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Great traders don’t necessarily have to be that smart, but mastery of their emotions – specifically, fear & greed – is absolutely essential. The same is equally true of great investors, except it just happens in slow(er) motion… But most people end up choosing investing over trading. Which is pretty fortunate – the trading gods delight in seeing meticulous logic & analysis abruptly savaged by fear & greed.

Many would-be traders never recognize this, and fail accordingly. Others grasp it, but remain trapped in a never-ending struggle. Only the brave few ever learn to fully master these emotions. Investing, on the other hand, seduces you with the luxury of time & positive long-term equity market trends. Which often makes it far more difficult to recognize the corrosive impact of fear & greed on your portfolio returns. The fact many of us shy away from any kind of critical self-examination doesn’t help either. But there are two solutions available to us:

The first is reading. In my last post, I argued for an important alternative to most investors’ non-fiction diet – literature, and lots of it. The great novels, plays & poetry are windows into the hearts & minds of other people – and in turn, yourself. Learning to actually recognize emotions like fear & greed in yourself, and their potentially disastrous impact on your investing, is the first & likely most difficult part of the battle you face.

Now, I didn’t cover the second solution – how to actually conquer those emotions. Because unfortunately, when it comes to that challenge, we are all truly alone… 

Even when we recognize the investing sins we commit – both of omission & commission – many of us can’t seem to help but repeat them. [Let’s leave the grim details in the confessional – we’ve all got plenty of them seared across our hearts…and wallets]. And nobody can really save us anyway, except ourselves – because their fear & greed (and its consequences) are never quite the same as yours, or mine.

The best I can do is share what works for me – maybe you’ll find some inspiration, or figure out an adaptation (or two) that works for you. Some of the techniques I’ll describe may seem like simple tricks – but seriously, take ’em for a road-test, I bet you’ll be surprised! Some I’ve taken from the trading world – traders are often notorious for their rigid enforcement of certain rituals & habits. And these days, more & more people are realizing simple tricks & habits are often far more effective in altering & controlling their behaviour. [Try laying out your running/exercise gear the night before…] [I suspect the field of biofeedback inspired some of those ideas. I haven’t read it yet, but the bestseller ‘Nudge’ also appears to touch on many of the same ideas]. Right, let’s get into it:

i) Learn To Love The Black Box

Now I’m talking about the effects of fear & greed, I’m already presuming you’re a fairly accomplished stock analyst – one who’s no longer tripped up by silly analytical & valuation mistakes. But how true is that really..? Even the best of us usually still nurse a blind spot or two – through ignorance, laziness, or whatever. Companies with poor returns, poor cash-flows and/or too much debt can still ensnare experienced value investors – ‘cos there’s nothing so cheap (& dangerous) as an over-indebted small cap value-trap… Ugh!

The only way to stamp out disasters, whatever the reason, is to systematically study ’em & learn from your mistakes. For that, you’re gonna need a black box to consult… [Otherwise, losses tend to horribly corrupt the accuracy of your recall]. Which will require you to keep a written record – nothing elaborate, just a summary of your investment thesis & even briefer notes documenting key developments & changes in your position.

[See Why I Write…]

Walking back through your notes, accompanied by the company’s press releases & price chart, will provide an all too accurate real-time autopsy of how & where things went terribly wrong. Sure, sometimes it just boils down to tough luck, but usually it’s due to simple analytical error and/or the consequences of fear & greed. Almost inevitably, there’s an obvious lesson to be learned – so apply it! Now just iterate…well, as little as possible. 🙂

ii) Checklist It

In my opinion, the vast majority of business books are worthless dross – their only value is to signal you’re good corporate drone material. But one recent book’s already being lauded as a valuable business classic: ‘The Checklist Manifesto’ by Atul Gawande. What I like is the focus on people (like surgeons & pilots) who regularly experience v real & immediate consequences to their decisions. Unlike most business people, these people are invariably intelligent, clearheaded & experienced in a crisis. But despite that level of intelligence & experience, it’s fascinating to see so many acknowledge a simple checklist approach to their jobs offers valuable, sometimes critical, benefits.

