MANAGE YOUR EMOTIONS AND INCREASE YOUR WEALTH

Every time there’s a market correction to the downside it seems the man on the street loses more money than bankers or institutions, you’ll hear people say “we didn’t get out quickly enough” conversely when markets pick up the bankers and institutions seem to get most of the upside and the man on the street might be heard muttering “we missed the boat”. So is this an urban myth or some kind of conspiracy against the masses? We would suggest it’s neither.

Maybe it’s simply a product of human behaviour; take for example the oft heard complaint about the extreme levels of trashy TV or the modern obsession with celebrity. We may complain about it but the fact is viewer numbers drive TV programming and magazines with celebrities on the cover sell more copies. Create enough of a marketing buzz around a new diet fad and suddenly its weight loss nirvana and better than anything that came before it.

The simple fact is that whether we are conscious of it or not our consumer choices are often driven by clever marketing and then herd mentality completes the job. We’re all highly susceptible to the influences that surround our daily lives be it friends, family and media in all of its forms. Investment decisions can be influenced in the same way.

Of course the result of this generalised consumer behaviour is mostly harmless, trashy television or celebrity magazines are unlikely to damage you. You can also find alternative well-crafted drama and intelligent documentaries should you wish. You might even find the strength to resist the latest diet fad and stick with eating sensibly and getting regular exercise. Unfortunately the same can’t be said for a bad emotionally driven investment decision, this can be highly damaging to your wealth.

What sits behind all this are human emotions and the stronger the emotional response the more irrational the decision making can become, think falling in love! In most cases the emotional part of our brain over-rules the rational part and drives important decisions that we make every day.

If we always made decisions with our rational brain life almost certainly wouldn’t be as much fun, however banishing our emotional brain from certain parts of our lives might be a real help. It would almost certainly reduce the amount of time the man on the street is seemingly out of kilter with more savvy investors as per my opening paragraph.

Managing our emotions is a tough job and one’s level of intelligence is no defence, the best illustration of this might be “Sir Isaac Newton’s Nightmare”. Sir Isaac would have been considered one the most intelligent men on the planet in his day but an emotionally driven set of investment decisions left him a virtual pauper.

Take a look at the following graphic, at the start point Sir Isaac is ”in the know” and makes an investment along with the smart money (the bankers and the institutions) then the buzz starts to pick up and more people begin to invest, the price rises dramatically and Sir Isaac along with a lot of other smart money exits happily after almost doubling his money. His less well informed (man on the street) friends are staying in and buying in ever bigger numbers as the hype and the get rich quick mentality takes hold. Sir Isaac can’t stand watching his friends treble and quadruple their money, greed has paralysed his rational thought process and he eventually borrows money and reinvests the lot. The price falls dramatically shortly afterwards but Sir Isaac fails to exit and take a partial loss, less than 2 years later he exits broke.

Interesting isn’t it that investing is just about the only time we all pile in as things get more expensive and all run for the exit when things are on sale. Herd mentality at its glorious best!

newtons-graph

So what’s the solution to making rational investment decisions when your emotions are suggesting otherwise, what would have helped Sir Isaac remain comfortable with his decision to exit? I think it can be summed up as follows:

The best way for investors to avoid making big investment mistakes is to have an investment process that they implicitly trust as this will help them override emotional investment decisions.

The secret is to access an investment service that responds to asset price movements (dynamic asset allocation), armed with this the investor will feel less compelled to deploy an emotionally driven response.

Dynamic Asset allocation is a process that responds to the changing relative values of asset prices. In simple terms buying into asset classes when they are cheap or fair value and moving out of or not buying into asset classes that are fully priced or expensive.

It sounds like common sense doesn’t it? However our emotional side will override this which is why the “man on the street” often piles into an asset class when it’s becoming expensive, this is typically why asset bubbles form.

So to get with the smart money, utilise a dynamic asset allocation process, you’ll avoid the “man on the street” herd mentality and have a great chance of not being exposed when the bubble bursts!