What’s emotional investing? What type of emotions will prevent you from making good investments?
When investing in the stock market, emotions of all kinds could stir you up. Howard Marks’s book The Most Important Thing contends that three key emotions (greed, fear, and the desire to conform) affect investors’ decisions and cut into potential profits.
Check out how emotional investing could make or break your career as an investor.
Pitfall #1: Greed
First, Marks argues that greed leads investors to make suboptimal decisions as it causes them to abandon caution. He points out that when investors are overcome by their desire to earn money in the stock market, emotions such as greed influence investors to cast aside risk aversion in hopes of earning an outsized profit. For instance, a greedy investor might spend an exorbitant amount of money investing in an unproven cryptocurrency, leaving them exposed to massive losses if the investment fails. For this reason, Marks maintains that greed is one of the most potent forces working against investors.
(Shortform note: Although it’s impossible to precisely determine greed’s influence, CNN business experts have developed a fear and greed index that estimates which emotions are driving the market. This index relies on seven metrics—including market momentum, market volatility, and the demand for junk bonds—to assess whether the market is greedy, fearful, or somewhere in between. For example, a high demand for junk bonds (bonds that have a high likelihood of defaulting) suggests a greedy market, while an above-average degree of volatility suggests a fearful market.)
Pitfall #2: Fear
On the other end of the spectrum, Marks holds that fear causes investors to leave profits on the table because scared investors are unwilling to take even well-informed risks. According to Marks, fear paralyzes the would-be investor. For example, a fearful investor might see an opportunity to purchase a security for far below its intrinsic value, only to be frozen by the possibility that they’ll ultimately lose money. In this way, fear can hinder investors from maximizing their potential returns.
(Shortform note: According to experts, one way to mitigate fear when investing is to start with smaller investments and gradually work your way up to investing larger sums. Because fear is proportionate to the amount of money you’ve invested—after all, the more money that you invest, the more money that you could lose—slowly increasing your investment portfolio will help you cope with gradually increasing amounts of fear.)
Pitfall #3: Conformity
Both greed and fear, however, can result from a greater problem afflicting investors: the desire to conform to other investors’ behavior. Marks argues that conformity often leads investors to act irrationally when the consensus view is misguided, as it often is. Specifically, he contends that pressure to conform causes investors to forsake their own due diligence when assessing securities and incur excessive risk, as they reason that the consensus view can’t be mistaken. In turn, this behavior leads investors to purchase securities that they would never have purchased otherwise.
(Shortform note: In The Warren Buffett Way, Hagstrom explains Buffett’s idea that conformity doesn’t just influence investors, but also business leaders. According to Buffett, these leaders often succumb to the lemming factor and blindly follow industry trends, like constantly acquiring other companies, even when these trends are ultimately irrational. Thus, Buffett recommends investing in companies that are unafraid to look foolish and buck industry trends because they’re less likely to mirror these harmful tendencies.)
