Emotions and Investing: Managing Ourselves

By: Joe Thomas, CFA

There’s a joke out there, a factory of the future will operate with only robots, except that it has two employees, a human and a dog. The human is there to feed the dog and the dog is there to keep the human from touching anything. Robots don’t design themselves yet, humans at some point designed this wildly efficient and unemotional thing that does exactly what we want it to without questions or interpretation, yet we somehow just can’t leave it alone.

As we just wrapped up the NCAA Basketball Tournament it made me reflect on the inefficiencies of playoff systems in college sports (mainly basketball and football). If you look at professional sports the playoff system is straightforward based on wins and losses. There are tie breakers built in that has been agreed upon for years. We don’t hear complaining about a team just missing the playoffs being better than a team that made the playoffs. The reason is every knows at the start of the year what they need to do to get into the playoffs.

College sports are unfortunately not like this at all, basketball has some built in guarantees to get into the tournament.  Football is the toughest as there’s 129 teams and only 4 make it to the playoffs. Both these sports have committees to determine who makes it to the playoffs. These committees love to reference the “eye-test” and routinely change the parameters of how teams get it. There’s plenty of statistical measures of how teams should be ranked and those are even considered, but the final determination just comes down to how these people “feel”.

Investors have that “eye-test” or “how they feel” too, does this company do something that I like, is it exciting, have I ever heard of it, do I use it, does it pay a dividend and so on. What would you rather invest in a boring old conglomerate or an innovative tech company? Funny thing is, depending on who you are the answer could be different. Boring conglomerates are appealing to some and vice-versa, we all have a bias in this situation.   A process should be determined to eliminate the “eye-test”, objective analysis should be the goal.  Sometimes, the ugliest looking investments can turn out to be some of the best investments.

Joel Greenblat created what he called the magic formula for investing. He tested it for a period and recorded the success. The strategy created a list of stocks and recommended investing in the complete list. Like any investment strategy there were not 100% winners, but the average returns from the basket were better than his benchmark. He then managed money for people directly but also put his results on a website that allowed people to pick from his buys or follow his strategy to the letter. They tracked and recorded this data, and it was found that the people who were least successful were the ones who reviewed the list and pick only the ones they thought would be the best investments. The best performers were those who just bought the list and held for the specified time. As humans we can create something great and efficient, but we have an issue just following that plan, we think we can do even better. Even the best strategies have losers in the portfolio or losing years, sometimes that is nothing more than luck or random unpredictable events.

Utilizing a process of investing based on your goals and the parameters you trust has shown to be the more prudent and more important, a repeatable approach. Decisions based on gut feeling or emotions are impossible to differentiate between luck and skill, and very difficult to replicate. Objective constraints designed to help meet your long-term goals can be repeated and measured. The more you can take your feelings out of the equation, the more you’ll be able to avoid emotional  biases that could hurt your long-term results.

Investing involves risk, including the potential loss of principal.

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