Investing and Emotion
❝The investor's chief problem - and even his own worst enemy - is likely to be himself.❞ -Benjamin Graham
I’m out on a walk with my dog Bingo. We generally walk in areas where she doesn't have to be on a leash, and today is no different. As I walk in a straight line, Bingo spends her time exploring. She lags behind for a while before running up in front of me to see what's ahead. She spends some time over to the left looking for critters and then heads off to the right side to investigate what other dogs have been here.
We are heading to the same place, of course, but we take a different path to get there. I walk in more or less a straight line to complete the loop that we are on. Bingo walks more than twice as far as I do once you account for all the zigging and zagging that she does. Ultimately, though, we finish the loop at the same time and in the same place.
If, at the start of our walk, you wanted to know where we were heading, the smart play would be to focus on where I'm going. The path I'm on is quite predictable. Trying to figure out where we are going by tracking Bingo's path wouldn't be very helpful to you.
Imagine, though, you were broadcasting my walk to the public and wanted to make it more exciting. Your show would focus on Bingo. You would focus on where Bingo has been, where she is now, and have a team of experts try to predict where she will go next. Doing this might help you sell some ads, but it does nothing to predict where Bingo will go. Bingo's path is noise, while my path is the signal.
Such is the case with investing. Shows would be pretty boring if they focused on the signal. Focusing on the noise manipulates your emotions, and by having your emotions manipulated, you're more likely to tune in again. But it's not good for you.
INVESTING AND SPECULATING
It's important to differentiate between investing and speculating. Investing is for the long run. When you invest, you put money aside to be there for you a long time from now. You make no predictions about the direction of the prices of your investments. You make no predictions about when to get in or out of your investments.
By contrast, speculating is trying to move in and out of your investments at the appropriate time by making predictions about the future.
This distinction is worth noting. The future is both unknown and unknowable. Speculating, if done at all, should only be done for entertainment.
The media encourage us to speculate because they sell noise. By selling noise, they can induce fear - both the fear of losing money and the fear of missing out (FOMO). By speculating, we increase our chance of experiencing guilt if we risked money that we couldn't afford to lose. If we do that consistently, we can induce shame in ourselves. All of these emotions are tied to envy if we have to watch our friends and people we follow on social media get lucky by speculating, making it seem like it was easy and we should have done it (keep in mind that you don't see the friends that lost their money posting on social media).
RISK AND RETURN
Investing comes with risk. This makes it different from, say, saving. When you put your money into a savings account, you have a lot of faith that that money will be worth at least as much as you put in. When you put your money into an investment, there are no guarantees. There is risk involved.
It's tempting to think of risk and return as two separate concepts, but they are, in fact, intricately linked. They are the same concept. You can think of them as being two sides of the same coin. If you want to make money with an investment, you have to take risk. To say that in another way, if you don't want to take any risk, you can't expect any return.
With stock market investing, many people talk about risk as volatility, or the everyday ups and downs of your investments. If you think about risk this way, it might be helpful to consider the fact that risk is the fee that you pay in order to get higher returns in the long run. This is a different way of framing it to how most people think about it. Many people think of risk as a fine - a penalty that comes along with investing. Reframing it as the price you pay to get higher returns helps put your day-to-day fluctuations in context.
SHORT-RUN AND LONG-RUN
It's easy for us to think about the short run. This is our natural default setting. When we see our investments going up or down, it's easy for us to only see how it's behaving today and how that might affect us next week or next month. Focusing on the noise is what keeps us thinking about the short run. Short-run thinking is what leads to negative emotions around investing.
Taking a long-term view is much more difficult but definitely worth it. In a long-term view, we don't think about next year. With the long-term view, we're thinking about 10 years from now, 20 years from now, and beyond. By viewing your investments with a longer-term perspective, you've given yourself permission to live your life and not worry about what's happening today and next week.
In any given year, your investments can double or more. The flipside, though, is that you can lose half the value of an investment in any given year. The range of outcomes in the short run is extensive. In the long run, though, all of the good and bad years offset, and you're left with a long-term average rate of return. You earn this rate of return by letting the market do its thing.
DON'T RISK MONEY YOU NEED
Short-run investing isn't always about speculating and trying to get in or out at the right time. Sometimes we need the money that we have invested. Perhaps we've been investing for our child's college or a down payment on a house. Maybe we've been investing for retirement, and now we need to start taking withdrawals from our retirement account.
If we have money invested that we need, we are at the mercy of whatever the market is doing. The easy way to withdraw the money you need from your investments is to simply sell on the day you need it. However, you must first ask yourself how you will feel if the market drops when you need that money.
Asking yourself ahead of time what emotions might be present if you're forced to sell at a loss helps you reconsider whether or not you want that money invested. You might be asking about the missed upside by taking your money out of the investments. You would be right; you are giving up some upside, but what you get in return is to not lose the game.
Compare the emotions you'd feel if you kept your money invested and made more money to the emotions you'd feel if you kept your money invested and lost a good chunk of it. For most people, the sting from not having enough money to pay for college, your house, or your lifestyle vastly outweighs the sting from losing some extra return.
Understand why you are investing. Are you gambling? Are you looking to make a quick buck? Are you buying these investments because your peers are? Or are you lending your money to the market to reap the long-term benefits?
These questions are important to ask because if you don't ask them ahead of time, the emotions you feel afterward could be difficult.
You get one life; live intentionally.
With gratitude,
derek
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Related Money Health® ReadingReferences and InfluencesAriely, Dan & Jeff Kreisler: Dollars and Sense
Bernstein, William: The Four Pillars of Investing Clements, Jonathan: How to Think About Money
Ellis, Charles: Winning the Loser’s Game
Gibson, Roger & Christopher Sidoni: Asset Allocation
Housel, Morgan: The Psychology of Money
Kahneman: Daniel: Thinking Fast and Slow
Pompian, Michael: Behavioral Finance and Wealth Management
Zweig, Jason: Your Money and Your Brain
Note: Above is a list of references that I intentionally looked at while writing this post. It is not meant to be a definitive list of everything that influenced by thinking and writing. It's very likely that I left something out. If you notice something that you think I left out, please let me know; I will be happy to update the list.
