing to be optimistic when sitting on losses.”³ This, he says, comes as a result of investors’ belief in their own judgment: If a company is a strong company, has good fundamentals and solid earnings, consistent, steady losses in the stock serve as a challenge to one’s intellect. “When we get a gain, we’re allowed to crow about its success and it is proof we were right,” he says, but losses create an opposite effect. Since investors believe that they have not been proven correct or incorrect until the actual sale of shares is made (just as paper gains are just that, so are paper losses, as the rationalization goes), they can continue to believe their theories will come out ahead in the market. Barry Ritholtz, the author of Bailout Nation and chief investment officer at Fusion IQ, has the perfect rejoinder to this thinking: “Do you want to be right, or do you want to make money?”⁴

Unfortunately, investors are at times psychologically more inclined toward being right. Berkeley professor Terrence Odean found this to be the case more than ten years ago, finding that people tend to sell winners and buy stocks that have been performing less well. Instead of selling winners and pocketing the cash, they sell and buy...worse stocks! But those who held onto their winners instead of buying past losers exceeded the market average by 2.4 percentage points, and bested the losers by 3.4 percentage points. The motivations for doing so relate in part to an aversion to paying taxes by selling winners (gains not yet realized aren’t taxed).⁵

Still, investors are predisposed to hold onto losers—what’s called the disposition effect, which was coined in 1985 by Meir Statman and Hersh Shefrin when they began applying behavioral science to the stock market. They found that investors go through a series of mental calculations when it comes to buying and selling shares that leads them to make the wrong move—letting losers ride—instead of selling them when they should. Why would they do this? Because there’s always the possibility that the stock rebounds, and if it does, an investor can “just break even,” or perhaps recoup a bit of a purchase with a profit. However, there’s also the chance that the stock can go lower, but in these cases, researchers have found that investors, when given the choice of letting it ride or accepting the smaller loss, tend to let it ride.

There’s a term for this: “getevenitis disease,” or get even-itis, coined by author and investment strategist LeRoy Gross, and he noted that this disease “has probably wrought more destruction on investment portfolios than anything else.” While investors wait around for the stock in question to recover its original loss, the stock continues to drop—witness the slow destruction of investor capital in shares of General Motors, Citigroup, Nortel Networks, and scores of other companies that steadily deteriorated even though some held out hope that there would be a recovery.

Sometimes this aversion to loss—and the willingness to gamble further to avoid those losses—has devastating results, and not just for individual investing accounts. One of the most famous examples in recent years was in 1995, when derivatives trader Nick Leeson caused his employer, Barings Bank, to go bust as a result.

Leeson originally was profiting as a result of unauthorized trading in derivatives, but over time, he started losing money. He started to hide those trades, and instead of realizing those losses by selling—and admitting them to his employer—he made a series of even more complicated bets to try to recover his losses. Perhaps he was suffering from “getevenitis” himself. He eventually fled his home base of Singapore in February 1995, and Barings was declared insolvent a few days later. He was arrested a few weeks later, and his losses came to $1.4 billion. His comments, however, illustrate the disposition effect perfectly, as he said he “gambled on the stock market to reverse his mistakes and save the bank.”

When it comes to actualizing losses, that is, selling shares at a loss, regret enters into the equation also: Just as a stock that’s held in one’s portfolio that carries a loss is not actualized until you go ahead and sell it, there’s regret to making that decision—and not making an active choice to sell the stock at a gain or loss keeps people from feeling that regret. (When someone sells a stock at a loss they open themselves to the possibility of regret if the stock should rebound; when someone sells a stock for a gain, and then sees the stock go further, they are likely to repurchase it, in part because of regret of not having continued to hold the shares.) But here’s the thing: Choosing not to decide still constitutes a choice, and if you think you can avoid regret by not actually making a sale, you’ll feel differently if that asset you own falls by 30 percent out of nowhere.

By now you’re probably admitting to having committed such an act at some point in the past: It’s those moments when you say, “If only I hadn’t sold that stock then,” or “If only I’d bought the shares when I thought about it.” I’m not trying to be a behavioral coach, but the process of investment is too complex and involves too many factors to allow regrets to dominate one’s thinking. Instead, one needs to understand that such feelings are going to crop up in the course of buying certain funds or using a certain allocation strategy, and discipline can help reduce the risks of depending too much on emotion. But those emotions cannot be ignored: In fact, they are in some ways even more important to the decision of purchases, Shull argues. “Let’s say you’ve invested in something that’s gone up, and then it has pulled back,” she says. “It could be that the fundamental situation has changed, and it could just be a good time to cut your losses. If people just were able to become aware of their feelings around that, it would save a lot of people a lot in their retirement accounts.”

There are ways to get around this. Although this book does not advocate buying individual equities, it does advocate buying asset classes, funds, and possibly sectors. Those who seek to take a more active approach—that is, beyond just rebalancing yearly through an automatic selection (if your 401k plan has this)—should seek to step back and justify their purchases. If they’re sticking to a disciplined asset allocation (60-40 or what-have-you), the discipline should be maintained instead of changing your guidelines to take advantage of a new opportunity.

