Taking the Emotions out of Investing
Avoiding the emotional traps
Why is it so important to think about emotions when it comes to investing?
Emotions lead us to make bad decisions when investing our money. We tend to attach more than monetary value to money; sometimes we put our ego on the line with it. For example, we may buy a stock for $50, watch it go down to $30, and refuse to sell it until it goes back up to $50 because we don’t want to admit failure. That’s just one example of how emotions can get in the way of effective investing.
How do you work with clients to make sure they stick to their investment plans?
We educate like crazy. Our quarterly newsletter stresses not letting short-run fluctuations get in the way of long-term goals. Our Web site preaches the same philosophy. And our clients meet with our associates regularly to discuss the short-term volatility and long-term performance of investing in equities.
When working with clients, how do you build patience into the investment plan?
We always talk long-term. In our firm, we use what we call a 10-year rule: if clients can’t leave their money in the stock market for 10 years, then we don’t want it there. That may sound very conservative, but it’s not. For example, a person age 70 may only need liquidity for the mandatory withdrawals in their IRA, and could have a portfolio that’s still 70 to 80 percent equities. A young person in his or her 30s or 40s could possibly have 100 percent of their portfolio in equities, since they don’t need anything more than emergency liquidity.
Why should an investor have a 10-year horizon?
We’ve done studies on returns that have included dollar cost averaging over 10-year periods of time. That’s how most of us do it in our 401(k) plans. Generally since 1929, over the long-term, many investments in equities would have beaten many investments in bonds. Equities are generally more volatile than bonds. That’s why we use a 10-year time period. Some people may be more aggressive than that and have a shorter time frame, but for the vast majority of people it works fine. If your child is age 5 and you’re saving money for his or her education, you may consider investing in the stock market. If the child is age 15, consider a CD. If you’re planning for retirement and it’s 30 years away, — putting your money into the stock market now may be a good idea to capitalize on long-term growth.
What can investors control and what should they focus on when managing their investments? Is there anything we just have to accept as uncontrollable?
Yes. We cannot call what the stock market will do tomorrow or in a month or in a year or at any time in the future. All we can say is that if clients continue a long-term investment approach of dollar cost averaging into the market, there has not been a 10-year time period when the performance of investing in stocks hasn’t exceeded the performance of bonds. Of course, remember that past performance cannot guarantee future results. So they can control the asset allocation and the regular investments, but otherwise don’t try to time the market. Emotionally, people want to buy stocks when they are going up. They want to sell stocks or not buy when the market is going down. When rationally, they should do just the opposite.
With recent market volatility, investors sometimes feel paralyzed by the fear that as soon as they invest, the value of their holdings will fall. What do you suggest for getting over these jitters?
Don’t put all your money in the market at one time. Dollar cost averaging, which entails putting the same amount of money into the market on a regular basis, takes advantage of market declines. You will always buy more shares when the price is down than you will when the price is high. Investors should keep in mind that the only time they really want the market to be sky high is when they’re selling — not when they’re buying. The stock market is the only place where, if someone cuts the price, buyers have the tendency to spend less. If you cut the price of a Rolls Royce in half, people would buy more of them. But if you cut the price of a stock in half or the market in half (which I hope doesn’t happen), then people are reluctant to buy.
I feel terrible when an investment choice doesn’t work out as I had hoped. I’m becoming afraid to invest. How can I remove or minimize emotional reactions — including greed — from the investment process?
Well, when you make a decision to buy a stock, there should be a rational reason behind it. First, you feel the stock is a good solid, company, that its earnings will continue to grow, and hence its price will go up in the future. Now, it’s possible to buy a stock that meets all your earnings expectations but declines in price. That doesn’t mean you’ve made a bad investment, it means that you should simply bide your time and hold onto it. On the other hand, if it doesn’t meet your earnings expectations, then you should reconsider and possibly sell the stock. We all buy stocks that go down in price — it’s the nature of the beast. You must reassess your position in terms of why you bought it. If nothing has changed, hold onto it and possibly buy more. Take your emotions out of the investment process.
If you were to recommend one book to read to help take the emotions, the agony and the greed out of the investment process, what would it be?
“A Random Walk Down Wall Street,” by Burton G. Malkiel. Or “Common Sense on Mutual Funds,” by John Bogle.
What suggestions do you have for keeping my head straight when it comes to managing my personal finances?
Some people never can. They may need professional help, either by having individual account management or using a mutual fund. Most people who accumulate lots of money do so through their 401(k) plans. The reason they are so successful is that they generally forget about the investment process. The money is automatically taken out of their pay, so they are effectively dollar cost averaging. They don’t have to agonize over where to put their savings because it automatically comes out of their check and goes into the investments.
People can emulate this with their personal funds by having money taken out of their bank account every month and automatically invested in mutual funds selected through a broker.
When to make an investment it should have an exit plan in mind. How would it make an exit plan? Or do it just buy and hold?
We do have an exit plan when we invest. One, if the company fails to live up to the assumptions we had when we bought, then we sell. Two, we set an upper limit of value when we buy, and when the stock reaches that price we re-analyze. And if nothing justifies the price, we will sell. Now, in most cases stocks don’t rocket through the roof or go down like crazy after you buy them. In fact, when we take a position we like the price to stay around where we bought it, giving us more time to get comfortable with market movements. You need to know a lot about the stock you’re buying because some are highly volatile by nature. For example, Applied Materials has a very high beta and it fluctuates a great deal. So just because it may move up or down a lot after you bought it doesn’t mean you should sell it.
When should follow instinct and sell?
Never. Don’t deal on instincts.
Do you think there is too much coverage of investing? Is the media treating the field like a sporting event?
