This post will focus on where our negative emotions come from, why we should be skeptical of our emotions when it comes to investing, and the benefits of overcoming our current emotional state in favor of a longer term view.  Many people have a total intolerance for pain, current discomfort, and near term uncertainty.  Overcoming our natural aversion to these things will make us better investors.

The investment manager Tom Russo has discussed how important it is for businesses and investors to develop what he calls the “capacity to suffer.”  This ability to deal with difficult circumstances and the associated uncomfortable emotions separates the successful investor from the typical.  The fact of the matter is that the thing that is holding most investors back is not a lack of intellectual ability, or lack of access to information, or anything in the external environment. The number one fault in most investors is that they lack emotional control because they they fail to understand their emotional wiring and the subtle ways it can negatively influence them.  For almost all investors, even great investors, their biggest enemy, their largest impediment to long term successful investing, is likely to be themselves.

Our Emotions Come From Our Evolution 

Our ability to experience negative emotion is a naturally evolved set of systems that had adaptive value over time.  What we experience subjectively as emotions are really a complex interaction of chemistry and electrical signals occurring in the brain.  These biochemical processes evolved as a way to give us a built in head start in dealing with important dangers in our environment.  So when we experience something like pain, fear, or anxiety we are experiencing a type of basic biological information processing that helped us survive over time.  

The first major drawback of our emotions, however, is that they evolved us for environmental problems very different from the ones we now encounter.  Many things in our modern complex economy simply weren’t present in our evolutionary past so proper emotional responses could never have been selected for. Things like multinational corporations, capital markets, and financial instruments are much different than the areas of concern in our past.  In short our emotions were never meant to deal with many of the types of problems we must deal with when making investment decisions.  

The second problem to understand about our emotions is that,as a result of evolution, some of our emotions may become “over-calibrated.” Imagine being our ancestors walking through the brush and all of a sudden hearing the grass next to them rustling. Our emotional response system immediately alerts us to the movement, we are likely filled with fear, we might quickly jump back or even run away.  It could just be the wind, but it could also be something that means us harm and we simply cannot afford to take that chance.  If it is merely the wind, and you scurry away, you have suffered no loss by being wrong. But if you instead assume that the rustling is nothing and you turn out to be wrong even once, you have suffered the ultimate loss. As a result, your brain’s warning system, concentrated in the thalamus, amygdala, and insula, comes with a hard wired hair trigger.  We are systematically prone to be overly sensitive to perceived threats, and we will be skewed toward aversion to sources of perceived danger. Our react first, ask questions later, tendency simply is now part of human decision making.   

Therefore… Our Investment Decision Making Is Emotionally Skewed

Our hardwired emotional responses spill over into our investment decision  making even though the decision making we are involved with today concerns things unknown to our ancestors. Our emotions are not good at knowing their own boundaries.  When left to their own activity they will interject themselves into decision making they are ill equipped to solve. 

For example, because of our evolutionary history we typically feel financial  losses with about twice the intensity that we feel gains. A $1000 gain and a $1000 loss are not on equal footing when it comes to our mental processing; the bad feelings with the $1000 loss will be about twice as “bad” in compared to how strong our good feelings will be with the gain. 

Knowing that we have these inborn mental skews is vital to investment decision making. If we simply uncritically go with our evolutionary derived emotions to make 21st century judgments we are likely to make consistently flawed investment decisions.  

Recall that the primary point of our negative emotions was to create an automatic behavioral aversion to the thing giving us the response. This pre-made response provides us with decisive, fast, but somewhat simple, responses to what is happening in our environment. They give us blanket directional responses that flash “danger”, “stay away”, “bad”, “run”, and they have a hard time holding multiple pieces of information in tension with one another like is required for making sound investment decisions. 

When we experience negative emotion the typical resolution we are guided to is, not to find the correct decision is some objective sense, but rather to make the decision that will remove our feelings of fear or anxiety.  In simple terms, our emotional systems make it straightforward to take the easy way out. We  know from the outset what our emotions want us to do: get rid of the thing causing us the distress. Our emotions tend to offer only one track solutions. 

Our Negative Emotions Affect Our Decisions When Dealing With Investment Losses

There are three negative consequences of our inborn emotional responses to financial losses.  1) Our investment time horizons get shortened–we focus almost exclusively on the short term 2) The object of our investment attention turns solely to market price predictions, and almost no emphasis is given to the actual cash flow value of the underlying business and 3) we tend to become unduly influenced by the behavior of others rather than objective evidence.

We already know what solution our emotional response will offer under times of distress: find a way to remove the feelings of discomfort, get out of the situation that is causing you danger.  This causes us to act on our short term feelings rather than the long term merits of a given investment. We are likely to sell our ownership in a business that we believe will be successful over a 5+ year time horizon just to relieve our emotional discomfort in the present. 

But your feelings of comfort or discomfort are not good replacements for investment analysis.  Many times the correct long term investment decision will still involve short term pain or uncertainty at moments during the course of the investment. It is poor thinking to believe that the “correct” investment decision is the one that doesn’t give you any discomfort and therefore if you are feeling discomfort something must be wrong with the investment.

