Common Psychological Pitfalls
Managing our emotions is a prerequisite for intelligent investing
“Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. … The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
— Howard Marks
Introduction
In early 2011, I attended a conference at Columbia University. At the time, I was two years into managing my investments on a full time basis. While the stock market rocketed up in 2009, I was left in the dust due to my belief that the bear market would continue. I had a far more successful 2010, but I was well aware of the limits of my abilities. I decided to attend the conference to improve my thought process.
Howard Marks made the keynote presentation about his forthcoming book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor and that speech is one that I still think about over a decade later. I was aware of Howard Marks and his memos prior to the conference but thought of him as a distressed debt specialist and I was an equity investor. However, the reality is that both distressed debt and equity investing require the analyst to understand the economics of a business. The choice of where to invest within a company’s capital structure is one that follows a full analysis.
After the conference, I had a few hours before catching a train at Penn Station. The weather was not great for walking around the city so I went to a coffee shop and wrote an article. My main takeaway was related to human psychology rather than the blocking and tackling of balance sheet and income statement analysis. Although I did not say so in the article, I saw much irrationality in my behavior during 2009 and wanted to gain a better understanding of the “human side of investing.”
The punchline of the book’s title is that there are many “most important things” when it comes to intelligent investing. Solid analytical skills are merely table stakes in the twenty-first century. Investors have to understand financial statements and have the ability to understand business models, but these skills will not provide any value if we are not masters of our emotions. This requires a firm grounding in psychology.
A Toxic Mix of Skepticism, Cynicism, and Fear
In retrospect, the main reason I underperformed in 2009 had to do with innate traits that are probably hardwired in my personality. I tend to view the world with skepticism that all too often shifts into cynicism.
Skepticism is a healthy trait for investors but cynicism is not.
Unfortunately, the news cycle makes it easy for someone with a tendency toward cynicism to reinforce that mentality. This was abundantly true in 2009. Social media, still in its relative infancy, combined with a negative news cycle early in the year, created a toxic brew for those predisposed to have a negative outlook.
My defensive posture in early 2009 had reasons that went beyond a tendency toward cynicism. I made the decision to leave traditional paid employment in September 2008 just days before the collapse of Lehman Brothers sent markets into a tailspin. I did not reverse my decision to quit, thinking that markets would soon recover. By the time I became a full-time investor in March 2009, my portfolio was around half of its peak level. I was afraid that I had made a terrible mistake and would need to find a new job. This naturally led to a high degree of risk aversion. Let’s be honest and call it fear.
The bottom line is that I succumbed to negative psychological influences and this hurt my performance in 2009. Thankfully, I did not panic. I made money in 2009, but I invested conservatively at a time when the strongest returns accrued to those who were willing to venture further out on the risk spectrum. However, it was not necessary to speculate in 2009 to earn better returns, just to have a higher tolerance for potentially taking short-term losses that were likely reverse in due course.
Given this history, by the time The Most Important Thing came out in May 2011, I was receptive to what Howard Marks had to say about combating negative influences. I had enough self-awareness to understand that my psychology was at odds with maximizing my potential as an investor and I was eager to improve. In this article, I’ll take a look at the seven psychological pitfalls Howard Marks wrote about in his book.1
Greed
There is nothing wrong with a desire to make money. Financial independence clearly requires obtaining a decent return and any active investor is, by definition, looking for returns that will elude most market participants. Howard Marks makes the point that “people who don’t care about money generally don’t go into investing.” A desire to beat the market is healthy unless it becomes an all-consuming obsession:
“Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble. Instead, from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price.”
In my opinion, a healthy desire to make money morphs into greed when the end goal is simply to accumulate assets without any purpose, simply for the pleasure of seeing a number go up on the screen. Of course, there is no bright line that demarcates the border between a healthy desire for wealth and greed. It is easy to slide into greed over time, especially once an investor already has amassed a great deal of wealth.
Fortunately, greed as we have defined it here, has never been a major problem in my case. I have not sought wealth to be able to spend it but for the sense of financial security it provides and the ability to control my time. How a person views and uses wealth can be clarifying in many ways. We can never let our guard down and declare ourselves immune from greed. Resisting its force is a lifelong challenge.
Fear
“In the investment world, [fear] doesn’t mean logical, sensible risk aversion. Rather, fear — like greed — connotes excess. Fear, then is more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.”
