“Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions.” -Howard Marks
Mistakes, of course, are what prevent us from generating superior investment returns. Mistakes—by others—are also the source of our successes in the market. The source of mistakes, both our own and others, arise out of our psychological issues.
In chapter 10 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” Howard Marks (Trades, Portfolio) addressed these emotions and negative beliefs:
- Greed.
- Fear.
- Willing suspension of disbelief.
- Conforming to the view of the herd.
- Envy.
- Ego.
- Capitulation.
Greed represents an excess of our common desire to make money. Wanting too much, too soon can override our common sense, risk-aversion, logic and other elements of caution. It becomes particularly worrisome when greed is combined with optimism and investors chase high returns without regard to the high risk to which they may be exposed.
Fear is the flipside of greed and, like greed, is an excess of emotion. It is more like panic than caution. Marks wrote, “Fear is overdone concern that prevents investors from taking constructive action when they should.”
Willing suspension of disbelief refers to the tendency to “to dismiss logic, history and time-honored norms. This tendency makes people accept unlikely propositions that have the potential to make them rich … if only they held water.” More technically, he described it as the belief that some fundamental limitation no longer exists, as in the old and misleading phrase, “this time it’s different.”
Conforming to the view of the herd means giving in to the pressure to conform, combined with a desire to make a lot of money. By giving in, investors lose their skepticism and overcome their risk-aversion even though the ideas they’re pursuing may not make sense.
Envy is also an emotion of excess, improperly comparing ourselves with others. Marks wrote, “In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.” He offered the example of a non-profit that earned 16% per year between June 1994 and June 1999; its managers were dejected because their peers averaged 23%. But they were thrilled after the dotcom bubble burst and they were earning 3% while their peers were losing money.
Investing, noted Marks, should not be about glamour or ego gratification. It should be about steady, long-term wealth creation as “thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation—but it doesn’t provide much ego gratification in the short run.”
Capitulation is something Marks has seen in the late stages of bull markets, when investors finally succumb to economic and psychological pressure. They know assets are overpriced but cannot help themselves.
While all seven factors are theoretical, there was nothing theoretical about the pain experienced by investors when the dotcom bubble burst. More specifically, the S&P 500 index grew every year from 1991 through 1999 and grew at an average rate of 20.8% per year. Investors couldn’t help but be optimistic and “receptive to bulls--- stories.” Especially if they were tech stories.
It’s not surprising investors were psychologically ready for the stories. Marks noted they began with the real potential of technology, were given a push by wild rationales and supercharged by what appeared to be unstoppable price appreciation. And soon after the bubble popped, the same psychological factors drove many investors into the homebuilding and mortgage company stocks.
Marks offered several “weapons” we can use to us avoid the temptations:
- Know, and stick to, intrinsic values.
- Be disciplined when price diverges from value.
- Learn about previous cycles, and their results.
- Understand the “insidious effect of psychology on the investing process at market extremes.”
- Something “too good to be true” in the market usually is.
- Be willing to look wrong when the market gets increasingly misvalued (remember Warren Buffett (Trades, Portfolio) in the 1990s).
- Associate with “like-minded friends and colleagues,” giving and getting support.
He reported these are the sorts of psychological tools they use at Oaktree Capital. And although Marks does not mention in this chapter, his idea of “second-level thinking” is applicable. Deep and complex reflections on stocks and their values are partially embraced in this list, but could be taken further.
The gurus who have become investing legends all did so with deep and complex thinking of one kind or another. Their profound knowledge of stocks, markets and other investors helped them achieve their returns, despite the temptations for quick profits.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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