Beware of the Cycle of Market Emotions
It is hard to be a successful investor. No matter how much due diligence and analysis is performed before an investment is made (and, afterwards, while the security is held) mistakes will be made. To think otherwise would be foolhardy. Even if the investment ultimately meets our long-term objectives, there are going to be days when it falls in price. At times an investment may even fall below our cost basis, meaning there will be an unrealized loss.
Part of being a successful investor is realizing that in order to generate gains you have to be willing to suffer losses. Losses are a normal part of a properly functioning market. In fact, according to research at A Wealth of Common Sense, since 1950, there have been only four years – 1954, 1958, 1964 and 1995 – where stocks did not correct by at least 5% at some point during the year. (So far 2015 is on track to be the fifth such year.) If there was no risk of potential (or even real) loss, stocks would not earn a risk premium relative to safer asset classes such as bonds and cash.
As rational beings, we should be able to recognize the risks and withstand the losses associated with the equity markets; however, many investors experience euphoria when the market is performing well and despair when it falls. The rational part of our brain tells us to “buy low and sell high,” but our emotions often encourage us to “buy high and sell low.”
Chart Source: Westcore Funds / Denver Investment Advisers LLC, 1998
Oftentimes, the pain associated with a loss can hurt much more than the joy that comes from an equal-sized gain. This phenomenon can create a problem, particularly for investors who check the value of their portfolios too frequently or get too caught up watching financial television. It can lead to outsized losses and reduce the size of gains. It also can keep individuals from investing in the market. The fear of loss basically keeps some investors out of the market. This fear has caused many individuals to miss the market’s rally over the past several years.
At BWFA, we certainly pay attention to how the stocks held in client portfolios are performing. At the same time, we also have an investment process in place that we apply consistently. This process forces us to document the reason we buy a stock (our investment thesis). As part of our process, we also try to identify the potential risks that come with owning a particular security. In addition, we have specific sell criteria in place that make it easier to decide when to sell a security. At the same time, we aim to maintain an even keel whether a stock goes down unexpectedly or goes up faster and more quickly than we anticipated.
We are more likely to find a potential investment on the list of stocks trading near their 52-week lows than on the list of those trading near their 52-week highs. If we own a stock that is underperforming, we complete additional research and go back to our thesis and check to see if our long-term view still holds.
When investing, it is important to keep your emotions in check. While there is no foolproof method of doing so, understanding why a given security is owned and consistently applying a well-defined process can go a long way.
For more on behavioral investing, readers can also check the following: