All posts from Janet
Janet in Trading psychology,

Logic: The Antidote To Emotional Investing

Much has been written about crowd and group behavior in the investment industry, but one aspect that has received little attention is emotional contagion. As the term suggests, people can infect each other behaviorally. And in the field of investment, this can cost everyone a lot of money.

The term contagion has a negative connotation from its customarily application in the field of medicine and disease. Still, the term is very apt in the context of investment, because contagion frequently leads to irrational or imprudent behavior. It prevents "healthy" evaluations of investment opportunities, and gets in the way of sound judgment in decision-making.

Contagion leads to the classic blunders associated with following the crowd - buying into the market when prices are high, and fleeing in panic when they drop. Contrarian behavior, generally the best (or even, arguably, the only) way to really make money, is, by definition, undermined by emotional contagion.

How Does Contagion Infect the Investor's Mind?
As an example, let's assume that Ivan leads a placid life, earning a good living and putting his money into a secure retirement fund that does ok, but does not "shoot out the lights." Some of his friends are investing money in foreign bonds, and making double the return that Ivan receives from his conservative fund. Ivan's resistance is strong at this point, and he follows his gut feeling that these bonds are too risky.

However, out of a mixture of curiosity and envy, Ivan the investor starts asking his friends how well the bonds are doing. They tell him that the returns are excellent, and are sure to stay that way. Ivan's resistance slowly weakens, as he hears repeatedly how much he is losing out on and eventually, he gives in, buying bonds when they are nearing their peak.

Soon afterwards, some crisis occurs overseas, and his friends start to panic - as do many other investors. Once again, Ivan is contaminated and thinks he should also sell out before it is too late. After all, that is what his friends are doing.

Two months later, when the price is half of what it was when Ivan bought in, he is disillusioned and still recovering from his losses. Under normal circumstances, this would be the ideal time to make an initial investment, to get back in to the market or to top up existing holdings, but the emotions of contagion always work in the wrong direction, and Ivan retreats to recover.

Subconscious Contagion
Emotional contagion is relatively automatic, and inevitably entails the suppression of conventional rationality and caution. In the investment industry, the heady mixture of media reports of money to be made, and seeing others capitalize without much effort, leads to emotional pressure to charge ahead and share in the gains. It is very tempting to go into an investment that is doing strikingly well, and people tend to suppress any warnings of overheating or information to the contrary. 

Downward Pressure Is More Powerful Than Upward
Negative events tend to elicit stronger and quicker emotional, behavioral and cognitive responses than positive events. Hence, whenmarkets and investments go sour, the contagion of panic is even worse than the pressure to buy when markets are booming and overheated. This explains why investments can lose their value so fast. The sheer blind panic, as people desperately try to avoid losses, is an irresistible and disastrous force.

Why Is Emotional Contagion Common?
On the one level, people tend to imitate those who seem to be successful. Envy and greed invariably attract others into the same activities. Evolutionists have another explanation, as well. In some instances, emotions help people to adapt to the circumstances, and contagion can thus aid survival. For instance, if people see others work hard to earn a living and the results are there to be seen, the mimicry is a purely positive reaction.

Similarly, where there is danger of fire, for instance, if the emotional contagion leads to precautionary measures being taken in order to prevent fires, the positive aspects are obvious. But if people only react when the town is already on fire, and trample each other to death in a belated attempt to escape, the contagion is too late and only exacerbates the loss of life and limb. This is exactly what tends to happen in investment markets. By the time contagion sets in and most ordinary people buy, it is too late in the cycle to make money. Prices and the risks of a crash are too high by that stage.

In other words, contagion is a natural emotional process that can be advantageous. But in the investment industry, it is frequently the exact opposite. Over-the-top emotions lead people to charge into investments at precisely the time when they should be getting out of them and into something on the ground floor. 

Emotional neutrality is the key. Only invest for coldly rational reasons, and never because other people are buying in droves and making money right now.Heated emotions, euphoria, excitement and similar sentiments are the enemy of prudent and profitable investing. Make sure that you do not get carried away with the crowd. In fact, it is generally best to do the diametrical opposite. When the crowd is cheering, leering and buying, look to sell; when it is moaning, groaning, panicking and selling, it is generally time to make your move.

Having a good, neutral advisor is a great help. Before taking the plunge - either in or out - ask informed friends or brokers who can be trusted for their advice. Objective third parties are invaluable in ensuring that you don't get carried away or become imprudent in the face of peer pressure and temptingly high, but unreliable and unstable, returns. Indeed, if you have a broker, his or her job - either ethically or even legally - is to ensure that you never join the proverbial queue of lemmings at the edge of a cliff.