Triggers and Emotional Investing: Part 2

We’ve been commenting recently about our use of triggers as part of our process in managing risk in client portfolios. The use of triggers compels us to rationally assess potential risks in the macro environment and take steps to protect client capital by establishing a rule to take specific action if the potential risk actually materializes. One could argue that you can’t anticipate every risk, or you can’t do it “after the fact”, so why set triggers? It is true that no one can anticipate every risk; however, as fiduciaries of client capital, it is incumbent upon us to analyze macro risks to the best of our ability and take prudent and compensatory measures to protect client capital from these risks. In this way, we try to reduce the “risk” of making emotionally-based investment decisions.

As humans, we are all prone to make emotionally-based investment decisions. However, these types of decisions can be some of the worst and most harmful decisions we can make as investors. They usually occur at or near market extremes when we are painfully aware of a trend and finally reach the point where greed and fear override rational logic. They occur when one has not taken the time to understand the fundamentals of an investment and buys too high (GREED). They can occur when we act on casual advice or a rumor without doing adequate homework (GREED).  A market bottom usually is accompanied by extreme fear and pain, and many people decide they “can’t stand it anymore” and bail right at the bottom. Again, a bad decision based on FEAR.

Great investors like Warren Buffett have done so well by investing in a very rational and non-emotional way. What are some of the keys to Buffett’s success? Rational and thorough analysis of business fundamentals and valuation for any investment; not “chasing” stocks that have gone way up; avoiding the temptation to time the market (in fact, generally, Buffett couldn’t care less what the market is doing).

All of us can learn a great deal from the approach of great investors like Buffett; their process is rational and disciplined. The carryover lessons for financial planning are several: 1) develop sound long-term financial and investment plans and stick to them; 2) do not be tempted to time the market; 3) maintain a diversified portfolio to reduce risk and portfolio volatility; 4) have a disciplined investment process that minimizes the risk of making emotionally-based decisions; 5) stay humble and admit if you don’t understand aspects of financial planning and investments and, if it seems “out of control” or too complex, seek the help of an experienced advisor that you trust.

 

 

Our Triggers and Emotional Investing

We talked last week about our firm’s use of triggers in our investment process. We use triggers not only as a way of managing risk but also as a way of avoiding emotionally-based decisions. The trigger is part of what we believe is a rational decision-making process. The trigger essentially sets a rule or requirement for us to take action in client portfolios based on the outcome of a perceived risk event that could or will happen usually in the near future.

 Avoiding emotionally-based decisions is a critical element in successful investing. A lot of people get caught up in “fighting” the market: buying or chasing stocks after they have run up; or conversely, selling at the bottom after stocks have plunged. Why do people do this? Emotions: fear and greed -- greed on the way up, fear on the way down. This reaction is natural: we humans are prone to emotional investing because we are emotional beings, not robots. And issues surrounding money can get highly emotional.

When done properly, a rational investment process that can be repeated greatly reduces the chances or temptation to make emotionally-based investing. Some of the key elements to a rational process include: a solid understanding of investment fundamentals and macro risks; having a sound vision and investment thesis regarding the global investment environment; and having a sound process for managing risk. When you really boil it down, investing is all about assessing probabilities and managing risk.

Why is our use of triggers important in managing risk? Because we attempt to identify risk in a rational way, anticipate this risk, and have a plan of action to deal with that risk. We consider triggers at every investment strategy meeting for various macro risks that could be a problem. Some of the risks that could cause us to set a trigger include economic and political risks, risk from geopolitical events, risk of central bank policy changes, corporate earnings and/or industry sector risks, inflation and interest rates…. The list goes on and on. The trigger literally forces us to make a non-emotional decision because it is based on an indentifiable risk with a pre-defined action. While we may not be correct 100% of the time on our forecasts (and no one is), taking a pro-active policy towards risk enables us to address a very important part of investment management in a reasonable and rational way and avoid making emotional decisions in the wake of news events that may have already moved the markets significantly.

 Next week we will discuss a little more about emotion-based investing and why it occurs.