Fear vs Rationality: The key to investor success (Part 1)
The stock market awakens a dangerous emotion in all of us: Fear. It is sitting dormant in most investors, awaiting an excuse to wake up and rear its ugly head. When stocks are going up, investors find themselves engulfed in the fear of missing out (humankind even invented an acronym for this – FOMO). When we are consumed by FOMO our investment time horizon magically expands. In these good market times, investors delude themselves into believing that they are long-term investors with an infinite risk appetite. Risk of decline, you ask? Investors thump their chests and proclaim “bring it on!”
And once the market actually does decline, a very different fear surfaces and rattles the investor’s confidence – the fear of loss. The investor’s previous self-proclaimed invincibility in the preceding FOMO moment melts away like ice cubes in the Sahara desert once the fear of loss creeps into the investor’s thoughts. Our investor-hero’s chest collapses, and so does the time horizon, shrinking from years/decades to months, days, or even minutes.
These two fears interfere with successful investing and are detrimental to rational decisions of every investor. The more you are dominated by these fears, the less rational you are. Think of the total skill set of an investor as a multivariate equation in which all your skills are combined: the skill to understand and apply macro- and microeconomics, to understand the academic underpinnings of portfolio structures, to be an independent and creative thinker, etc. And then that grand sum of all of your combined cognitive skills must be multiplied by your ability to remain rational. Think of your ability to remain rational as a number between 0 and 1. If you are totally rational, you are a perfect 1. If you let the fear generated by the last tick of the market seep into your investment process and into your decision making, then it won’t really matter what the sum of your other cognitive skills really is. That sum will be multiplied by a big fat zero, and thus your total skill level as an investor will be exactly that – ZERO. You’ll be doing what the average investor does – buying high and selling low. Thus, rationality is one of the most important qualities you as an investor must strive for. Recent market volatility – a financial euphemism for when the market doesn’t only go up but also declines – makes the rationality discussion even more pressing at this very moment. Staying rational is a very proactive, not a reactive, journey. Smart investors deliberately structure their lives and design their investment process in a way to protect themselves from the fear-inducing toxicity of the daily market gyrations. The more you let the stock market into your life unguarded, the more room you create for fear – and the more your rationality slips from one toward zero. In our next blog article we will discuss strategies how to mitigate or even eliminate fear, both FOMO as well as the fear of loss and how to maximize your own investment rationality.