Longtime Fidelity manager Peter Lynch advocated recording his thoughts on different companies, keeping notebooks that contained information on holdings. Hedge fund manager Julian Robertson reportedly quizzed associates in the hallways as to why they were buying a particular stock. Can your purchases be justified? If not, why not?

Fred Dickson, longtime market strategist at D. A. Davidson & Co., in Lake Oswego, Oregon, says individual investors often enter the markets with what seem like reasonable strategies, but are too quick to abandon them as things get difficult. “I think individual investors tend to come into the market intrigued by owning individual stocks and they have a basis of discipline for buying, and it’ll work for a while,” he says. “They lose the discipline along the way and when mistakes start happening, they abandon a sound strategy.”⁶ The inability to cope with making mistakes is compounded in a volatile market, especially after investors spent years living in a world where stocks didn’t go down all that much, and the daily to-and-fro of stocks was easy to deal with. The last ten years have been very difficult for all of us, and giving yourself a few rules to work with will help you deal with those inevitable moments where you’re frightened beyond belief.

Following the Herd

The herd mentality often spoken about in markets also revolves largely around regret or rather, the expectation of regret. Bubbles are borne out of this behavior. It’s true that without a real investment behind it (okay, maybe not in the case of Pets.com), investors won’t be expected to jump on board a speculative idea. But the idea that one has missed out on something is a powerful motivator for individuals, mutual fund companies, institutions, and large corporations as well: Many a mistake made during the massive financial crisis, the thing that doomed a particular institution, was a bet on a particular subset of the company’s business that had previously only accounted for part of the business, but suddenly looked attractive, in part because other investors were making a mint in a particular area. Washington Mutual became one of the biggest victims of the subprime mortgage lending crisis in part because the company decided to increase its exposure in 2007, when the tide was already turning for this troubled sector of the housing market.

The effects can often be more dangerous for the company that gets into an area with even less expertise (WaMu was already a large mortgage company in its own right). Merrill Lynch & Co., the gigantic retail brokerage, elected to get into the subprime industry in late 2006, buying the First Franklin mortgage origination business from National City Bank of Cleveland for $1.3 billion. First Franklin was founded in 1981 and in 1994, decided to start serving the “nonprime” market, that is, those buyers who had poorer credit ratings and therefore, a greater chance of defaulting on their mortgages. Eventually National City bought the company, and the purchase helped National City become the sixth-largest mortgage originator by 2003.

Merrill Lynch came into the picture in 2006. They bought the business for $1.3 billion even though, as an article on MarketWatch.com noted, subprime loans had “become riskier as the housing market has begun falling faster than expected and as defaults have started rising.” They noted that David Daberko, National City’s CEO, had warned at a conference a few weeks prior to the Merrill announcement in September that “he had seen a marked increase in first-payment defaults on loans.” One year later, the purchase was in tatters, and the horrendous purchase was part of what crippled Merrill Lynch, which brokered a deal to be sold to Bank of America Inc. on the fateful weekend in mid-September 2008 when Lehman Brothers went bankrupt and American International Group became a ward of the state. Merrill made a number of stupid decisions during the financial crisis, but their ownership of terrible mortgages originated by First Franklin, and additionally, the ownership of loan obligations created from a pool of subprime loans, was a big part of what doomed the franchise.

So it’s not just individuals that make bad decisions based on the madness of others in the crowd—big-time moneymakers do the same, which should call into question their ability to provide wise counsel to you in your financial decisions. Still, individuals remain among the worst offenders when it comes to latching onto a rally that has by then run its course. Data from the Investment Company Institute shows individuals continued to buy heavily into equity funds well into 2007, only beating a hasty retreat in late 2008 when the market melted down. (The two worst months for outflows were in September and October 2008, which of course turned out to be reasonably solid buying opportunities.) “People have a fear of missing out—that’s really the fear of regret in the future, and that’s really the fear behind bubbles,” Shull says. Investors buy Google “because everyone else is buying Google, and that keeps working until the last person buys Google.”

One of the more memorable examples of this mentality took place at the end of the previous decade. This was the time period when all investors wanted were technology and Internet-related stocks, and the mutual fund industry adeptly decided to capitalize on it. Investors flocked to the Munder NetNet Fund, a popular fund offering exposure to Internet stocks. This fund ballooned in size amid stellar performance thanks to the dot-com bubble. The fund posted returns of about 175 percent in 1999 and soon had more than $11 billion in assets by the spring of the next year—just as the market peaked. It then lost a ton in the next few years, losing 54 percent in 2000, 48 percent in 2001, and 45 percent in 2002. Since its inception in August 1996, the shares have returned an average 7.66 percent annualized, while the class C shares (which have a different expense ratio) have averaged just a 1.27 percent gain since inception in November 1998—even closer to the top of the bubble.

The fund underwent a pair of name changes, first to the Munder Internet Fund and then to the Munder Growth Opportunities Fund, no doubt trying to outrun its history. And even more recently fund executives talk of the misunderstanding that investors have when it comes to Munder, and how clients continued to complain about the fund as the management company tried to find more investors. But this goes back to investors’ general aversion to that which has burned them in the past: When investors have lost substantial assets as a result of a poor investment, they become reluctant to buy the same investment again.

