Stock market and emotions

I don’t think anybody will be surprised to hear this but these days not a single day goes by where I don’t have a discussion on the price of something around me. House prices going through the roof (love the analogy here), used bike prices making no sense, lumber prices reaching unheard of levels, rare baseball cards selling for millions of dollars, what the heck is going on?

One simple answer; a lot of emotion combined with a lot of money.

As a finance professional for the last 25 years, I have been trying to find and build processes to separate emotions from the investment decisions I need to make. To be perfectly honest, the best decisions I made were always when my emotions were completely in check. As you are surely aware, we are currently in an unprecedented period where many things don’t seem to make sense. For sure, the pandemic really came as a total surprise to all and seems to have changed a lot of the economic dynamics that were in place. In a stable system, price movements are usually dictated by supply and demand. In most markets we eventually reach some kind of equilibrium between the buyers and the sellers justifying “normal” prices. Of course, when something happens on either side of supply or demand, prices move, and those moves can be dramatic when these two are truly out of balance. When you add a good portion of vivid emotions on top of a situation like this you get the perfect recipe for prices rising faster than we can think!

As you and I know, we are now in that exact situation. Many price movements don’t seem to make any sense. The stock market is not any different and when you get a lot of emotions and some imbalance in the supply and demand equilibrium, like we have now, you can get price movements that seem to defy gravity.

In this article I discuss my view of this phenomenon, how we should deal with this, and what lessons can we draw from past similar events. One thing remains constant in all overinflated price environment, historically very few people get out before it's too late. Of course hindsight is always 20/20. Either we never learn or there is something deeper in the way we deal with those situations that make them very difficult to foresee.

Emotions VS decisions

Over the past several years and following certain events in my personal life, I embarked on a personal mission to know myself better, especially how to deal with my own emotions. That ongoing journey led me to read a pile of books on related subjects, to meditate daily and it opened up a part of me I did not really know existed. Since the pandemic landed on us last year, we have all been faced with a lot of very different and sometimes difficult situations and emotions.

Emotions are simply part of our lives and I don’t think any of us would enjoy being on this planet if this was not the case. But sometimes, when we are faced with important decisions, it’s important to understand what our main triggers are in making such a decision. When looking at your portfolio, your finances, or investments, two emotions immediately come to mind: fear and greed. Depending how investors deal with them when facing buy, hold or sell decisions, they can have very material consequences on your future returns. The goal here is not to remove emotions totally from the equation because frankly it’s almost impossible unless you have automated computer-based systems. Even when you think you have systems that protect you from being overwhelmed by fear or greed, it’s not that simple because you can, and often do, change the parameters of that system in highly emotional times like 2008. From personal experience, managing my hedge fund in the 2008 financial crisis, it was very difficult not to change the basic parameters of the risk system we had in place to reflect the current situation. In hindsight, the system was very good and prevented us from losing money and we ended up the year (2008) marginally positive, which was quite a feat in those times. That being said, how do we as individual investors navigate those high stress and highly emotional times when dealing with our own investments.

What is the situation on the stock market?

Let’s look at the current stock market and current valuations. Yes, it’s high and getting higher almost every day. There is no shortage of market experts saying this is all justified, and it will go even higher! I don't pretend to know more than any of them but let’s not fool ourselves as well, this has also been the case in 100% of previous bubbles.

SO HOW DO I KNOW WHAT’S MOST LIKELY TO OCCUR?

You won’t, that’s the hard truth and precisely why we then need to rely on facts, then gauge how those facts affect our decision-making process, and likely our emotions. Of course, nobody can predict the future but sometimes looking at past similar situations is instructive of not necessarily what will happen but how does today compare to past events. If we agree that humans and their way of thinking hasn’t changed much in the last 100 years, then let’s look at how did we react in similar situations where the market kept climbing relentlessly. To put current valuations of the stock market in perspective, I look at the level of the market vs the total economic output (see chart below). Again, this is not a predictor of any future event, but it shows how far are we from a historical average in valuing companies on the stock market. The facts are that in the last roughly 100 years, only 2 times (in 1929 and 2001) have we been in situation like today where we are at 3 standard deviations above the average valuation.?

