Sentiment and Investing

I'd hold onto you
Till the mountains crumble flat
I'd hold onto you
'Till you figure out just where you're at
--Ric Ocasek

Previously we discussed the primary asset classes available to investors and shared some sample asset allocations. We also examined the relationship between income, saving, and investing as well as the negative effects of debt on the process. Finally we offered a brief primer on technical analysis using uptrend and downtrend patterns.

Today, let's briefly consider sentiment and its influence on investing. In our context, sentiment is synonymous with emotion. Many assume that humans make economic and financial decisions rationally with little emotion. Research suggests that this can be a bad assumption. At best, people are 'boundedly rational,' meaning that limits in cognitive capabilities limit capacity to be completely rational. At worst, people rarely choose to engage the slower thinking, rational portions of their brain, opting instead to let fast thinking, emotionally charged thought processes govern most of their decisions.

This general tendency to weave sentiment into our thought processes can impair ability to make consistently good investment-related decisions. Impulse purchases at the mall reduce capacity for saving--the necessary precedent for investing. Get-rich-quick desires motivate speculation on popular high flying growth stocks with unknown underlying fundamentals. Overconfidence drives belief that we are smarter than other investors in the market. Fear of missing out on big market moves encourages asset allocations tilted toward risky extremes. On the other hand, fear of losing money can prompt overly conservative asset allocations, or keep us from cutting losses by selling poorly performing investments that we should no longer own.

How can people keep their emotions in check when making investment decisions? A few ideas come to mind. Slow the process down. Think, read, study the possibilities before making a choice. The more rushed the investment decision, the lower the likelihood that it will be a good one. Also, consider tracking your investments on a routine basis. Make some spreadsheets that lay out your investment positions and show their performance over time. Calculate your asset allocation so that you know where you stand. It is more difficult to let your emotions drive you too far into the weeds when you routinely review the numbers. Finally, talk to others about markets and investing. Bouncing ideas and experiences off of others helps you learn how well you are thinking things through.

It also helps you realize that wrestling with sentiment when making investment decisions is not just a 'you' problem. It is part of the general human condition.