The Psychology of Money Management

Quarterly Letter

Within the process of building and maintaining your long term financial well-being, achieving a reasonable rate of return on your investments is the obvious main contributor.

Yet, the lack of understanding regarding the psychology side of money management has been one of the biggest roadblocks for investors in achieving their goals. In this letter, we would like to show you that the psychology component in money management is not to be underestimated. It has been discussed many times before but it is worthwhile repeating after a 7 year bull market.

Investors tend to overreact to what they read on or hear in the media. However, their reactions are quite different during bull and bear markets. You have probably noticed the following:

  1. Stocks slowly rise on good news but collapse when the news is bad;
  2. As stock markets go up, volume builds up slowly but when they go down, volume spikes up abnormally;
  3. On the way up, stock prices increase in small increments, but on the way down, they exhibit larger increments.

This psychological reaction is due to the fact that people are driven by greed and fear, but fear creates a panic reaction. The media understands this concept very well and also that bad news sells: Witness the amount of bad news in your daily newspaper, on your TV, radio etc. Considering the media’s enormous skill at crowd manipulation, it is easy to create a state of panic in a particular group of people.

The following points are what we have observed after more than 30 years managing clients’ money:

  1. The number of calls we receive go up exponentially when one stock amongst the 50-70 in the portfolio has a move (up or down) or when market volatility increases;
  2. We get little new money from clients when stock markets are going down. Vice versa, we get a lot more new money when they’re going up. The more they’re going up, the more we get;
  3. If it is perceived that we keep too much cash in a portfolio as a means of being prudent, clients will get irritated – especially when the markets keep going up – because, as they say, they are not paying us to manage cash;
  4. Clients often pay more attention to their portfolio when markets are correcting. However, they measure their performance in dollar terms from the peak valuation, i.e. how much they are down from the highest point…

Yet, good money management practices would dictate behaving in the exact opposite manner:

  1. Not to pay attention to any one particular stock but to the whole portfolio: diversification (owning 50 to 70 stocks) is essential in prudent portfolio management practices;
  2. Add money on a regular basis regardless of whether markets are up or down since new money buys more stocks when markets are down and fewer stocks when markets are up;
  3. Cash is an asset class that is tremendously valuable when markets are down. This is precisely when bargains show up. Therefore we are paid to manage cash;
  4. Performance should be measured over a longer time interval, i.e. 3 to 5 years and always since inception.

Why is it so difficult to abide by the good money management practices mentioned above? The main reason is that our DNA is ingrained with irrational behavior. It is driven by emotion, essentially fear and greed. At extreme points, due to this irrational behavior, humans have a tough time staying rational and assigning a reasonable probability of an event happening. The obvious example would be lottery tickets: considering the probability of winning, the payout is so ridiculously low that the windfall profit for Loto-Québec is obscenely high (no wonder the government keeps it for itself). Yet, the lineup to buy tickets is there every week… Unfortunately, investing is about probabilities and payout ratios.

Even knowing our psychological shortcomings, we often have a tough time preventing them from affecting us. The only practical solution is defining a set of rules in advance and applying them when circumstances are warranted and avoid the urge to override the rules that are designed to block out our emotional and irrational reactions. That requires a tremendous amount of discipline and faith in the capitalist system, which everyone seems to think they have when markets are up and which most realize they don’t when markets are down. Think about it: if all money managers were so rational, why are markets so volatile at times? It shows how difficult it is to be steady at times.

The real value of an investment advisor:

No matter what strategy a portfolio manager uses to achieve above average returns, there will be periods of underperformance, significant at times, caused by the vagaries of stock market participants and their irrational behavior. There is a saying that “markets can stay irrational a lot longer than you can stay solvent”. Although the warning was meant to apply to speculators, it is also very relevant to whoever participates in the investment game.

Moreover, one can go to the website of AAII (American Association of Individual Investors) to find hundreds of strategies that have outstanding back tested historical performances. Yet, very few investors manage to achieve those results because they are plagued by the psychological shortcomings described above.

On top of being able to understand the psychology of markets, having access to tools for good money management practices, the following human characteristics are just as important:

  • Empathy, i.e. being able to listen and at times – more often than you think – act as somebody to shoulder the blame as clients express their frustrations;
  • Conviction, enough to talk clients out of panicking during periods of extreme volatility.

In short, an investment advisor’s most important value is the ability to offer an unemotional solution in order to counter the emotions of the average investor when faced with the irrational reality of markets.

The Claret team