This article on emotions in investing is a guest post by Xavier Hill and may or may not represent the opinions of anybody else at The Broken Leg. Photo credit: Acid Pix, Creative Commons.
Have we gotten emotions in investing all wrong or are emotional decision making always a poor decision when buying stocks?
It’s a fair question. Most intelligent deep value investors consider emotions in investing a non-starter, poison, something to be avoided. Yet, the reality of the situation is far more nuanced than that. So, should smart deep value investors avoid emotions in investing or not?
It is only now that science is beginning to understand the importance of the gut for humans and how it affects everything we do. For example there are over 100 trillion brain neurons throughout the human gut - your gut has a bigger brain than that of a cat! It is why over time, and as you gain in experience as an investor, you need to trust it - but don’t just take my word for it.
Not only is science revealing the brain power within our gut, it is also revealing the value of gut decisions and why they are so often right. In his landmark book Blink: The Power of Thinking Without Thinking business writer Malcolm Gladwell discussed the science behind gut decisions and why we can trust them.
Our gut decisions are often right as they utilize a process Gladwell calls “thin slicing” whereby our brain automatically processes data to make a decision. To support the concept Gladwell cites numerous examples such as the Los Angeles Getty Theatre’s purchase of a sixth century B.C Greek statue for sale - a kouros. The theatre undertook a 14 month investigation of the statue to ascertain its authenticity, which included numerous scientific tests, opinions from various experts in Athens and analysis of the statue’s provenance. The investigation concluded the kouros to be legitimate, however upon its unveiling the statue was instantly dismissed as a fraud by famed Italian artist Federico Zeri. Zeri of course could not substantiate why it was a fraud beyond stating that the fingernails did not appear right.
Other experts were called in who dismissed the statue as being a fraud upon their first viewing and yet they could not explain exactly why. The experts at first could be easily dismissed as the suite of reports and scientific testing supported the kouros’s authenticity. But then then in 1990 a known fake of a kouros torso turned up and the Getty theatre purchased the fake, conducting the same tests and sort to compare it to their “authentic” kouros.
This process soon cast serious doubt over the authenticity of the kouros. As Marion True - the Getty’s curator of antiquities stated. “Everything about the kouros is problematic...I always considered scientific opinion more objective than aesthetic judgments...Now I realize I was wrong.” The kouros can still be seen in the Getty theatre today however it comes with a caveat and no one is really sure as to its legitimacy.
What’s Behind Gut Decisions?
The science of gut decisions continues to develop through people like Antonio Damasio - a neuroscientist at the University of Southern California and head of the Brain and Creativity Institute. His work shows how important emotions are in decision making and that our emotions ultimately need to be able to live with a logical decision.
“You don’t just remember facts, whether the outcome was good or bad, but you remember whether what we felt was good or bad...That tandem of fact and associated emotion is critical: what we construct as wisdom over time is actually the result of cultivating that knowledge of how our emotions behaved and what we learn from them.”
Similar research is being undertaken at the Medical Research Council Cognition and Brain Sciences Unit in Cambridge, UK.
All of us can cite examples of our gut making the right call and yet our thought processes have overridden it. A classic for this is in exams where your initial answer is inevitably the right one.
But here is the caveat that you absolutely have to keep in mind:
In order to have a gut worth trusting you need to have a suitable suite of knowledge and experience on which to draw upon.
Gut decisions made by experienced practitioners are really indications of pattern recognition. Over time, as a practitioner gains in experience and reads more literature that highlights best practices, this knowledge is internalized and recognized when decision making. Some patterns become adopted without conscious recognition, such as noticing the shape of fingernails crafted by a famous artist.
Newer practitioners lack the experience critical to making solid gut decisions. My gut may determine the Kouros to be a fake, for example, but I lack experience with art so would not trust my gut feeling. But then again because I have no knowledge or experience it is doubtful my gut would form a strong opinion in the first place.