But suffering losses in the short term is painful, and following losses, investors are frequently tempted to withdraw from markets altogether to avoid additional anguish. History seems to show that following a string of poor results, loss aversion can cause investors to forgo objectively attractive investment opportunities. 

You will notice a natural inclination following short term losses is to become fixated on market price fluctuations. All we try to figure out is whether the next move for market prices is up or down.  Our emotional responses cause us to become obsessed with a narrow set of information rather than focus on all of the other information that allows us to evaluate the merits of an investment.  We forget about the competitive position of the business, the structural attractiveness of the business model, operating margins, return on invested capital, free cash flow, and valuation.  Our negative emotional responses tend to turn us solely into market price speculators. 

Humans are reflexively afraid not just of physical dangers, but also social signals that transmit an alarm.  Our negative emotions make us more susceptible to social influence and our decision making may take the form of simply believing there is safety in doing what others are doing.  Ideas tend to be contagious, whether or not they are actually true. But the crowd is likely to be driven by the same crude emotional responses that you are, so in times of panic there is likely to be little wisdom in reflexively following the herd.  If you unquestioningly trust your emotions you are likely to get flushed out of the market along with everyone else when exposed to periods of stress.

Our Negative Emotions Influence Our Perception of Risk

We tend to judge the probability of an event by the ease of which we can bring it to mind.  So things that evoke drastic or vivid imagery in our minds are often overestimated.   For example, because plane crashes evoke extreme images in our mind we overweight the probability in which they occur. Many people are afraid of flying even though the odds against dying in a plane crash are around 6,000,000 to 1. In a typical year, only a couple dozen people will die on average in plane crashes, but over 40,000 each year die in car crashes.  Yet we tend to fear flying over driving.  Similarly, people are often afraid of sharks, bears, alligators, snakes etc, because they evoke scary images. Yet deer are responsible for seven times more fatalities than all of those animals combined because deer jump out in front of people on the road. 

The same thinking is at work when it comes to investing. For example, because of the panic that images of a stock market crash evoke, investors often overweight the significance of these events.  For example, based on history the odds that U.S. stocks will lose a third of their value in a given year are only 2%. In comparison, there is a guaranteed risk that inflation will raise the cost of living and erode your savings over time. In other words, the real risk for most people is not that they are too exposed to investment assets, it is that they are drastically under invested in relation to how much they are going to need in retirement.  Yet because of the mental glitches in our thought processes what we fear when we think about investment risk is stock market declines, not outliving our retirement funds.    

Small to intermediate declines are a fairly common part of public market investing and are simply part of the normal operation of the market adjusting to investor expectations.  When these perfectly normal declines occur, investors will still often act with surprise and make drastic decisions to their own detriment. Past market draw-downs have tended to create attractive investment opportunities. But because of the psychological reasons we have discussed, most investors have a very difficult time being greedy when others are fearful. Recognizing and overcoming these psychological obstacles is critical to long term investing.

Overcoming Our Automatic Emotional Responses

The attempt to avoid negative emotion in the short term will be disastrous to your long term results.  Setbacks and their accompanying negative emotions are simply part of investing.  There are investors that work to overcome these difficult emotions and still make rational decisions, and there are other investors that give in and simply act to alleviate their short term discomfort.  

You must realize that you are systemically biased in regard to how you experience negative emotion and that it is not a good guide to investment decision making.  Under pressure we will tend to sacrifice potential long term success to the certainty of gaining short term emotional comfort.  

We should strive to develop a more stable emotional temperament and the ability to separate our current emotional state from our rational long term decision making.  You must isolate your natural reflexive response to things that elicit bad feelings. Try to withhold judgment as to whether something is “good” or “bad” because the problem with our emotional judgments is that it is hard to stop them from subsuming all the rest of our analysis. Remember our emotions are rather blunt instruments that evolved to guide our behavior “directionally,” they are not great at nuance. 

When dealing with market conditions that are evoking negative emotions, try coming up with mental hacks to counteract them:

• Find something else to distract yourself
• Constantly remind yourself to adopt a detached and unemotional attitude.
• Don’t wait for a moment of crisis to mentally prepare
• Don’t make any drastic decisions in the moment. Only make major changes to your investment situation after careful deliberation considering the long term. Do not allow market volatility to be the determining factor behind your decisions.
• When market prices are moving drastically, you must return to the facts regarding the underlying investment and not get swept up in the market volatility:
  • Other than the price, has anything else changed with the underlying investment?
  • What were the original reasons for making the investment? How have they changed?
  • If something has indeed impacted the earnings power of the business over time, by how much?
  • What additional information is required in order to make a rational long-term decision?
  • Has anything changed your investment horizon so that you cannot ignore market volatility?

To be a good investor you have to be able to overcome negative emotion. Realize we are hard wired to respond to certain things in the environment, and that these responses are not always conducive to long term investment results. Our emotions will attempt to compel us to simply take the action that will relieve our short term suffering, but it is an error to think that the right decision is the one that gives us current emotional satisfaction.  Try developing the capacity to suffer in the short term which will help you make more rational long term decisions.