"The Investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely converting his basic advantage into a basic disadvantage."







—Benjamin Graham



I have my own personal buy and sell indicator at home—she is called my wife. During the quick market plunge during the late summer of 2002, my personal indicator was flashing sell. The greater the market fell, the stronger my wife insisted that I sell all her holdings. Finally when the drop culminated in late September or early October, she was not merely suggesting, she was demanding that I sell her stocks and buy a new house with the remaining balance in her portfolio. She is an effective indicator, indeed, a contrarian one!



Any discussion about the role of emotion in investing must begin with a synopsis of Benjamin Graham's mythical character Mr. Market. Mr. Market is a bipolar fellow who bases his investment decisions on his current mood rather than any objective criteria. One day he may be wildly optimistic about the value of his holdings, the next day he may turn excessively pessimistic. Warren Buffett has compared the irrational actions of Mr. Market to those of a manic-depressive individual making bids on a piece of farmland on a daily basis. The bids sometimes reflect the intrinsic value of property but other times they do not reflect the property value. Rather they reflect the wildly changing mood of bidder.







It appears that much of Mr Market's irrational behavior is rooted in brain chemistry. Behavior either learned or genetic in nature is extremely difficult to overcome, and many times enlightenment does not necessarily translate into rapid change. Otherwise psychoanalysts would not be able to afford condominiums in Manhattan. I have no interest in turning this into a philosophy discussion between free will vs. determinism. Therefore I am going to assume that investors have the ability to recognize their shortcomings and implement more rational behavior.



The following section is a summary of the wonderful research and opinions of James Montier. I consider him to be one of the world's foremost authorities on Behavioral Finance, in addition to being an outstanding writer. While I will inject some of my personal insights, the main body of the discussion is a synopsis some of the key points in Chapters 12 through 14 of Montier's book, Value Investing: Tools and Techniques for Intelligent Investment http://www.amazon.com/Value-Investing-Techniques-Intelligent-Investment/dp/0470683597/ref=sr_1_4?ie=UTF8&s=books&qid=1301928567&sr=1-4







X vs C Systems in the Brain







It seems that a human brain has a reactive system (X) as well as an analytical system (C). During a perceived crisis, the X system generally overrides the C system. Have you ever felt like selling first and asking questions later after hearing a negative piece of news about one of your holdings? That is the X system kicking into play.







I have my own personal story about my X system overriding my C system, although it has nothing to do with investment. A few years back I was visiting the Henry Dorley Zoo in Omaha. The gorillas were still inside and probably not happy about that fact, since it was a lovely spring day. Anyway, a crowd of people were watching a particularly large male when he suddenly charged the glass and banged both of the palms of his hands loudly against the glass. Now I pride myself as being analytical in nature but I have to admit I lead the retreat knocking over women and children in the process. Sort of a George Costanza moment where my X system was in total control even though the glass offered an impenetrable barrier against the gorilla.







Empathy Gaps



Empathy gaps refer to the inability of the brain to visualize how we will feel in the future as opposed to the any particular moment in time. For instance, if I am ill with stomach flu, it is virtually impossible for me to imagine that I will be enjoying a meal in a few days. Frequently human beings become "what they feel" at any particular moment, the negative investment consequences can be dire if one decides to act during those periods of high emotion. It is the investment equivalent of a "Crime of Passion," and most investors have been guilty of this type of mistake at one time or another.







Loss Aversion







Investors tend to be more emotionally effected by losses than gains. Their portfolio may have appreciated steadily for a number of year,s but when they finally sustain a losing year they tend to forget about the past gains and sell their holdings. No value investor is going to outperform the market on a yearly basis. Buffett underperformed during the Internet madness of the late 1990s, prompting some of the TV touts to proclaim his investment concepts had outlived their usefulness. More recently he showed a temporary derivative loss on the long-term market insurance he sold a few years back. That prompted traders such as Doug Kass to question his judgment, advising investors to sell Berkshire stock short. The point is, making judgments based upon an aversion to losing money in the short term can be extremely damaging to one's long-term capital appreciation.



Overconfidence



When things are going right, most people feel like standing up on their chair and proclaiming, "I'm king of the world!" Legendary turf writer Andrew Beyer coined this acute attack of overconfidence as "The Messiah Complex." Overconfidence based upon short-term success can lead to hasty decisions where investors shun proper due diligence in favor of rapid analysis. That mistake should be listed among the deadly sins of investing.







Herd Mentality







Humans tend to follow the herd and most individuals prefer buying and recommending stocks that are at or near their 52-week highs with surging momentum. For years I exercised on Saturday morning while I watched the Saturday morning Fox Business investment shows. The only two "analysts" that did not supply touts at 52-week highs on a regular basis were Pat Dorsey and Jim Rogers. Jim Rogers used to lament that fact on a regular basis, chiding the other regulars, "You have to pay attention to what price you pay for a stock," and "Doesn't anyone ever pick a stock that is not at a 52-week high?" Dorsey and Rogers are no longer regular guests but otherwise nothing else has changed.







Self Control is Exhausting







Here I will employ a direct quote from a Montier:







"The fact that time seems to drain the ability to think rationally fits with a lot of the work done looking at the psychology of self-control. Baumeister (2003) argues that self-control (effectively our ability to hold our emotions in check) is like a muscle—too much use leads to exhaustion."







I would only add that my years of experience at the race track back up the above conclusion. Virtually everyone has a compulsive gambler locked up deep inside their psyche. Most people do a good job of suppressing this beast until they become emotionally worn out. It is at that point when fortunes can be lost if the gambler/investor is unable to walk away and reestablish his composure.







Conclusion







So what can the average investor do to control his inner self which is aimed at destroying his long term gains? What measures can be taken to control the "Mr Hyde" that lurks deep inside our psyche?







1) Take a Seth Klarman approach: When stocks get expensive and it is hard to find value, take money off the table and wait for a better opportunity to invest.







2) Use the Templeton approach: Make buy and sell decisions well in advance. Set limit buy orders well below the current stock price, reflecting a price that you deem to be a bargain. Set sell orders at a point where you feel the stock is no longer a worthy hold.







3) If you are an index investor you might consider basing your equity weightings on the current valuations of tangible metrics such as Q-ratios, Schiller PE10 ratio http://www.multpl.com/ or TMC/GNP http://www.gurufocus.com/stock-market-valuations.php



4) Most importantly: Know yourself, recognize your tendencies and if you tend to make rash emotional-based decisions, call a timeout. Use the timeout to analyze your urge to buy or sell and determine whether the impulse makes rational sense.







The next edition of Tenets of Value investing will focus on the difference between speculation vs investing.

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