Monday, September 22, 2008

Market Tremors Series - Emotions


This is #4 in the Market Tremors series.

Previously, I stated that few retail investors ask and answer the right questions before portfolio construction, with the result that they panic during both bear and bull markets. This panic, whether due to significant market decline or portfolio lag, is the cause of most market underperformance.

I suggest that all investors need to ask and answer these five questions, in order to outperform the market:

1. Process;
2. Rationale;
3. Emotions;
4. Holdings;
5. Market Exposure

Today, we are looking at Emotions, through the lens of my own recent portfolio reconstitution. Here’s how I define Emotions:

What is my emotional readiness to handle declines or lags in my portfolio, without changing strategies?

Of all the questions, this is the one that is most problematic for retail investors in particular, especially self-directed ones. That’s because there are so many sources for emotions to arise from, and everyone has a different risk tolerance and also because so few people work through questions like these. With rationale thought, chosen at a time of low stress, comes a better ability to handle the inevitable marketplace ups and downs.

Having said that, there are some sources of emotional distress that you can actively “turn off”. Firstly, we are bombarded today by news – including business news. The anchors and talking heads act as if its’ all meaningful to your portfolio.

Most of it isn’t. It’s mental plaque that’s tough to get rid of. Here are a few suggestions for doing so:

Unless you are actively seeking to reposition your portfolio, shut off or restrict your business news intake. You have to view it like an addition – one that’s likely harming your financial health. If you are repositioning your portfolio, fine, intake that news, collect information for awhile, then shut if off again, and STUDY and THINK about what this means.

As a corollary to that, you also need to stop checking your portfolio every day, or even every week. Generations ago, the saying was “A watched pot never boils” and this still speaks to the impatience of people, when their expectation of the speed of the anticipated change is unreasonable. Just like in the movie “Hitch”, your equities portfolio needs time to percolate.

“Hang on”, you say – “How will I know what’s going on with my stocks/portfolio?”

That’s the point – you won’t – AND you’ll stop thinking that each day or week is meaningful in the life cycle of a business or the stock market. It’s not.

If you’re worried you’ll miss some opportunities to buy, sell or reposition your portfolio, then do this instead: set up email “alerts” when your current or desired stock or ETF hits a certain price (buy or sell signals), and/or for earnings announcements. You really don’t need to be more in the loop than that.

If you don’t believe that, then think about this: with all the changes and gyrations in the Dow Jones Industrial Index in the past 50 years, an investor would have been better off to simply have held those stocks in the Dow of 50 years ago, including all spin-offs and buy-outs, than to have followed the Dow in its reconstituted form. And if that’s the case for a relatively slow changing index, then what do you think the odds are that you can outperform the market with all your shifty moves and break-dances?

In order to break the “watched pot” habit, buy yourself some sort of treat as a reward if you limit yourself to checking your portfolio and stocks just once a month, or better yet, just once a quarter. I can almost guarantee you that treat will easily pay for itself, and the addiction will have been broken!

One other antidote to emotions is to think about how much time you’ll be actively “in the market”. If you perceive that as less than ten years, it’s understandable you worry with every belch and burp of the market. Maybe you shouldn’t be in market at all. You need to consider this.

However, if your time frame is more reasonable, like 10 to 20 years, then print yourself up one of those long-term stock charts and eyeball it every time you’re tempted to trade because the markets’ aren’t moving your way.

The other thing you need to consider is the rationale and holdings within your portfolio; how those stylist leanings might affect your returns in a bear and bull market. For instance, if you invest exclusively in micro-cap stocks, and portfolio is down 45% when the market is “only” down 27% (and all your friends are complaining about that), how will you react? Can you really be at peace with this? Are you prepared to hold those positions (or similar) long enough to capture the returns available as an asset class over the business cycle? Or will you bail at the bottom?

Similarly, whenever the next bull starts, there’ll inevitably be one sector or stylist leaning that’ll crush returns in other asset styles. If you see yourself as a value investor, will you long to be part of that crowd, and inevitably give in, just as the sector is screaming towards its pinnacle? You really need to truly face your mental and emotional aptitude to handle a particular portfolio style. You must adapt that style if necessary to reflect something you can handle over an entire business and market cycle.

Finally, going through a process like this (all five steps), including providing a clear and cogent synopsis of your rationale and the key attributes of your holdings anywhere near your computer, should help stop you from trading indiscriminately. In other words, it will help you to control your emotions at tough times in the market – when the market is falling, or when your portfolio is lagging market averages.

The next installment in this series will be “Holdings”, which will be published on Thursday.


The Confused Capitalist

No comments: