· OK SO NOW WHAT?

Recently I wrote about “why you still own it.”  Now I think it’s important to discuss “OK so now what.”  What I mean by that is while we are sitting here thinking we are the dumbest bag of hammers on the planet for riding “that sucker all the way down” we have to step back and say “ok we did it and we are going to have to deal with it – so now what do we do?”

In my footnote for the earlier Observation I emphasized that you should understand that market action like this puts you under stress and the longer this goes on and the lower the market goes the more chronic the stress becomes. I stated very plainly that you should not let chronic stress and your desire from relief from that be the cause of the divestiture of your economic assets. In large part your decision should be based on an objective analysis of the assets you hold.  A good way to make the decision to hold or sell an asset is to objectively evaluate whether you would buy the asset if, hypothetically, you had some cash.

Notice I used the word “objectively” and remember that in my view true objectivity is impossible in the investment world.  The best course for us then is to become aware of the emotions affecting us and the biases in investing they cause and then armed with that knowledge try and overcome them (or at least take them into consideration) when making our analysis and decisions. In short, we need to recognize and acknowledge our situation, the emotions we are experiencing and the consequent biases to which we become subject and deal with them as strongly as we can.

OK so how about now?  Well in the current market negative emotions are predominant.  While all negative emotions have the same vector (direction as in “lower” or if you are in California "bummer" dude*) they do not have the same effect on investment decision making.  A short list of negative emotions includes disgust, sadness, fear and anger.

The negative emotion of disgust has been confirmed in behavioral economic studies to cause people to “expel.”  They want to get rid of assets they own.  They do not want to buy new items – their reflexive brain is screaming - get out of the market.

Sadness on the other hand does not cause the desire to “expel.” Studies have confirmed that sadness causes investors to value items that they own less and increase their perceived value of things that they do not own. Sadness reverses the “endowment effect (July 2, 2007 Observation “If it’s mine its mighty fine and if its not it’s not worth a lot”). In other words sadness causes people to (subjectively) want to turn their portfolio over. Although the endowment effect is not good for us, its reversal isn’t either.

The negative emotions of fear and anger have the opposite effect on investors. Fearful investors have been confirmed in studies to be uncertain and pessimistic in their outlook.  This causes them to be risk averse.  Risk aversion increases a subjective desire to sell and flee to “safe assets” even when their account is perfectly balanced and diversified.  As we now know even safe assets can take a drastic decline, so fear is a dangerous emotion because it causes clients to want to de-diversify (is that a word?).

Angry investors oddly enough have been confirmed to have a belief that they have control over their situation.  They are much more certain about the future than uncertain. As a result angry investors are much more optimistic about the future and are not risk averse but risk takers.  When investors become angry (not disgusted) they amplify their risk. If you need convincing take a look at how the markets behaved once the initial shock and fear over September 11, 2009 dissipated and the American public became “angry” – investors caused the markets to engage in strong rallies. Anger may in fact be a beneficial emotion in our current market conditions.

The takeaway here is: identify the negative emotions you or your clients are experiencing, remember what biases then come into effect and what they temp someone to do, deal with that temptation and do your best to recommend or make objective decisions.

That’s enough for this week.  Next week I am going to talk about the fact that people compulsively believe that the way they “feel” (their current emotional state) will be the way they “feel” in the future and how this hurts our ability to plan for our financial futures.

* For those of you not currently sitting on a surf board this word is correctly pronounced "dahoude."