The Paradoxes of Investor Emotion

Published on

I believe that stock investors should aim to be as rational as possible. I believe that the big risk of stock investing is becoming emotional about it. The aim of investment professionals should be to help people rein in their emotions and make rational choices.

That’s what Buy-and-Hold is all about. The Buy-and-Holders pride themselves on their non-emotional perspective. I am not a Buy-and-Holder. I believe that investors need to practice valuation-based market timing and the Buy-and-Holders disdain all forms of market timing. That seems like a contradiction.

The problem is that, when people act on emotion, they are often not aware that that is what they are doing. No one says: “I bought my car because I fell in love with the color.” That sounds like a dumb thing to do. So we talk about how the car gets good gas mileage and performs well on safety tests and maintains a good resale value. Those things might well be so. But salespeople will tell you that often people fall in love with the look of a car and then look for rationalizations for their desire to purchase it and that the stated reasons for buying it are not necessarily the true motivators of the sale.

We humans are emotional creatures. We are certainly capable of reason and we engage in it all the time. But we can get ourselves in a lot of trouble if we convince ourselves that reason is our one and only guide. That’s usually not the case and, if it becomes important to us to persuade ourselves that it is, we can engage in a lot of deception and a lot of deception of others trying to make the case that it is.

The importance of price discipline

That’s what I believe has happened to my Buy-and-Hold friends. I have had thousands of conversations with Buy-and-Holders over the years, trying to understand why they fail to see the need for valuation-based market timing. In my eyes, valuation-based market timing is price discipline. Price discipline is critical to the proper functioning of all markets. How could valuation-based market timing be a bad thing?

In the eyes of the Buy-and-Holders, it’s bad because it’s emotional. An investor who believes that he can outsmart the market is deluding himself. He is failing to Stay the Course re his investment strategy if there are times when he changes his stock allocation. The better approach is to disdain market timing and stick with the same stock allocation at all times.

That really would work if all stock investors were entirely rational. If all investors were rational, stocks would always be properly priced. Stock prices would always reflect the economic realities and neither overvaluation nor undervaluation would exist. So market timing would serve no purpose.

But what if investors are not always entirely rational? In that case, stocks could at times be mispriced and the long-term value proposition of stocks would change depending on the valuation level that applied at a particular point in time. Investors who wanted to keep their risk profile constant over time would be required to engage in valuation-based market timing to do so. And of course they would be helping themselves by doing so. They would obtain higher long-term returns while taking on less risk. Investor heaven!

Dealing with investor emotion

The Buy-and-Holders think of the stock market as a rational place. My view is that it cannot become rational until most investors become market timers. There is always going to be some emotion that creeps into stock investing and that emotion is always going to cause prices to go haywire. If investors respond to overpricing by lowering their stock allocation, the stock sales would pull prices back to their proper level and the problem would be solved. But, if Buy-and-Hold strategies become popular (as they are today), prices will continue to rise until they are out of control and cause all sorts of negative outcomes to take place.

It’s a paradox. Buy-and-Holders crave rationality so much that they cannot bear to take action to deal effectively with investor emotion. So investor emotion gets more out of hand than it would if they simply recognized the problem and coped with it. It’s by pretending that the market is rational that we open the way for it to become highly irrational. It’s by acknowledging the human capacity to become emotional about stocks that we become empowered to stabilize prices.

It’s investor emotion that makes stock investing risky. It’s market timing that corrects for the effect of investor emotion. It’s the Buy-and-Holders’ inability to acknowledge the role of emotion in setting stock prices that permits stock prices to rise to the crazy levels where they reside today.

If we all practiced market timing, there would no longer be much need for it. In a world in which investors were being regularly exhorted to practice valuation-based market timing, there would be no more bull markets or the bear markets that follow from them or the economic collapses that follow from them. Price stability follows from an open acknowledgment that investors are humans and humans are highly emotional creatures. Making reasoned choices is something we strive for, not something that we can assume we will achieve without effort.

Rob’s bio is here.