By Tsachy Mishal
Emotions are the reason most investors fail to outperform the market. The tendency to buy when the market is high and sell when the market is low is built into our DNA. Humans have an evolutionary instinct to herd. During our evolution our tendency to stay in groups (herd) helped us survive attacks by both predators and human enemies. The herding instinct helped us to form societies and communities. When it comes to investing our herding instinct becomes a liability. It makes us want to join the excitement when the market is already up & run away when everybody else is running.
There are two ways to neutralize the effect of our herding instinct while investing in markets. The first is to systematically invest in a diversified portfolio of ETFs and rebalance at pre-determined intervals. This removes any decision making from the process and does not allow our herding instinct to get in the way. The second is to learn how to overcome one’s herding instinct. For the vast majority systematic investing is the better choice as it is extremely time consuming and difficult to try and fight what is coded into our DNA.
I chose the more difficult route and developed a process that that helps me remove my herding instinct from my investing. I learned early on in my investing career that emotion was my enemy. There were numerous times when I sold a stock because it was causing me so much pain that I could not take it anymore. Most often this turned out to be pretty close to the bottom. I knew that it could not be a coincidence and was determined to find a way to use this handicap to my advantage. It took me almost ten years of investing and hard knocks before I was able to profit consistently, which is why I don’t recommend this for the casual investor.
I use a combination of value investing and sentiment analysis to help me combat my emotions. During times when the crowd is extremely pessimistic values tend to be abundant. If one were following their emotions this is the time they would sell but a disciplined value investor would buy or at a minimum not sell. The opposite occurs when the crowd is jubilant. There is very little for a value investor to buy.
I use sentiment analysis to try and measure the mood of the crowd. I utilize surveys, market data and to a lesser degree anecdotal evidence to gauge when there is excessive optimism or pessimism. I attempt to have low market exposure when market participants are extremely optimistic and high exposure when they are extremely pessimistic.
In baseball no two hitters swing the bat the same way. The same goes for investing. I gave an overview of the method that I use to help me remove emotion from my investing. There are many other methods that could work. If one is actively investing it is imperative to develop a method to deal with emotions. Not having a method will likely result in buying and selling at the absolute worst times.
Tsachy Mishal is the Portolio Manager at TAM Capital Management. He holds a BS in Computer Science from Binghamton University and an MBA from Columbia University in Investment Management. He is the author of the investment blog Capital Observer. You can follow him on Twitter at @CapitalObserver