“Your intellect may be confused, but your emotions will never lie to you” – Roger Ebert
A spectre is haunting the world of investing. A ghost of Christmas past. A 13,000 pound African bush elephant squat squarely in all of our minds. That unavoidable, unassailable, metaphorical large gray mammal is human emotion.
There’s no doubt that emotions get a bad rap in the investment world. To many investors, an emotional trader may seem weak, incapable of rational decision, and doomed to failure. However, the more experienced trader views him in a different light. This blog is built around the fundamental principle that humans, and all human activity, are inherently emotional. To deny such realities is to deny one’s own humanity, and as such, the reader is invited to open their minds to new ideas whilst putting aside the traditional indoctrination prevalent in the worlds of trading, investing, and finance. Throughout this blog, such concepts will be used interchangeably, but given the universal humanity at the core of these activities, the fundamental lessons remain unchanged. You, the reader, are invited to embrace the exciting world of emotional investing.
So what is emotional investing? Well, it would be easier to first describe what it decidedly is not. Emotional investing is decidedly not a list of redundant, complicated, and confusing investment principles. Emotional investing is decidedly not an excel spreadsheet fitting a model to historical data. Emotional investing is decidedly not the topographical cartography utilized by the snake oil sales-purveyors of technical analysis trading.
Emotional investing is like a warm slice of apple pie under the dew kissed light of a magnificent sunrise. Emotional investing is like the aromas of said pie which waft up towards the rising star. Emotional investing is like those wisps of delicacy coalescing and culminating into a phantasmagorical, euphoric, exquisite, culinary experience. But even such dialogue can only scratch the surface, like a copper nail on a steel anvil, merely espousing what it is like to be an emotional investor but never quite explaining what it is. For emotional investing is a state of mind that words fail to describe and artists can only dream of capturing.
So how then can the novice – or even the most experienced of traders learn the principles of emotional investing? While many of the questions posed in this blog will have simple answers, this question shall linger on like a particularly persistent rash. It is safe to say that a single pass, or even multiple cursory passes, through this blog will yield little benefit. The lessons contained within must be ruminated, forgotten, re-read, and then re-experienced firsthand for the full impact of their implications to sink in. As will be discussed in later articles, these lessons are forged by the hammer of time, and while universal, take patience and thoughtful diligence to settle.
A couple of self-evident examples of emotional trading in finance include the clientele and signaling effects. These theories are widely accepting in the world of investing, and will serve as the basis of our journey. We’ll start by describing the former before the latter. The clientele effect, in it’s simplest form, refers to the impact that subjective changes in a security’s underlying policies have on said security’s underlying price. Suppose, for instance, if Colgate Palmolive (NYSE: CL) were to suddenly announce a new line of cat-litter flavored dog food during their Q1 Conference Call – we dog lovers know the… unique palate of our canine partners quite well – it may be subject to the clientele effect should excited canine owners decide to buy more shares in fur-tastic support, while cat lovers everywhere sell in petulant protest. You can see that this effect is clearly the result of an emotional reaction! For you see, some investors may choose to only invest in stocks that are related to the noble task of better nourishing our canine compatriots, while others may seek to only invest in companies that seek to respect the feline foe. The clientele effect can thus explain why a certain company or business line may attract a particular investor (cat or dog lover) in the first place. It is obvious then, that the widely accepted clientele effect involves an emotional reaction based on the personal beliefs and preferences an investor may have, and that in this way, stocks may “trigger” investors, causing emotional price corrections.
Now let us explore the second financial theory grounded in human emotion, signaling theory. This theory posits that increases in dividend payouts indicates positive future prospects for a company. Although many economists detest this theory, market data continues to prove it correct. James Poterba and Lawrence Summers of MIT explored and documented the signaling theory in the early 1980’s and came to a startling conclusion. Empirical market data showed that positive market signaling correlated with stock price appreciation, while negative market signaling correlated with stock price depreciation. The proof is in the pudding and the pudding shows that given the empirical reality of signaling theory, two identical companies may be priced differently simply because of what they are conveying to investors. In the more traditional view of the market, this should not be possible! Market signaling should not drive share prices in any manner. The continued vindication of signaling theory leads to the obvious conclusion that markets are not efficient, securities are not accurately priced, and emotions reign supreme.