A healthy level of fear might be constructive but panic can cause investors to make enormous mistakes. The classic image of fear is to picture someone in a frenetic trading room shouting out orders to get out at any cost. This is a classic mistake of commission. Fear drives an investor into a state of panic and the discomfort of panic leads to action meant to alleviate the discomfort at any cost.
Fear can also result in mistakes of omission. In my case, in early 2009, I was not in a panic and did not sell everything. One of the benefits of writing down my thoughts is that I can go back and look at my state of mind. In Coping with Market Meltdowns, written in early March 2009, I was obviously not in a state of panic. The main reason is because I had sufficient cash on hand and no need to sell securities to fund expenses in the near term. Although lacking a paycheck, I could look out further than many investors who needed to “make something happen” very quickly.
My fear in early 2009 resulted in focusing on conservative strategies such as “net-nets” and avoiding companies that could suffer in a long economic depression. What if we had ended up in a Great Depression II scenario? I might have been proven correct in early 2009. But if I had really thought that we were in for a depression, the wiser course of action would have been to go back to paid employment.
Willing Suspension of Disbelief
If you spin a good enough narrative, many investors will abandon logic and precedent.
“This tendency makes people accept unlikely propositions that have the potential to make them rich … if only they held water. Charlie Munger gave me a great quotation on this subject, from Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” The belief that some fundamental limiter is no longer valid — and thus historic notions of fair value no longer matter — is invariably at the core of every bubble and consequent crash.”
We can go back to the dot com bubble, the real estate mania of the mid 2000s, or the NFT craze of 2021 for recent examples of the willingness of investors to suspend their better judgment if they see prospects for making easy money. The gambling instinct will always exist, even for people who think they are immune.
A necessary element to get people to buy into a dubious narrative is that there must be at least some plausibility to the argument. If sophisticated mathematical models and computer science is involved, so much the better.
“It’s spun into an intelligent-sounding theory, and adherents get on their soapboxes to convince others. Then it produces profits for a while, whether because there’s merit in it or just because buying on the part of new converts lifts the price of the subject asset. Eventually, the appearance that (a) there’s a path to sure wealth and (b) it’s working turn it into a mania.”
When I read this explanation recently, it sounded like a perfect fit for the crypto trading bubbles of recent years. Con artists like Sam Bankman-Fried perfectly played the situation to the point where speculators were willing to suspend their disbelief in large enough numbers to levitate the price of worthless financial instruments.
Conforming to the View of the Herd
Many dysfunctional aspects of financial markets are due to the desire of investors to seek comfort in the warmth of a herd. What is the real purpose of earnings guidance or the Federal Reserve’s practice of “forward guidance”? Excuse the cynicism, but I think that the real purpose is to give comfort to investors that if they adopt the view of the herd, at least they only risk being wrong in the company of most of their peers.
“Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. It happens so regularly that there must be something dependable at work, not a random influence.”
I can understand, if not approve of, the desire of professional investors to seek comfort in the crowd. Being wrong with the crowd is less likely to get you fired than if you come up with a non-consensus view, no matter how well reasoned, that turns out to be mistaken. The problem is that in financial markets, there is no “alpha” to be earned inside the herd. Investors must take non-consensus stands and be right more often than they are wrong. Otherwise there is no possibility of generating value.
Individual investors also care about conforming to the herd. Why? They have no boss to report to and their results are private. Talking about your returns as an individual is an optional decision. Still, individuals are heavily influenced by the herd, especially by so-called experts. So, the professional investors who have incentives to stay within the herd end up influencing individual investors due to a mistaken respect for authority.
My skeptical nature provides some natural immunity to this pitfall, at least when it comes to the investment community at large. However, I cannot claim immunity to being attracted to the smaller value investing herd, at times. I monitor value investing message boards from time to time. I’m also influenced by 13F reports disclosing the investments of superinvestors even though I have sworn off blind coat-tailing.
Envy
Comparing yourself to others and coveting what they have are poisonous mentalities in any context but can produce especially bad results for investors. This problem has only been amplified in recent years by social media. It used to be considered in poor taste to discuss one’s finances in public. Today, speculators, particularly in crypto, regularly post screen shots of their brokerage account statements.
Envy is a really stupid sin because it's the only one you could never possibly have any fun at.