The same is true of the investing world, where one or two key decisions could possibly prove fatal to your portfolio. Checklists to accompany every stage of your investment process are a handy deterrent against simple errors & omissions. More importantly, they lend a steady hand & are a great antidote to the often corrosive impact of fear & greed on your decision-making. [btw Mental checklists aren’t sufficient – you’ll inevitably skip/forget steps – you actually need to walk-through & check off your lists step-by-step. Integration with the black box approach is an obvious enhancement – lessons learned can then be immediately incorporated into revised checklists].

iii) Valuation Orgy

As an investor, you’re always going to be surrounded by people – brokers, media, management, etc. – who are (financially) motivated to be bullish on stocks/sectors/the market. An age-old persuasion technique is to ‘tell ’em what they want to hear..!’ Perhaps it’s a high dividend yield. Or ad clicks per 100 K readers. Or a cheap P/E, or perhaps a high growth rate. It doesn’t really matter, they’ll find it… And if one valuation metric’s too high, you can be sure they’ll find a cheaper one. Or they’ll simply invent a new one (where do you think EBITDA came from?!).

When the market’s focusing on a single metric, and you begin to do the same, that’s a sure sign greed’s really kicking in. [Or fear… On that rare occasion when everybody’s turned gloomy, they’ll inevitably home in on the worst/most misleading metrics]. You should always try to avoid the hot metrics. And when you look at a stock/the market, force yourself to dive in, get sweaty, and value it in as many different ways & against as many different metrics as possible. If they all look & taste good to you, that’s promising… But if they’re in direct conflict, you might want to sit down & think about what that really means – before you start buying (or selling) something that’s perhaps wildly mispriced…

iv) Watch What They Do, Not What They Say

You have to remember, in reality, most CEOs reached the top (particularly in larger companies) because they’re consummate politicians & salespeople. It wasn’t necessarily because of their track record, skills, experience, or good looks (well, maybe the last!). I mean, think of all the great people they’ve left for dust in middle management… Nearly all of us (inc. investors) can be seduced by that kind of charisma. Remember, there’s an inherent bias to all interaction with management – you’re probably only going to see & hear positive commentary about the company & its prospects. But what’s said is often v different to what’s really meant, or what’s actually delivered…and anyway, the goalposts often shift too!

Small investors are often frustrated at their lack of access to company management, but frankly this may be a real blessing in disguise. Reading back through a number of years of results/annual reports can be a most revealing alternative – one can systematically track how management sets targets, what they’ve actually delivered, how they report on performance, whether they even admit to failure, etc. For new management, evaluating their prior track record is also invaluable. Basically, don’t just fall for a story & nothing else…

v) Well, Are You The Right Size?

Determining & observing a (pretty) rigid framework of position limits is one of the best ways to dilute the impact of fear & greed in your portfolio. Positions obviously need to be large enough to justify your conviction & research, but not so large you can’t sleep at night or afford an unexpected direct hit. [I’m already presuming you’re well diversified in terms of stocks & sectors, and adequately insured against home bias. If you aren’t…well, that’s really not investing, it’s more akin to gambling – now tell me, is this due to greed, or simply laziness?].

There’s some level of CYA involved, but observing how professional fund managers construct their portfolios offers some valuable lessons. Some prefer to swing for the fences (and boy, they sometimes miss, badly), but for most fund managers a 3-7.5% position is pretty decent for an individual stock. That’s good enough for me – not too small to be meaningless, and not too large to blow a fatal hole in my portfolio if things go wrong. You may prefer a higher max. limit, you just have to ask yourself honestly if you could really cope with a total blow-up..? Stakes in investment companies/funds can afford to be that much larger – say, up to 10%, depending on the level of diversification. And arguably, funds of funds justify an even higher weighting – say, up to 12.5%.

Some people will inevitably struggle to keep within these maximums – on the other hand, others will actually end up swamped with too many small(er) positions. But sticking fairly rigidly with this kind of limit framework in your portfolio (which should give you 15-20 core holdings) will definitely save you from your worst possible excesses. [btw If you really have an itch to scratch, a mini-portfolio of boom-bust stocks within your overall portfolio is a nice little cheat. Say, something like 5 stocks, at 1% apiece – that gives you plenty of excitement, but remains well under control in terms of risk].

To Be Continued…