How does this relate to emotions in investing?
“....When you just know in your gut. (that is when you take a big position)” Whitney Tilson 10th December 2014 - Presentation to Google.
So, as emotions in investing a negative or positive? As we gain experience and knowledge in investing our gut becomes more powerful and the intensity of the feelings stronger. This is why it’s very important to make sure that you’re acquiring real knowledge, information backed by solid empirical evidence. If you aren’t, you construct a skewed reality for yourself and your gut reactions will produce mediocre (or worse!) outcomes.
For the purchase of deep value stocks, I tend to be far more formulaic following the well crafted Core7 principles, but still make some gut decisions related to management, and whether it’s simply a value trap or a good investment prospect. There are lots of net nets out there, many may honour the Core7 principles yet you do not invest because they seem like hopeless businesses that will only get worse. Or you read previous annual reports and management continually underperform, your gut feeling is that management is so hopeless and the shareholding structure is such that this will not change. These may or may not be worthwhile objections… but you have to make sure you’re making them based on solid empirical data.
How Emotions in Investing Affect Selling Deep Value Stocks
Whilst your gut is important on the buy side and is something I definitely use, it is the sell side where emotions in investing can be a really powerful force. The easiest thing for net net investors to do is to sell once our stock’s market cap reaches NCAV, yet if this occurs within 12 months of buying you will likely have significant capital gains tax implications (at least in most western countries).
For investors with minimal knowledge or experience, emotions in investing can be dangerous so you are best to follow a formulaic approach like selling when a stock reaches NCAV or liquidating your portfolio every 12 months.
Yet for those who closely follow the market and are prepared to do the work I believe there are greater gains to be had through the use of your informed gut. As net net stocks are very illiquid the cost of both buying and selling is substantial, whilst the tax implications have already been mentioned. If you do the work and have been investing for a while, you can take a larger view of what intrinsic value is, allowing you to reduce these costs and yet maintain a net net portfolio’s returns. The knowledge and experience allows you to use Gladwell’s “thin slicing” to make regular determinations of a stock’s intrinsic value as news is announced and sell when this point is reached. Vice versa your gut allows you to hold on when an investment goes against you for what you know is just erroneous noise that has nothing to do with fundamentals.
“You need reasonable intelligence, but you absolutely have to have the right temperament.”
- Warren Buffett
For me gut instinct and temperament are inextricably linked. The “thin slicing” process relies on your knowledge and experience, so the better researched you are and the more experience you have the better the gut decision will inevitably be. This allows you to have the temperament to not be fearful when an investment works against you. It also makes selling easier as you sell with confidence knowing the stock has reached an intrinsic value you are comfortable with.
A recent example of this for me was the SGX listed consumer staples producer Hanwell. I bought in January this year at 23 Singapore Cents and the stock soon shot up. At 36 cents I considered selling but could not find another stock to invest in and I valued the stock at substantially more, at least 50 cents. Plus if I sold I was going to have to pay a 50% capital gains tax as I had held the stock over such a short period.
I held on and saw the stock fall from its high by 38% to 27c. My gut told me though once again not to worry. Hanwell did not released any news, they sell consumer staples which people need no matter what news comes out about the Asian economies they service. Lately Hanwell has strongly rallied - sanity has prevailed and my gut was proven right.
If you do the work to gain experience and knowledge in investing your gut feelings will become stronger and you will learn to trust them more. Of course they will not always be right but no investor is always right. When you develop your gut instinct you will be able to resolve the gap between the logical prices at which you buy and sell and when your emotions want to buy and sell. It takes much of the stress out of investing, making the process significantly less personal as you are not a genius when you get it right and neither a fool if you get it wrong. If you do not have the time to do the work or have the experience then follow a pure mechanical strategy.
Click this link here, or enter your name in the box below, to learn more about how we can do all of your investing for you because not investing well will cost you A LOT of money long term.