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Gordon Pape has put his finger on why many people get burned when they invest. In his new book, Sleep-Easy Investing (Viking Canada, 2008), he recounts how investors let their emotions get the better of them. He should know: he has been talking and listening to investors ever since his first investing book, Building Wealth, was published in 1988.
People may read an investing book that tells them they can get an average 9% per year if they only buy and hold stocks over the long term. This is a legitimate claim going by the historical record in North America. Stock markets do go down at times, but as long as investors stay the course, they will be around for the upturn and in the game to earn 9% annually over time.
So they take the leap. However, when the market does crater, the actual experience turns out to be a lot different than reading about it in a book. Newspaper headlines are full of doom and gloom. The permabears get more air time and their theories of cataclysmic decline begin to look more plausible. And so on: it’s truly a scary time, one that can even produce insomnia for some investors — and waves of selling.
Pape’s book offers one way to remain composed as an investor and that is to stick to securities with low volatility, and to choose conservative asset allocations. That works well, although it entails sacrificing the higher returns possible from investing.
An alternative is for the investor to prepare themselves mentally to handle the ups and downs of the stock market. This is what many financial advisors say is their main role — to help investors cope with the fluctuations. If an investor has a good advisor, they will be getting pep talks along with studies/graphs showing it is best not to capitulate to panic and fear.
Investors without advisors (or good ones) need to take responsibility for their own mental preparation. This is where some understanding of psychology comes in handy. For example, visualization techniques might be used whereby the investor pictures the reoccurrence of an episode like the summer of 2002 when stock markets plunged by nearly 30%. Then they need to think about and/or rehearse what they will do when it happens (e.g. keep mind off stocks by getting busy with work or home projects).
The visualization will be more effective the more vivid it is. To this end, an investor should read accounts of stock market downturns to get the details fresh in their mind, and then post a clipping or two in a place where they will get a reminder. I see professional investors doing this, many of whom also add some quote or aphorism that advises what to do when panic and fear reigns (e.g. Warren Buffett’s prescription is to be greedy when others are fearful and fearful when others are greedy).
There is more that can be done to become an investor in control of their emotions. In fact, some enterprising financial advisor, journalist or self-publishing type could probably write a good book on this topic. It would help fill a gap in the investment book genre, I believe. Plenty of investment books have dealt with the intellectual side of investing, but relatively few have covered the emotional side.
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