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.