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SUMMARY
- Investing is emotional, in our view.
- Greed and especially fear can cause us to make poor long-term decisions, in our opinion.
- We offer some strategies to help overcome our emotions.
A study by Amos Tversky and Daniel Kahneman in 1992, showed that for most people the distress of loss is twice as powerful as the pleasure from an equivalent gain. Warren Buffett talks about buying from the fearful and selling to the greedy.
Largely due to COVID-19, in the last three years investors have experienced more than usual volatility and thus the full range of emotions. The pandemic was scary in so many ways, and yet investors experienced a remarkable recovery in the second half of 2020. Investors who sold based on fear might easily have missed the recovery as the COVID-19 headlines were still negative.
2021 was a banner year for stocks and there was likely some euphoria at the end of 2021, especially for those invested in stocks that benefitted from the pandemic, (mostly but not exclusively, Technology stocks). In hindsight, it was important not to allocate more to stocks at the end of 2021 as both stock and bond prices tumbled in 2022 as the Fed raised interest rates dramatically. This likely caused a return to worry and fear, and yet 2023 has seen a strong recovery. The probability of making a costly mistake by reacting emotionally and changing the structure of portfolios since 2020 has been unusually high.
As an investment manager who works with advisors, we believe that helping clients manage their emotions and complete their investment journey is one of the most important services we can collectively provide.
Emotional Alpha
In investing jargon, alpha (the first letter of the Greek alphabet) is used to describe how much a portfolio exceeds its benchmark. We think there is more to a portfolio manager’s role in a client’s investing journey than this. Emotional alpha is a term we have coined for the value of helping a client navigate market swings without making decisions purely on emotion. We submit that changes in asset allocation have the biggest impact on long-term returns. For example, consider an investor who is 100% invested in stocks and then sells 20% of their portfolio during a bear market when the news is usually at its most dire. Let’s say the market falls another 10% after the sale but ends up 10% higher than its previous peak over the next year. If that investor still has 20% cash, their return will be 20% lower than it would have been if they had done nothing.
Considering this example in hindsight is different from living it. To us, emotional alpha is helping investors make good decisions in times of both fear and euphoria. We believe that when RiverFront makes tactical adjustments in our balanced portfolios (such as raising cash temporarily), it can potentially offset the emotional urge for the investor to take action themselves. Our job is to seek to reinvest that cash so it can participate in the market’s recovery.
Ways To Combat Fear
- Don’t make decisions in isolation, seek out a financial ‘emotion counselor.’ There is a reason that most pension funds and endowments create clear asset allocation targets and have a board of trustees. A trusted financial advisor can play that role for individuals.
- Know yourself. Risk tolerance is personal, and so a portfolio tailored to your personality may be very important in offsetting the risk of failing to achieve your investment goals. Learning your emotional tolerance for ‘statement risk’ or unrealized losses is hard to do theoretically and so starting to invest small amounts at a young age can help you to become more comfortable with volatility. Also recognize that your risk tolerance may change as you get older, especially at the point of retirement when you move from accumulating wealth to distributing it.
- Clear communication. At RiverFront we believe passionately in open communication to build trust. We communicate our views of market moving events and how we are responding to them consistently through written publications, videos, and conference calls.
- Trusting a process. Our mantra is ‘process over prediction’. If you believe in a process, we believe you are much less susceptible to making an emotional decision to deviate from that process.
Measuring Fear
Extreme fear or pessimism is often but not always associated with market lows. One of our Three Tactical Rules is ‘Beware the Crowd at Extremes’ and one of our favorite gauges of investor sentiment is the Ned Davis Crowd Sentiment Poll (see chart to the right).
Ned Davis Research has combined a group of indicators reflecting investor sentiment which highlight what an emotional journey investing can be. The small table below the chart shows that better returns are generally achieved during periods of investor pessimism than investor optimism. The chart itself shows that market bottoms often coincide with extreme fear, as measured by low readings on this indicator (see 2003, 2009, and 2020). This is another reason why we believe managing emotions can be so valuable, especially in times of distress.
In seeking to make tactical judgments we don’t look at investor sentiment in isolation but combine measures of sentiment with central bank policy (‘Don’t Fight the Fed’) and the slope of the 200-day moving average (‘Don’t Fight the Trend’). At the time of writing (July 2023) the trend is positive and there is little fear.
In summary: Emotion is a constant presence for investors. History tells us that acting on both fear and greed can lead to poor decision making and so we believe a strategy for emotion management is very valuable.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.