Yes, I do. And as part of the media myself, I can say that the only time we get huge coverage is when we have a milestone breakthrough on the way up, like 10,000 on the Dow. But more often than not it’s when the market “crashes.” The press likes bad news — if it bleeds it leads!
How do you filter out the noise from commentators and news sources today from the real investment information?
Only by practice. It’s very difficult to assess what’s important and what isn’t. The important factors are the fundamental reasons for purchasing the stock, not the day-to-day changes in the markets. Most commentators and TV programs talk about market changes, not about the fundamentals of the individual companies in which you’re investing. Ignore the market noise and concentrate on the factual information provided about the companies in which you are investing.
With Nasdaq stocks getting clobbered lately, what would you say to investors whose plans call for holding those stocks for the long term? How should someone keep from hastily selling?
I think that if they have a long-term perspective on investing then they should try to ignore short-term price movements. Also, they should probably not have all of their money in highly volatile Nasdaq stocks. They should diversify over a broader range of stocks.
What is considered a high beta for a stock?
You should think of beta as relative to the market. A stock with a beta of 1 moves on average the same as the stock market. If the stock market is up 10 percent, the stock on average will be up 10 percent. If the stock market goes down 10 percent, the stock will go down 10 percent. A beta of 1.5 (high beta) will fluctuate 50 percent more; hence if the market goes up or down 10 percent, the stock will go up or down 15 percent. A high beta means high volatility.
Do you feel that high-tech stocks are overvalued? With their recent price declines, will they ever bounce back and make a profit?
I don’t think that high-tech stocks are overly expensive. However, I’m talking about real companies that have real products and make real money. I’m not talking about dot-com stocks. A number of stocks in the high-tech industry have high price/earnings (P/E) ratios, but their strong earnings growth justifies them. The key phrase is EARNINGS.
I’ve read that cash-to-debt ratio is very important. If this is so, what about those popular technology and dot-com stocks with no earnings and lots of debt? Are their price run-ups being caused by day traders?
I don’t know whether the run-ups are caused by day traders or not, but anyone who buys these stocks is not an investor — they are a speculator. There is nothing upon which to base these stocks’ values. A company with no earnings and no projected earnings is worth zero to me. It’s all based on the greater fool theory: I’ll find a greater fool to sell the stock to who will pay a higher price than I paid for it.
How do you define risk in investing?
I define risk as not knowing what the future holds. That doesn’t mean risk should bother us; we should take advantage of it because that’s what we get paid for when investing in the stock market. If we put our money in a CD in the bank, we’re only going to earn 5 percent. But we don’t even know if we really are going to earn 5 percent because we think inflation is only going to be 2 percent. If inflation turns out to be 4 percent, then we made a bad deal. We took on risk even if we bought a CD.
With the current low commission rates to buy common stocks, it seems cheaper to buy a batch yourself rather than asking fund manager to buy them for you. Are mutual funds obsolete?
I don’t think that mutual funds will ever be obsolete, for several different reasons. To start, most people don’t have enough money to buy a diversified list of common stocks. Generally, you need at least 10 in different industries, so it probably requires somewhere around $50,000 to have a well-diversified portfolio. But people need to start somewhere. A mutual fund is a good place to start because you have instant diversification.
Second, many people are terrible investors. It takes them a while to discover that. So even though mutual funds may have higher expenses, they do offer dispassionate, professional management to these investors. We strongly recommend that people invest in individual stocks over mutual funds if they have enough funds to diversify effectively and are willing to spend the time and effort to do the research.
Which type of fund is best for a depressed market?
In a depressed market, funds that invest in high-quality, large-cap stocks usually offer the best investment opportunities, because historically these are the companies whose profits rebound first — and whose stocks are first to rise.
Which large-cap blend fund would you recommend?
A large-cap blend fund invests in companies whose total capitalization exceeds $5 billion. It also typically invests in companies that have reasonable P/E relative to growth. Some of the companies the fund buys will be depressed in price, hence their value. And some of the companies will be growing rapidly, but their P/E may still be reasonable relative to growth. So the fund offers a “blend” of value and growth. Now, one of the ways to achieve this is to buy an index fund; for example, the Schwab S&P 500 Fund, the Vanguard 500 Index Fund, the Schwab 1000 Fund and of course the Henssler Equity Fund.
My largest mutual-fund holding is a value-oriented fund. Like some other value funds, it has done poorly in recent years. Should I hang in there or move on to a better-performing fund?
To have a fully balanced mutual fund portfolio, you should include mutual funds that have growth orientation and value orientation. You can’t expect one particular fund with a strong value bias to do well all the time in the market. Sometimes growth-oriented funds will outperform, and sometimes value funds will outperform. You need to compare this fund’s performance to other large-cap value funds to determine whether it is doing what it’s supposed to be doing. Don’t measure against the broad market.
My company has a progressive 401(k) plan that allows us to self-direct our investments. My question concerns the firm handling them. We have a limited number of no-load funds, of which very few have received 5-star ratings by Morningstar. The name-brand funds require a minimum investment of $5,000. Since I am charged $30 per trade, would it be better for me to invest in individual stocks or one of the mutual funds?
It doesn’t sound like a very user-friendly 401(k). However, I may suggest that you select the best large-cap blend fund available and put all your money into it. This would minimize your costs. Even if the fund is just average and not a 5-star fund, I believe it’s still better to take advantage of the tax deferral in the 401(k) plan and have your money in a 100 percent equity fund than not to do so. However, I would max-out your 401(k) contributions first and then contribute $2,000 to your Roth IRA. If you have additional savings capacity after that, consider contributing more to your 401(k) plan.
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