— Charlie Munger
Envy is so poisonous because it makes you miserable while also clouding your ability to make good decisions. As Charlie Munger said, it is the only sin that has no upside. Howard Marks takes a dim view of envy:
“People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.”
The cure for envy, in my experience, is to consider whether you would want to trade places with someone who has more than you, but the catch is that you cannot pick and choose which aspects of their life you will take and which ones you will pass on. For example, if you envy Warren Buffett because you want to have a twelve figure net worth, consider whether you also envy the fact that he is ninety-three years old.
Envy might be an innate personality quality. Some people are naturally skeptical or even cynical while others might be naturally envious and covetous. Or perhaps it is not innate from birth but driven by early childhood experiences. Whatever the origin, we should be aware of these pitfalls if we suffer from them. Envy might be the most toxic of all the negative influences and I’m thankful not to be afflicted by it.
Ego
It is often said that active investing is an inherently arrogant act. By attempting to pick securities rather than index, you are saying that you are smarter than the average investor. It takes a healthy ego to even attempt to beat the market given how hard this is to do. A healthy ego is not a handicap but a prerequisite for successful investors.
In the physical world, there are substances that produce a positive response in low doses but a toxic response in high doses. This is known as hormesis. Greed, fear, and ego are psychological equivalents of hormesis. A minimal “dose” is necessary to succeed as an investor but too much is toxic.
Howard Marks has a somewhat different view and believes that humility, the opposite of ego, is the road to investment success.
“Emotion and ego: Investing — especially poor investing — is a world full of ego. Since risk bearing is rewarded in rising markets, ego can make investors behave aggressively in order to stand out through the achievement of lofty results. But the best investors I know seek stellar risk-adjusted returns … not celebrity. In my view, the road to investment success is usually marked by humility, not ego.”
This boils down to whether an investor has an inner or outer scorecard. Professional investors, by definition, have an outer scorecard of some sort. Their performance is measured but perhaps they can put themselves in a position to be measured on a longer term basis. Individual investors have the luxury of adopting an inner scorecard. While there are limits to the concept of an inner scorecard in life, to the extent possible it is important for individuals to not seek glory in their financial returns. After all, for most individuals, investing is a means to an end, not the end in itself.
Capitulation
Markets can remain irrational for long periods of time and many investors cannot stand appearing to be “wrong” indefinitely. Especially for professionals, the prospect of reporting poor results relative to a benchmark for multiple years can result in throwing in the towel at exactly the worst time.
“Much of the time, assets are overpriced and appreciating further, or underpriced and still cheapening. Eventually these trends have a corrosive effect on investors’ psyches, conviction, and resolve. The stocks you rejected are making money for others, the ones you chose to buy are lower every day, and concepts you dismissed as unsafe or unwise — hot new issues, high-priced tech stocks without earnings, highly leveraged mortgage derivatives — are described daily as delivering for others.”
As conditions get more extreme, it gets harder for investors to stay the course even though it should logically get easier. Investors start to doubt their own process and think that the crowd might actually be right.
I did not capitulate in March 2009 and the same was true in March 2020 when the pandemic hit. But it would be arrogant to claim that I am immune from capitulation. What if stocks had halved from their already depressed levels of March 2009 or March 2020? At what point would the pain have been too great to endure?
Conclusion
No one is immune from the seven psychological forces that Howard Marks described in his book, at least not from all of them. This might seem obvious but there are people who deny that they are susceptible.
“Investors who believe they’re immune to the forces described in this chapter do so at their own peril. If they influence others enough to move whole markets, why shouldn’t they affect you, too? If a bull case is so powerful that it can make adults overlook elevated valuations and deny the impossibility of the perpetual-motion machine, why shouldn’t it have the same influence on you? If a scare story of unlimited loss is strong enough to make others sell at giveaway prices, what would keep it from doing the same to you?”
At a very minimum, it is important to honestly evaluate how you have reacted to past market gyrations. For those who are new to investing, it is safest to assume that all of the pitfalls will apply to you unless you prove otherwise over multiple decades.
I cannot point to any specific investment decision made over the past thirteen years that I can attribute to reading The Most Important Thing, but I know that it greatly improved my thought process and resulted in an honest reassessment of my own psychology and that my net worth is almost certainly higher today than it would have been if I had never read the book.
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The seven psychological pitfalls are discussed at length in Chapter 10: The Most Important Thing Is … Combating Negative Influences.