Have you heard of the saying “when emotions are high, intelligent is low?” Everyone understands the logic of the sage investment advice to “buy low and sell high”. But in reality, how many investors really stick with the principle?
How many times have you felt like the stock market has taken you on an emotional roller coaster? Whether the market is performing at all time high or at the depth of its lowest in history, we should never let emotions get in the way of intelligent investing.
There are several notable phases in the emotional cycle of an investor. The first phase starts with optimism as investors hold a positive outlook for the future and anticipate potential gains from their respective investments. This is quickly followed by a period of elation, even outright thrill, as the investment pays off and the investors congratulate themselves for their smart decision. This is the most dangerous investment period since it represents the point of maximum investment risk. It is when investors overlook the negatives and truly believe the market’s value will always go up. On the contrary, the bull market reaches a peak and the market becomes overpriced instead. Investors feel nervous at the sight of falling prices. Fear takes hold as market realities finally set in. At this point, depression may even sink in as the fallen investors take in their failure and the regrettable decisions that contributed to the predicament. As the market gradually picks itself up again, hope returns and investors begin to look out for the next opportunity. Faith is renewed, setting the stage for sentiment to turn optimistic once more.
It is not uncommon that we sometimes let emotions dictate the way we invest. After all, we are only human – we have feelings, attitudes, desires, beliefs, and biases. We come to the investment field with our experiences and varying degrees of ability to manage our emotions. Hence, one of the most common mistakes made by investors, especially successful businessmen in particular, is investing based on their ’gut feeling’.
Take for example, you have been offered a proposal to invest in a prime waterfront property in another country. If you go by what you feel, you may be tempted to invest simply because you like that country. Perhaps you had a wonderful experience on holiday, and the idea of owning a home there is appealing.
If you are going through a phase of optimism about properties, this too may expedite your decisions, without the level of scrutiny you would apply if you were going by a research-based, thought-led process. This is what we call, making investment decisions based on what we feel.
A few years ago, I was approached by a successful businessman named Roy, who ran a construction company.
We started talking about investments and he excitedly shared how almost all his successful investments decisions were made based on his gut feel.
He used three private bankers and on occasion, they would bring him investment proposals.
If he liked a prospect in Japan, he would invest in it. If he felt that Europe would bring good yields, he would put his money there.
He especially enjoyed high-risk ventures, to the point of sometimes investing as much as 20-30% of his considerable investment portfolio into these investments.
Roy enjoyed testing his ability with every investment — he said it gave him a sense of how good his foresight was, and it felt like winning a game.
I could immediately see that he was walking on wafer-thin ice.
I asked Roy whether he had a snapshot of all his investments with the three banks, so that he could immediately see what his overall commitments were.
He said he didn’t need one because even without knowing the big picture, he was still making money.
I suggested that he at least use an asset allocation tool to map out what sort of investments he had, their varying risk levels and the countries they were in.
It was a simple, practical way to track and control his risk exposure. Still, he insisted that he preferred using his own method.
A few months back, I met him again.
In the space of three short months, he had lost 30% of his entire investment portfolio. His private bankers had brought him proposals to invest in some oil & gas shares, which he took up substantially, only to be hit badly by the recent crude oil crisis.
The risk of investing using only his gut suddenly became harshly clear to him.
The take-home points
Emotional investing might mean that you don’t scrutinise as closely as you otherwise would. You may not fully understand the risk of a particular investment, especially when the focus is only on the potential return.
Emotional investing may also lead to investing in silo – focusing only on certain asset classes, which you feel comfortable. This stops you from looking into other sound opportunities, as you are uncertain about other assets.
Finally, the nail in the coffin – putting all the eggs in one basket. Due to sentimental attachment, you may have allocated most of your investments in one country for example. Not only would you have miss out investment opportunities available outside the country, but you would also have failed to diversify the investment risk across several countries.
Managing the emotional factor
As Warren Buffett puts it, “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
It would be best to take a systematic approach when it comes to investing. Use the asset allocation tool as your investment decision-making blueprint. Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an investor’s goals, risk tolerance and time horizon.
Firstly, plan your asset allocation based on different risk levels. This means deciding how many percent of your investment would be in high, moderate or low risk investments.
Next, decide how you will allocate your assets into different assets classes. You will need to decide how much of your money goes into equity, property, bonds, cash or other asset classes.
Finally, monitor and re-balance your investment by using asset allocation. Over time, certain investments in your portfolio will grow and some will shrink. As a result, the percentage of certain investment will not be the same as where you have previously planned. Your 20 per cent Malaysia equity investment may have grown to 35 per cent. However, without rebalancing it back to 20 per cent, you will risk over-exposing your Malaysia equity investment.
It is undeniable that it is very difficult to remain objective especially when emotions are high. Savvy investors get experienced professionals to give them second opinions and objective views, thereby removing the emotional factor.
Therefore, when it comes to investing, it would be best to leave emotions at the door and use “what you think”, instead of “what you feel” approach. Remain objective and you will see the bigger picture much more clearly. Through this, you can build a sound decision-making framework as warranted by Warren Buffett, the most successful investor of all time.
Yap Ming Hui (email@example.com) is a bestselling author, TV personality, columnist and coach on money optimisation. He heads Whitman Independent Advisors, a licensed independent financial advisory firm which has helped people to optimise their wealth and achieve financial freedom since 2000.