When you are 3 standard deviations above an average, it means you are in the 1% chance event.?Looked at the other way, it means that there is a 99% probability that the market is overvalued by historical standards. Of course, the next question that ALWAYS comes is: What if we are not in a historical pattern? What if this time it’s different? Maybe it is, but am I ready to accept that based on a 1% chance? This is the big question!!!

How does FEAR affect your portfolio?

There are basically two fears in the investment world, the fear of loss and the fear of missing out (FOMO).

The fear of loss is what will get investors very safe (sometimes too safe) in their investments. But if that fear gets the investor to reach its objective no matter what, the consequences are usually not very grave. Always better to be safe than sorry. Is there such thing as being too conservative when you still reach your objectives? If that fear is too present and makes the investor having no return when a return is needed to fund future living, then yes we have a problem. We don't see this too often as the prudent investors tend to be the ones that have sufficient wealth to fund all their needs for their lifetime.

The flipside of fear of loss is the fear of missing out. The current period is very much dominated by FOMO where we see all kinds of people diving into a situation just because others are doing it and they believe they will miss out on something. We see this in the stock market, in crypto currencies, but also in houses, bikes, RV’s, etc., etc. This fear is VERY powerful because nobody wants to be less than the other. But this fear of missing out is also the strongest force in creating immense bubbles. People end up following others without any real personal reason.

And for whatever deep routed emotion we have, getting consciously out of this FOMO is surprisingly difficult. I don’t pretend to be immune to any of this but the way I personally deal with the FOMO emotion?is to go back to hard facts about the situation. I look at facts as in the chart above and put that into perspective and I look at my fear of missing out and ask myself, do I really need to take that risk? Can I do something different? Can I invest somewhere else?

How does GREED affect your portfolio?

Fear of missing out will get you buying into an overextended market of any kind. Greed will prevent you from getting out! In 2000, my father had some shares in Nortel and he got greedy on the way up, at 60$, 80$, 100$ and 120$ and decided to hold on to them because of the tax hit he would take in seeling them. Well he was greedy too all the way down and NEVER sold them all the way to 0$. Yes he did not pay taxes on that profit!!! But I remember discussing with him and difficult if was for him to let go and accept a GOOD profit, maybe not the BEST profit. His greed in that decision ended up costing him a significant amount of money and I could see how powerful this emotions was to him but also to most of us.

Because in the end, if we know there is a high degree of risk in an investment and we keep the position it’s often because we are greedy. This one is tricky and quite honestly not easy to do. We always say in the investment world that buying a position is always very easy because you obviously know the price when you buy it. Selling is the HARD decision but also where all the money is made. Buying at a price and selling higher is what we all want but you have to make that decision to sell to make that a reality.

There are basically two ways to avoid being overtaken by greed and making the sell or exit decision.:

1. Have an objective on a position and exiting when that objective is realized. This tends to be much more difficult than we would think because we change the objective as the price goes higher.
2. Put the price in context with something like other companies, other periods in time, some kind of neutral fact. Just like in the chart above, put the current valuation in relation to historical events. As we have said, it's does not guarantee any future outcome but it helps in quantifying the risk versus the objective.

To summarize:

• Fear is ultimately what gets you buying a position that you would normally avoid (getting in).
• Greed is what will keep you holding on too long to something you should let go of (getting out).

This is where real money is made though. The best investors don’t let themselves be overtaken by fear or greed.?

From my own experience, it’s almost impossible to overcome fear or greed on the simple basis of perceived sound judgement. You need something like a team, collaborative thinking, hard fact-based factors or any system that will ponder all facts and possible outcomes to formulate a BETTER decision, not the BEST decision. The best decision is always known looking backwards. The better decision takes into account factors that can be very personal and/or emotional but will be aligned with YOUR GOALS.

