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
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
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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.
“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.”