What, overall, does all of this have to do with a book that’s counseling people to avoid individual shares in the first place? Much. For one, this book is not just about staying away from single stocks. It’s also about avoiding the temptation to follow the rest of the crowd headlong into an investment because it happens to capture the public interest at any one given moment. Eventually decisions will have to be made by one or a married couple to shift assets from one investment class to another, or markets will start to undergo a series of stomach-churning dives or euphoric rebounds, and that’s going to entice people to want to buy. They’ll convince themselves that it’s time to get back into getting individual shares, under the notion that perhaps you weren’t all that ready to do this last time, or you’ve become smarter somehow.

Some will call this greed, but in reality, this isn’t greed—it’s just more fear masked as greed. It is fear that you will be “losing” by not winning, that you will fall behind others as the market goes off to the races. It’s fear that you will miss out on opportunities in suddenly hot markets away from stocks, such as commodities or emerging markets—goaded by advertisers, financial experts, and cheerleading members of the media promoting this notion. But rallies can be participated in with much less risk than that of buying individual shares, at less of a cost, in a way that will salvage one’s peace of mind.

Much of this may seem touchy-feely, but there’s a good basis for understanding your emotions. But you need a few concrete ideas to help you get through the day without making decisions that deviate from your stated goals. Here are a few ideas, expressed very briefly:

1. Establish a level that will serve as the absolute low for a speculative investment you own. Obviously we’re trying to limit trading costs, so you don’t want to have it triggered too easily. A 15 percent sell-off in a particular asset should be enough of a move to convince you that it’s time to sell your holdings and move to a cashlike asset until the market rebounds.
2. Don’t buy any investment product that hasn’t been in existence for at least a year. Really, you need an even longer track record for an investment to be worth anything, but let’s start with this much. (If we were buying individual shares, that would be one thing; but new products can quickly become oversaturated with investors having already driven prices to unsustainable levels. Or, they’ll prove to be illiquid investments.)
3. Is the asset in question up 300 percent in the last year or some other unfathomable amount? Are you buying it because you believe everyone else is buying it and you’re seeing it go straight up, like the Munder NetNet Fund? If the answer is yes, ignore it. Stay way far away. Don’t tell me about all of the amazing gains you’re missing out on—you’ve already missed the easiest gains, so don’t bother now. The only prices that matter are where you buy it and where you sell it—not where it was when your neighbor bought it, etc.
4. Do you own some asset—be it a fund, emerging market ETF, or commodity—that has doubled in a year’s time? Sell it, now—at least part of it. You’ll feel better for having gotten some gains, and won’t feel exposed if things take a bad turn. If it still goes up, that’s fine—you still own it, and it’s helping your portfolio still.

Those ideas aren’t set in stone. They’re kind of crude, to be perfectly honest, and may not come close to fitting your needs. But there’s a need to get comfortable with something other than inertia—the idea that you should sit tight just because things are going well, or that you should hold on because of some perceived expectation that the market is going to rebound at some point. That’s myopic, and in markets like what we’ve seen and what we’re expected to see, potentially very dangerous. Just because you fail to make an active decision to buy or sell an individual holding in your portfolio does not mean you have not made a choice—you have made a choice, even if it is a passive one. To get truly secure with the idea that you’re perfectly free to sell your holdings if you’re not happy with them, it’s going to take a bit more deconstruction of popular myths that have become pervasive in the last few decades. The primary tropes are the ones that say any investor can beat the market through buying individual stocks, and that the stock market, no matter what, is such a powerful force of good that it will eventually deliver the kind of strong returns that you are somehow entitled to even if you simply let it all ride.

As we shall see, this is not exactly the case.

Boiling It Down

• Beware of inertia. When you do nothing, you are making a choice—a passive choice. It may hurt more emotionally to sell an investment and watch it run higher, but it’s worse to hold onto something as it goes into the tank.

• Be ready to sell assets that aren’t performing. There’s nothing heroic about holding onto losers. Forget about trying to break even.

• Have a sell discipline. Establish a level that will serve as the absolute low for a speculative investment, and if it falls through that, get rid of it.

• Don’t buy any investment product that hasn’t established a track record.

• Have you gotten a windfall from an investment that’s gained something ridiculous like 300 percent in a year? Good. Sell it. Yes, you’ll have to pay taxes. That’s better than losing money.

• If you’re considering a purchase of something that’s up 300 percent that you don’t own, stay away. Resist the temptation to follow the crowd.

Endnotes

¹ Author interview.

² Brad Barber, Terrance Odean, and Michal Strahilevitz, “Once Burned, Twice Shy: Naïve Learning, Counterfactuals, and the Repurchase of Stocks Previously Sold,” Working Paper, March 2004.

³ Author interview.

⁴ Author interview.

⁵ Terrance Odean, “Are Investors Reluctant to Realize their Losses?,” The Journal of Finance, Vol. LIII, No. 5, October 1998.

⁶ Author interview.