Known and unknown VS GOALS

In any system that measures something to gauge if it was successful or not, there?needs to be a set of goals against which outcomes are measured. If there are no goals, no objective or destination, how can we know if what we did or where we are is on track?

The conclusion of the previous section is that emotions (fear and greed) are driving a lot of our investment decisions, and this is even more pronounced in periods of higher stress like we are in now, with Covid, high debts, etc. On top of this, no one really knows what’s coming next. It is hard to position yourself between the known, which is the past with all its historical statistics, and the unknown, i.e. the future. Two things come to mind then:

1. The future is very often a repeat of historical events or patterns. Many studies have proven this, and the simple fact is that we humans don’t easily change our habits. We tend to make the same decisions, based on the same emotions, facing similar events. We never know if things will be different looking forward, but the best tool we have is looking at what happened before in similar situations to what we are in. This comes back to what I eluded earlier about the fact that we are in an environment that historically says stock markets appear overvalued based on the ratio of the GDP to the S&P 500 at a 99% probability.
2. Since we don’t and never will know for sure what is next, the only way to attain our investment goals is …well to have goals… and set limits on the risks we CAN and CANNOT tolerate regarding those goals.

Goals based planning and investment decision making.

This may seem trivial and almost too obvious but knowing precisely what you want to do with your wealth, portfolio, or investments is critically important. It will get most people out of major pitfalls like a bubble bursting, chasing stocks too high, missing a rally or keeping dead ducks in your portfolio. This is what goals-based planning and investment is all about:

1. Define and state your goals clearly and make a plan
2. Set clear boundaries on what is acceptable and not acceptable on the upside and downside
3. Redefine your goals and the plan as your life situation evolves
4. Religiously stick to the plan.

There is no magic here, but this is what pension funds and large institutional investors do all the time because they have accepted the fact that they CANNOT predict the future. They instead control risk by making a plan and they stick to it until the plan changes. This is the main reason they consistently outperform individual investors over the long term.

But like any successful strategic business plan, if it stays in a drawer it won’t be of much help to anyone.

What to do in times like these? It’s all personal!

In the end, nobody knows what the next year or the next decade will bring for the economy and financial markets. We urge you to be very skeptical of anyone who says otherwise. The hard fact is, stock market direction in the short term is simply random. ?Your wealth and your portfolio are yours and yours alone, so it absolutely needs to be managed according to YOUR GOALS and not anybody else’s. Yes, it’s all personal and no one has the same tolerance to risk and to loss.

This is why your investment goals need to be about YOU. Because in the end, setting goals, making a plan and sticking to it no matter what (including FOMO generated by potential bubbles) is to be disciplined and not fooling our own worst enemy, i.e. ourselves.

Taking the necessary time to truly understand what you want with your wealth and the risks you can and cannot tolerate will necessarily provide a better decision-making framework and process. When the goal is important to the owner of the wealth, it becomes the driving force behind all decisions. Just like for a pension fund that HAS to fund those future pensions from the assets they have today. They can’t decide to stop paying those pensions when markets are tough. In the end, they plan accordingly and the ones that do it well survive all market conditionss and are able fulfill their goals.

Conclusion

In this article we discuss something that we all experience daily, how to make better decisions when facing facts and hard emotions (fear and greed). From experience and research, we find that there is only one way to make better decisions. It is to have a system that looks at a set of facts, their probability of occurring, and putting that against very personal goals and our tolerance in attaining them or not. In our world of wealth management this is called GOALS BASED investment planning. When you begin with your goals in mind and then build your portfolio around them, taking your risk tolerance into consideration, you will have removed much of those sensitive emotions that can undermine your and your family’s financial future.

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Christian Gagnon

Chief Investment Officer

NCP Capital Partners

[email protected]

This commentary is provided for information purposes only.?All opinions and estimates contained in this report constitute NCP’s judgment as of the time of writing and are provided in good faith.?All data, facts, and opinions presented in this document may change without notification.?No use on NCP Capital Partners’ (NCP) name or any information contained in this report may be copied or redistributed without the prior written consent of NCP.