Friday, July 12, 2013

Acting On Fear

Well it's been a while since I last wrote anything here so I thought I would write a few thought on a subject recently discussed among some fellow value investors and myself.  The topic was acting on fear.  More specifically the discussion centered around how the best investment ideas are often the ones you are most fearful about. 

Understanding our biology is perhaps the best place to begin to understand why this is a problem.  Over the last few years I have read a number of books relating to this topic as well have been party to a number of discussions at my workplace on this subject. 

To best understand this topic I would recommend reading about the different parts of the brain and what the different elements are responsible for.  To begin with, our limbic system is responsible for the emotional part of our mind, fear included. This part of the brain is responsible for self preservation, fight or flight tendencies, and emotional hijacking.  Questions like, "Does it eat me or do I eat it?" is what this part of the brain processes.  We should be thankful this part of the brain is located at the base of the spinal cord. This allows for a quick response when faced with a physical threat.

Today however, the most common threats are not physical threats but psychological threats and this part of the brain is unable to distinguish between the two. Think of this system as an early warning radar system, constantly looking for any and all threats. 

This part of the brain becomes fused by the age of two and stops developing. That is why you can be 2, 42, or 82 and still have an emotional meltdown. 

Now, if the fight or flight response to a threat is strong enough it will result in an emotional hijacking in which the cortex is flooded with hormones and the rational portion of our thinking is rendered useless. This process happens countless times daily in the workplace and at home whenever some one's ego becomes threatened (including our own).  Often it isn't till after the chemical response has subsided that one will be able to think rationally and reflect on how irrational their behavior was.  This is most common when people are confronted with their mistakes. 

If you would like to witness an emotional hijacking, just go tell an engineer that his design is crappy and won't work.  If you are unable to locate an engineer to perform this experiment, just go home and tell your wife she looks fat and her cooking is sub par.  I've never seen that one fail.   

Investing Implications

The consequences to investing are numerous, however patience and emotional intelligence/awareness are key.  Let's start with patience.  Never, ever make a decision on a whim or when the markets are making wild swings.  You are often not thinking rationally when you feel strongly threatened.  Personally, I have made it a practice that upon deciding to make a stock purchase to wait three days to "think it over".  Sometimes I change my mind, sometime the market corrects and the opportunity goes away, but most often the stock continues to fall and I get to purchase at an even better price. 

Secondly your should never "trust your gut" when investing.  Emotions are not tools of cognition, but they likewise shouldn't be ignored.  Emotions will be able to recognize patterns far sooner than you will be able to mentally recognize and understand them.  Learn to utilize these emotions but always utilize rational part of your brain in the analysis.  Keep in mind that rational thinking takes considerable effort, but as in life and investing... no pain no gain. 

You must also learn to trust your thinking and not your emotions when faced with conflicting signals.  There are often times when your thinking will tell to buy and your emotions will be telling you to sell.  These conflicting signals need to be properly understood and processed.   If you are unable to maintain a rational position in the face of a sharply dropping market, perhaps investing just isn't for you.  I have had stocks fall by 60+% and I can tell you my emotions were questioning my logic of doubling down and then tripling down as the continued to fall.  This leads me to my next point. 

Thirdly, learn and develop your critical thinking skills.  As Ben Graham said, "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right."  Learn to be firmly independent in your thinking.  Write out your ideas, use checklists to find biases in your thinking, and always maintain a long term perspective.  Be willing to be wrong and actively try to prove yourself wrong.  Some people will have no idea what I mean by that last statement.

The most important aspect of being independent is taking personal responsibility.  If you are like most people you are afraid of taking personal responsibility and thus read blogs like this one and search the internet for investment ideas.  Then once you buy a stock your continually search the internet looking for validation that you are correct in your thinking.  Then when the stock goes down and you lose money you blame the writer for providing the stupid investment idea, and then continue your search for a "better" blog or site. 

While reading the last paragraph you may have felt insulted, if so great, that was exactly what I intended.  It was intended as an exercise to help you feel the tension created by your emotions and your thinking.  On the one hand, your ego was likely telling you that your need for respect was being threatened invoking an emotional response.  On the other hand, your mind may have been telling you that the statement is true (if your thinking is rational).  This is the tension I am talking about and the statement is either true or not true.  Your emotions didn't want it to be true because it threatened your esteem need while your (rational) thinking was telling you it is true. 

If you didn't feel the tension or it was short lived, I have bad news for you.  You are likely a skilled egocentric thinker who quickly told yourself some sort of lie to make the unpleasant truth go away quickly.  Self-deception is something you may not even be aware of and may want to investigate further. 


After reading about how the brain works, I strongly believe some people are "wired" differently and thus someone like Warren Buffett is an anomaly.  He is a strong rational thinker who properly understands and integrates his feelings (emotions) and his thinking.  The good news for the rest of us is that new neural connections can always be created and the brain is tremendously adaptive.  If you want to understand this process and change your thinking I have some recommended reading below.  Once understood it will require a lot of conscious effort and a double dose of courage.

Best Regards,

Kevin Graham

Recommended Reading

Leadership & Self-Deception - by Arbinger Institute
Your Money & Your Brain - by Jason Zwieg
Feel The Fear and Do It Anyway - by Susan Jeffers
Emotional Intelligence  - by Daniel Goleman
The Human Mind - by The Foundation for Critical Thinking
Critical Thinking - by Richard Paul & Linda Elder
Thinking, Fast and Slow - by Daniel Kahneman
Predictably Irrational, The Upside of Irrationality & The Honest Truth About Dishonesty - by Dan Ariely
My "Stroke" of Insight - by Jill Taylor
(Yes, I like to read)

1 comment:

  1. Gotta love those big banks, eh!!

    WASHINGTON - The U.S. Federal Deposit Insurance Corp. has sued 16 big banks, including the Royal Bank of Canada (TSX:RY.TO - News), for alleged rigging of a key global interest rate.

    The banks, among the world's largest and also include Bank of America, Citigroup and JPMorgan Chase, are accused by the FDIC of fraud and conspiring to keep the rate low to enrich themselves.

    The FDIC says it is seeking to recover losses suffered from the rate manipulation by 10 U.S. banks that failed during the financial crisis and were taken over by the agency.

    The civil lawsuit was filed Friday in federal court in Manhattan.

    The banks rigged the London interbank offered rate, or Libor, from August 2007 to at least mid-2011, the FDIC alleges. The Libor affects trillions of dollars in contracts around the world, including mortgages, bonds and consumer loans.

    A British banking trade group sets the Libor every morning after the 16 international banks submit estimates of what it costs them to borrow. The FDIC also sued that trade group, the British Bankers' Association.

    By submitting false estimates of their borrowing costs used to calculate Libor, the 16 banks "fraudulently and collusively suppressed (the Libor rate), and they did so to their advantage," the FDIC said in the suit.